Lecture 16: Review • Mundell-Fleming • AD-AS------Mundell-Fleming IS : Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*, Ee / (1+i-i*)) i IS LM Interest parity YE eE = E 1+i-i* * Fiscal and Monetary policyFixed Exchange Rates (Credible) - A little bit of it even in “flexible” exchange rates systems; “commitment” to E rather than M => i = i* => M = YL(i*) P - Central Bank gives up monetary policyi Interest parity i* IS LM YE - Fiscal and Monetary policy - Capital controls; imperfect capital flowsExchange Rate Crises i IS LM i* YE Note: There is a shift in the IS as well… but this is small, especially in the short runBuilding the Aggregate Supply • The labor market • Simple markup pricing • Long run (Natural rate: Aggregate demand factors don’t matter for Y) • Short run – Impact: Same as before but P also change (partial) – Dynamics (go toward Natural rate)Wage Determination • Bargaining and efficiency wages W = e P F(u,z) Real wages Bargaining power Unemployment insurance Nominal wage setting Fear of unemployment Hiring rate (reallocation) BargainingPrice Determination • Production function (simple) Y = N => P = (1+µ) WThe Natural Rate of Unemployment e• “Long Run” P = P • The wage and price setting relationships: W = F(u,z) P P = 1+ µ W => The natural rate of unemployment F(u,z) = 1 1+ µW/P 1 Price setting 1+ µ Wage setting u Unemployment n z, markupFrom u to Y nn u = U = L - N = 1 - N = 1 - Y L L L L F(1 - Y /L, z) = 1 n 1+ µW/P Wage setting 1 Price setting 1+ µ YYn z, markupAggregate Supply eW = P F(1-Y/L,z) P = (1+ µ) W => eP = P (1+ µ) F(1-Y/L,z)eP = P (1+ µ) F(1-Y/L,z) ASP eP YYni Aggregate Demand IS: Y = C(Y-T) + I(Y,i) + G LM: M = Y L(i) P LM’ [ P’ > P] LM YAD: Y = Y(M/P, G, T) + + -P AD YAD-AS: Canonical Shocks P AD AS YnY Monetary expansion; fiscal expansion; oil shockFrom AS to the Phillips Curve * The price level vs The inflation rate e P(t) = P (t) (1+ µ) F(u(t), z) Note that: P(t)/P(t-1) = 1 + (P(t)-P(t-1))/P(t-1) e e P(t)/P(t-1) = 1 + (P(t)-P(t-1))/P(t-1) Let π(t) = (P(t)-P(t-1))/P(t-1)•Then (1+π(t)) = (1+πe(t)) (1+ µ) F(u(t), z) but ln(1+x) ≈ x if x is “small” Let also assume that ln(F(u(t), z)) = z – αu(t)The Phillips Curve * The price level vs The inflation rate eP(t) = P (t) (1+ µ) F(u(t), z) ≈> eπ(t) = π (t) + (µ+z) - α u(t)The Phillips Curve and The Natural Rate of Unemployment π e(t) = π (t) => u = (µ+z) n α eπ(t) = π (t) - α (u(t) - u )
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