Role of Interest Rate in the Aggregate Supply, Classical Model - Assignment Example

1/ With reference to the basic Keynesian model, explain how a specific change in income will restore equilibrium following a fall in investment spending. Outline what would occur in the labor market with respect to wages and employment. Keynesian Model Lets have a brief look at the Keynesian aggregate supply and demand curve before going into the details of the question. Aggregate supply curve is horizontal indicating that firms will supply whatever amount of goods is demanded at the existing price level. Aggregate demand curve would show the level of output at the given price level at which goods and money market are in equilibrium. Given below is the diagram showing a horizontal aggregate supply curve in Keynesian Model. Change in income If there is a decrease in income, the reasons are assigned to decrease in government spending, increase in taxes or decrease in money supply and so on. The change in income leads to changes in a number of things out of which fall in demand is one of them. Aggregate demand depends on real money supply. The real money supply is the value of money provided by the central bank and the banking system. If we write the number of dollars in the money supply as M' and the price level as P, we can write the real money supply as M'/P. When M'/P falls, interest rates increase and therefore the investment falls, leading overall aggregate demand to fall as well. When there is a fall in demand we need less output to cater the market, this is another reason for fall in investment, and an increase in unemployment as well. This was a briefing of how things would change with a decrease in income. The below given diagram shows AD as the aggregate demand before the reduction in income with E as the equilibrium. Once the demand decreases due to above-mentioned reasons another line AD' is formed showing the current level of demand at the given price level. We get a new equilibrium E' which depicts that once the demand has decreased we are producing less output at a higher price and then the price would consequently affect the wages of the employees. When we talk of wage we know that the labor market involves long-term relations between the firms and the market. Normally the wages are adjusted once a year. Wages are normally set in nominal terms. Now consider how wages adjust when the demand for labor decreases and firms do not need any over times. In the short run when the demand decreases workers are being paid more as compared to the output produced. The employer would want to reduce the wage expense. Change in wages is a slow process hence the employer will have to look for an alternative like looking for those employees who would be willing to work at a lower wage. This would increase some of unemployment. The employer has to be very careful in setting the wage through negotiations with the employee to consider the morale of the employee. If there is an overall decrease in demand then hiring new labor force may not be difficult, but if only one employer's demand of output has decreased then the employer may have to pay higher wage in order to keep the employees attracted to their current job. The Keynesian theory believes that, the employment offered by firms depends on the demand for their output, workers would be unemployed if the output produced exceeds the demand of the products excessively. Which would mean too much of unnecessary labor force. As such, demand-deficient unemployment is not caused by labor insisting on a wage incompatible with full employment. Since that unemployment is not the fault of the workers, but is due to factors beyond their control, it may be termed 'involuntary unemployment'. Labor market is not depended on the rate of real wages but infact on the quantity of output required. Therefore wage does not have much to do with unemployment. When the aggregate expenditure equals to AD', the equilibrium level of income is established at Y', which happens to be lower than Yf (full employment). Referring to the production function diagram [sector (b)] we see that output requires for its production employment ON'. Taking that level of employment to the labour market [section (c)], it is evident that when ON' is the quantity of labour demanded by employers a margin of unemployment N'Nf exists. N'Nf is demand-deficient or involuntary unemployment. The size of the gap - if any exists - between full employment and actual employment depends on the position of the aggregate demand function in the commodities market. If AD' shifts to ADf, production will increase to Yf and employment will rise to ONf. It is evident that the going level of employment in the labour market need not correspond, to the point of intersection of the MPN and Ns curves. In Keynesian terms, the demand for labour is in fact given in the labour market by the position of the vertical line from the production function which indicates how much labour is needed to produce the amount of output currently demanded. The real wage would correspond to the marginal product of whatever quantity of labour was employed to meet the current volume of demand for output. This interpretation implied that, as demand for output varied, and the vertical labour demand curve correspondingly moved to left or right, real wages would necessarily rise or fall, giving an inverse relationship between the level of real wages and the volume of employment. We conclude that if the real wage rose when employment fell (and vice versa), the increase in wages was to be understood as an incidental (and automatically occurring) side-effect of the fall in activity, not the cause. (The rise in real wages in these circumstances was explained as due to money wages being sticky relative to falling commodity prices. Furthermore, it was doubted that a fall in money wages with prices would actually be of much help: that could be beneficial only in the unlikely event that a falling price level had a positive effect on planned aggregate demand.) Output/ Output/ Income Income ADf AD' Yf Yf PF 2 2 Y' Y' (a) (b) 45 1 3 Aggregate demand O N' Nf Employment Real wage Ns THE KEYNESIAN 3 (c) MODEL [Note: when the Keynesian model is updated to take account of Keynes's (1939) recognition that no inverse relationship, as predicted by neoclassical theory, in fact exists between MPN employment and real wages, the 'MPN schedule' would be Involuntary unemployment drawn as a horizontal line at the going rate of real wages.] O N' Nf Employment 2/ Derive the 'Classical' aggregate supply curve and set out what would happen to aggregate supply, real wages and employment if there were a sudden influx of migrant workers. Outline the role that the rate of interest plays in the Classical Model. Lets have a brief look at the Classical aggregate supply and demand curve. The aggregate supply curve is vertical, indicating that the same amount of goods will be supplied what ever the price level. The Classical supply curve is based on the assumption that the labor market is in the equilibrium with full employment of the labor force. We call this level of output corresponding to full employment of the labor force potential GDP, Y*. Potential GDP grows over time as the economy accumulates resources and technology increases or even if migrant workers come. Now the question is that with the influx of migrant workers, how are aggregate supply, real wage and employment affected. Lets discuss few facts about migrant workers. The issue of the economic repercussions of migration prompts intense debate and widespread controversy in various sectors. Different groups use this topic as the basis for arguments to justify measures designed either to stimulate or to control migration flows. Sectors in favor of immigration, for instance, hold that states should encourage it because it increases productivity and has a positive impact on the economic growth of countries. It is the groups that are against immigration, however, who most often cite economic repercussions as an argument to restrict migration. These sectors maintain that immigration has adverse effects on the economy and that, therefore, it is necessary to restrict it. The most common argument ventured by these groups is that immigration generates unemployment, lowers wages, overburdens state social services, and in general negatively impacts productivity in the country. These sectors particularly express their concerns during negative cycles characterized by economic contraction. Likewise, in migrant-supplier countries the question of whether emigration produces positive or negative effects for the economy leads to heated discussion among different groups. Pro-emigration groups highlight the importance of remittances sent by emigrants, while anti-emigration groups stress that it saps countries of their most qualified people and generates economic dependence. Unquestionably, one of the most commonly recurring arguments regarding the economic effects of migration is that it has a negative impact on employment and wages in receiving countries. Accordingly, immigration can negatively affect the employment situation and workers' wages in the receiving country. The logic of this argument is as follows: when migrant workers immigrate to a country, they enter into direct competition for jobs with local workers. As migrant workers are very often willing to accept inferior employment conditions (in other words, lower wages, no social security, and no union rights) employers prefer them because in this way they can reduce their operating costs and thereby increase profit margins. In practice, the effect of this is for migrant workers to displace the workers of the receiving country. Thus they increase unemployment, negatively affect wage levels in the job market, or simultaneously cause both unemployment and lower wages. According to this outlook, migration is especially pernicious during recessive cycles or periods of economic slowdown. At the macroeconomic level, the influx of migrant workers has minor effects, whether negative or positive, on the employment rate and wages of local workers. First, unemployment and wages have to do with economic cycles and the structure of the economy, and not with population size or density. In other words, what really determines if the market will be able effectively to absorb the foreign labor force without it increasing unemployment and depressing wages is the economic structure and the skills of migrant workers and local workers, rather than their number. Secondly, immigrant workers are either highly educated and, therefore, occupy positions in the highest stratum of the labor market, for instance as doctors, lawyers, senior executives, officials of international agencies, and researchers, or, on the contrary, have a limited education and, therefore, aspire to jobs at the lowest level of the market, in certain services that do not require skilled labor, or else in construction or agriculture.Poorly educated migrant workers, by contrast, according to these authors, in general tend to compete for jobs with less qualified local workers who work in manufacturing, certain industrial sectors, or services. In other words, very often, migrant workers can take jobs away from the local population. Therefore, in terms of wages and employment, poorly qualified workers tend to be the most affected by the arrival of immigrants. Third, immigrants do not only occupy jobs, they also create them. For one thing, the presence of these people increases the overall level of consumption of both goods and services and, therefore generates sources of employment. As a result, around immigrant communities a vast network of services is created that provides employment for nationals and aliens alike. For another thing, workers with an enterprising spirit very often to set up their own businesses and companies that generate employment. Fourth, by doing certain domestic labors, in particular looking after children, they may indirectly help local workers to get a job. It is important to mention that the presence of migrant workers performing this work frees up the local, educated labor force, in particular women, who otherwise would be unable to look for a job. This is particularly true in countries where there are no state or subsidized programs for preschool child-care. Fifth, the presence of migrant workers prepared to accept low wages helps to keep afloat certain local companies that would otherwise be compelled to invest in technology to keep their production lines competitive. Thanks to the presence of migrant workers these companies are not forced to invest in technology, something that allows them to continue on the market and not get bankrupt. In this way, middle and senior management positions in these companies, normally held by local workers, are not lost. There are several reasons why immigration should contribute positively to economic growth. First, the arrival of immigrants generates more consumption and also helps to create economies of scale. Immigrants also contribute to saving, since, generally speaking, they have a strong marginal propensity to save. More importantly, immigration helps to increase economic efficiency and productivity as it enables transfer of workers from unproductive areas to productive sectors of the economy. One very graphic example is the arrival of female workers who take jobs as nannies or domestic servants, which enables women, many of them professionals, to go out and work. In addition, the arrival of immigrants helps to prevent production bottlenecks, as these people take jobs that, for a variety of reasons, the labor market cannot fill. We have concluded that the output is going to increase from Y* to Y** with the incoming of migrant workers but the overall employment rate of the receiving country would fall as the labor force would not be able to fill the places already taken by the migrants. The unemployment would lead to a decrease in demand from AD to AD'. The equilibrium would go from E to E' depicting that the output produce would be of lower price level. Role of Interest rate in the aggregate supply The interest rate over here would be more as people are saving more then investing. A decrease in interest rate would allow more investment to occur and more investment would mean more output produced. This output produced would move the aggregate supply curve to the right. References 1. Macroeconomics by Rudiger Dornbusch, Stanley Fischer and Richard Startz (9h edition), McGraw Hill, 2004, ISBN: 0071-123237-0 2. Microeconomics Laws of Demand and Supply. Retrieved March 25th, 2006, from http://mason.gmu.edu/tlidderd/104/ch3Lect.html#Microeconomic%20Demand%20and%20Supply 3. Microeconomics Laws of Demand and Supply. Retrieved March 25th, 2006, from http://mason.gmu.edu/tlidderd/104/ch3Lect.html#Shifts%20in%20Demand%20and%20Supply%20Curves Read More