Macroeconomics for
Decision Making
MODULE 4
RMIT Classification: Trusted
Labour Market
RMIT Classification: Trusted
The Labour Market
Through the workings of the supply of labour and
demand for labour, the levels of employment and
the representative equilibrium wage rate is
determined.
The labour market as presented, can be understood
in terms of a representative model (in reality there
are many distinct labour markets).
Supply of labour: Quantity of labour provided by
households at various wage rates.
Demand for labour: Quantity of labour hired by
firms at various wage rates.
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Real Wage Rate
Real wage = nominal wage/overall price level = w/p
To calculate real wages, we divide the nominal
wage rate by the CPI and multiply by 100.
Real wage is the amount of purchasing power that
each worker receives and which the firm pays for
each unit of labour.
The wage rate can be viewed as the opportunity
cost of leisure.
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RMIT Classification: Trusted
Supply of Labour
The real wage rate
Real wage
determines the quantity of
labour supplied.
SL
Other determinants of labour
supply include: w0
p0
• social attitudes towards
work and leisure
• number of workers with N0 Labour
the required skills.
Changes in any of these other determinants will
cause a shift in the supply curve for labour.
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Demand for Labour
Output
Production
Firm decides on the benefits of 200 Function
hiring an extra worker by 174
144
looking at labour productivity.
100
A short-run Production
function shows how much
output a firm can produce
given various amounts of 1 2 3 4 5 6 Labour
labour.
Real wage
Most production functions
have the property of
diminishing marginal product.
The greater the number of w0
p0
workers used in producing
output, the less additional DL
output that comes from each N0 Labour
additional worker. 6
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Shifts in Demand for
Labour Output Production
Function 1
200
Production
Technological improvements 180 Function 0
increase the marginal
productivity of labour.
The production function
pivots upwards, indicating 5 Labour
higher productivity.
Real wage
Increased productivity shifts
the labour demand curve
rightward. w0
p0
Changes in other productive DL1
factors also shift the labour DL0
demand curve. N0 Labour
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Labour Market Equilibrium
In a perfectly competitive labour market, the wage
rate and level of employment is determined by the
intersection of the demand and supply curves.
Real wage Real wage
SL SL
w0
w0 p0
p0
DL DL
N0 Labour Labour
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Causes of Unemployment
When wages are set above their market-
clearing level:
• Minimum wage laws
• Unions and collective bargaining: Prevent downward wage
flexibility
• Efficiency wages: Firms may make higher profits by paying
above market-clearing wage rates (link between wages and
worker effort, worker quality and company turnover)
Government Policies that influence the
incentive to work:
• Job network & unemployment benefits and unemployment
insurance
Deficiency in Aggregate Demand:
• Cyclical unemployment
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Exchange Rate Market
RMIT Classification: Trusted
The Exchange Rate
The foreign exchange rate is the amount of one nation’s money that can
be obtained in exchange for a unit of another nation’s money.
Units of foreign currency per domestic dollar.
Example: e = 0.62€/$ = Value of the Dollar
If the e increases, we are receiving more foreign currency per dollar,
the dollar has appreciated.
Units of domestic dollars per unit of foreign currency.
Example: $1.62/€ = Value of the dollar/foreign currency
If the e increases, we are paying more dollars to receive one unit of foreign
currency, the dollar has depreciated.
The dollar is said to appreciate (depreciate) if the value of the
dollar rises (falls) relative to another currency.
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Demand and Supply of SGD
• Importing: • Exporting
– Demand for foreign currency. – Supply of foreign currency.
– Supply of SGD. – Demand for SGD.
• THUS:
– Depreciation e↓ EX↑ and IM↓ Quantity SGD demanded
increases & Quantity of SGD supplied falls.
Negative relationship between e quantity demanded
Positive relationship between e quantity supplied
– Appreciation e↑ EX↓ and IM↑ Quantity SGD demanded
decreases & Quantity of SGD supplied increases.
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RMIT Classification: Trusted
Exchange Rate Market
To buy Singaporean goods and services Singaporean
Why do people exports lead to D$↑
want Singapore To buy Singaporean-denominated financial assets
dollars? capital inflows lead to D$↑
For the convenience and of holding SGD D$↑
To buy foreign currencies to buy foreign goods
Why do people Singapore imports lead to S$↑
sell Singapore To buy foreign currencies to buy foreign $-
dollars? denominated financial assets
capital outflows lead to S$↑
What Price elasticity of foreign demand for Singaporean X
determines D$ slope
slopes of D$ Price elasticity of Singaporean demand for (foreign) M
and S$? S$ slope
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Exchange Rate Market
Exchange rate
SSGD0
SSGD1
e0
e1
DSGD
Q0 Q1 Quantity
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Economic
Consequences: Tariffs
A tariff is simply a Exchange rate
tax placed on the SSGD1
imported good. A
tariff increase the
SSGD0
price of the e1
imported good by
e0
the amount of the
tariff allowing
domestic DSGD
producers of the
Q1 Q0 Quantit
good to raise their
price above the
free trade price.
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Why Tariffs?
Proponents of tariffs often provide the following
narratives:
• Domestic Employment Argument
• Infant Industry Argument
• Cheap Labour Argument
• Improvement of Trade Balance
Political Motivation
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Exchange Rate Systems
In a (pure) flexible exchange rate system, the
foreign exchange rate is free to change every day in
order to establish an equilibrium between QS and
QD of a nation’s currency
In a fixed exchange rate system, the foreign
exchange rate is fixed for long periods of time
• Under a fixed exchange rate system, an increase
(decrease) in the value of the currency is known
as a revaluation (devaluation)
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How Governments Can
Affect Exchange Rates
To prevent its currency from being too
strong, or equivalently, to make its currency
more competitive, a country’s central bank
can sell the home currency (and
simultaneously buy foreign $)
To prevent its currency from falling in value,
or equivalently, to protect its currency, a
country’s central bank can would buy the
home currency (and simultaneously sell
foreign $)
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The Real Exchange Rate and
Purchasing Power Parity
RMIT Classification: Trusted
The Real Exchange Rate
The real exchange rate depends on the
nominal exchange rate (e’) and the prices
of goods in the two countries measured in
local currencies.
𝑷
𝑹𝑬 = 𝒆 × 𝒇
𝑷
where P = home price level and Pf = foreign price
level
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RMIT Classification: Trusted
The Law of One Price
Purchasing power parity (PPP): the prices of
identical goods should be the same in all
countries, differing only by the cost of transport
and any import duties.
Why?
If the law of one price did not hold, there would be
unexploited profit opportunities – arbitrage.
Arbitrage is the process of taking advantage of
price differentials between countries.
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Purchasing Power Parity
If purchasing power is the same at home
and overseas, the real exchange rate
should be constant: RE = 1
𝑷
𝟏=𝒆 × 𝒇
𝑷
Rearranging for e
𝒇
𝑷
𝒆=
𝑷
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PPP and Inflation
• PPP can also be expressed in terms of growth
rates:
• growth rate of the nominal exchange rate =
growth rate of the foreign price level – growth
rate of the domestic price level
∆𝒆 𝒇
=𝒑 − 𝒑
𝒆
• The term pf – p is the inflation differential
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Does PPP Always Hold?
The law of one price does not hold for non-
tradeables
The law of one price can break down for a number
of reasons:
• New technology/innovation other countries want
• Discovery of new raw materials wanted by other
countries
• Movement of money between countries to avoid
tax or as a result of criminal activity
• Government intervention.
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RMIT Classification: Trusted
Product Market
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Aggregate Demand
Aggregate Demand
AD = C+I+G+NX = AE shows the amounts of
goods and services
Price (RGDP) that will be
level purchased at any given
price level.
A decrease in the price
level increases the
AD
value of money
RGDP
because each dollar
you have buys more
and vice versa.
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RMIT Classification: Trusted
Aggregate Demand Slope
Changes in the price level, with other
Wealth things remaining the same, change
Effect real wealth, thus changing the level of
spending.
Higher prices requires more money for
Interest- purchases. Higher interest rates
Rate discourages business investment and
Effect reduces consumption expenditure on
consumer durables.
Foreign Higher prices causes consumers to
Purchases/ spend less on domestically produced
International goods and services and more on
Trade Effect imported goods and services.
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Demand Shocks – Shifts of AD
A demand shock is a significant
change in desired spending.
Investment
Consumption Spending: the Government
Expenditure: purchase of capital Spending:
Expenditures goods - plant and Conduct of
External
by households equipment, fiscal policy:
Sector:
on durable residential changes in
(Export -
goods, non- structures, and government
Imports) = Net
durable changes in purchases of
Exports
consumer inventory - that can goods and
goods, and on be used in the services and
services. production of other taxation.
goods and services.
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RMIT Classification: Trusted
Aggregate Supply
Price
The Short-Run Aggregate level
SRAS
Supply (SRAS) shows the
relationship in the short-run
between the price level and
the quantity of real GDP
supplied by firms.
RGDP
The Long-Run Aggregate Price LRAS
Supply (LRAS) curve level
shows the amount that
business firms are willing to
produce when the nominal
wage rate has fully
adjusted to any changes in
RGDP
the price level.
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RMIT Classification: Trusted
Aggregate Supply Slope
The SRAS is upward sloping, showing that in the
short-run firms will produce more in response to
higher prices. The reason for this is that the price of
inputs tends to rise more slowly than the price of
final products due to wage and price rigidities and
misperceptions.
• Nominal Wages Rigidities
• Sticky Prices
• Misperceptions
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Shifts of the SRAS Curve
The variables that shift the SRAS curve include:
1. Change in input prices
2. Expected changes in the future price level.
3. Adjustments of workers and firms to errors in
past expectations about the price level.
4. Plus any factor that shifts the LRAS curve.
Note: Factors 1-3 shift only the SRAS curve not the
LRAS curve
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Movement Along vs
Shifts
Price SRAS1 (W1)
level
SRAS0 (W0)
B’ C
Y2
B
Y1
A
Y0
Y0 Y1 Y2 RGDP (Y)
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RMIT Classification: Trusted
Shifts of the LRAS Curve
Shifts in the long-run aggregate supply curve occur because
potential GDP increases over time. Anything that shifts the
LRAS also shifts the SRAS.
Increases in GDP (or economic growth) which shift the LRAS
are due to:
1. An increase in resources.
2. An increase in the capital stock.
3. New technology
4. Changes in government policy (Incentives to work and
invest)
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RMIT Classification: Trusted
Macroeconomic Equilibrium
Price Level LRAS
SRAS
Price Level
LRAS
SRAS
P0
AD
Output gap/GDP gap
RGDP
Y0 YN
P0 Price Level LRAS
SRAS
AD
RGDP
YN P0
AD
Output gap/GDP gap
RGDP
YN Y0
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Macroeconomics for
Decision Making
WORKSHOP 4
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Solve Problems & Assess
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Questions & Answer Session