The speed of adjustment

1
The speed of adjustment

• Adjustment in the Classical world is rapid, so
  the economy is always at potential output (full
  employment).
• If wages and prices are sluggish, then output may
  deviate from the potential level.
• A "Keynesian" world of fixed wages and prices may
  describe the short run period before adjustment
  is complete.

2
Long term job commitments

• From the firms point of view it is expensive to
  hire or fire workers
• firing means severance or redundancy payment,
• losing experienced workers causes a decrease in
  productivity
• hiring means advertising interviewing and
  training costs

3

• from the workers point of view looking for a new
  job is costly in
• time and effort
• loss income or high wages

4

• The firms labour input is the total number of
  labour hours it employs in a given period
• LI NWNH
• NW number of workers
• NH number of hours per worker

5
Firms response to a fall in Aggregate demand

• In the short run
• they try to decrease working hours
• lay off some of their workers
• A lay-off is a temporary separation of workers
  from the firm
• in the long run
• if firm perceives the demand fall as permanent
• it will fire some of the workers

6
During a boom

• In the short run
• get existing workers to work overtime
• then they may seek temporary workers to
  supplement the existing ones
• in the long run
• if firm is confident that the increase in sales
  is permanent
• it will hire new workers

7
Wage adjustments

• Wages are determined by a bargaining between
  firms and workers
• but bargaining is costly both to firms and
  workers
• so it is done at certain periods
• the macroeconomic consequence of that is ruling
  out immediate wage adjustments to demand
  fluctuations

8

• When there is a fall in demand
• firms may offer lower wages
• some workers can find jobs in other firms at the
  same wage rate
• the firm can hire new workers at a lower wage but
• new workers are not good substitutes for the
  experience workers gone to other firms

9

• long term co-operation between a firm and its
  workers is more important than short-term gains
  from forcing of wages down

10
Recap

• In the short run
• variations in labour input mostly take the from
  of change in hours or supplemented by lay-offs or
  recalls from lay-offs

11

• in the medium run
• if the change in labour demand persists
• firm begin to alter its permanent workforce
• rather than large overtime or short-time working
  which is too expensive

12

• In the long run
• adjustment becomes complete
• firm adjust to the new equilibrium hence clasical
  model is relevant
• in the short run
• wage rate are almost given
• there is a bit of flexibility as
• overtime rate may be a little higher then the
  negotiated wage rate or
• short time wage rate may be a bit less

13
Adjustment in the labour market
Medium run (1 year)
Long-run (4-6 years)
Short-run (3 months)
Clearing the labour market
Largely given
Beginning to adjust
WAGES
Demand- determined
Normal work week
HOURS
Hours/ employment mix adjusting
Full employment
Largely given
EMPLOYMENT
14
The short-run aggregate supply schedule
Suppose the economy is initially at Yp in
full- employment equilibrium at A, with wages W0
WW
Wage ratel
A
W0
Yp
Output
15
Short-run aggregate supply

• If adjustment is not instantaneous, output may
  diverge from Yp in the short run.
• Firms may vary labour input
• via hours of work (overtime or layoffs)
• Wages may be sluggish in falling to restore full
  employment in response to a fall in aggregate
  demand
• The short-run aggregate supply schedule shows the
  prices charged by firms at each output level,
  given the wages they pay.

16

• Labour costs are the major part of the cost of
  production
• Although there are other costs
• land, capital, raw materials
• we assume that these are fixed so the most
  important determinant of cost are wages

17

• Profit per unit P - total unit costs
• prices should cover all the costs and leave a
  reasonable profit
• so there is a direct relation between wages a
  firm pays to workers and the price it charges to
  the product
• as W?? P?

18
The short-run aggregate supply schedule
Suppose the economy is initially at Yp in
full- employment equilibrium at A, with price P0
SAS
Price level
A
P0
Yp
Output
19
A fall in nominal money supply
Starting from long-run equilibrium at E
AS
SAS
Price level
E
P
With price at P' but wages unchanged, the real
wage rises bringing involuntary unemployment.
MDS
Yp
Output
20
In the short run

• In the short run
• economy moves to E
• nominal wages are still W
• price level is P
• then real wage w W/P
• higher then the initial value wW/P
• output level is lower
• firms are offering fewer jobs
• there is involuntary unemployment

21
In the medium run

• money wages start to be bid down
• firms move to a lower short run aggregate supply
  say SAS
• price level is lower at P
• output is higher
• the real money supply M/P starts to increase
• real wages w W/P starts falling but there
  is still some involuntary unemployment

22
In the long run

• Money wages have fallen in proportion to the
  original reduction in nominal money supply
• so dose prices
• real money supply,, interest rates output
  returned to their original positions
• output returned to the potential level
• real wages returned ot full-employment level
  involuntary unemployment eliminated

23
Adjustment paths for prices and output
Yp
Y
time
p
P
p3
time
24
Exercise

• Try to draw similar adjustment paths for other
  variables
• nominal wages
• real money supply
• interest rates
• upon a permanent reduction in nominal money supply

25
Exercise

• Analyse the long and short run effects of fiscal
  policy
• increase or decrease of government expenditures
• tax cuts or increases

26
A shift in aggregate supplye.g. a change in
social attitude towards women working
Labour supply shifts right increasing long run
employment and output to Yp
P
SAS
equilibrium from E to E'
SAS
P'
In the short run no change in output employment
P
E
E'
MDS
In medium run prices and nominal wages starts
declining real money supply increase but there
is still some unemployment
Yp'
Output
Y'
In the long run eq is established at E at a
higher output level no involuntary unemployment
27
Exercises

• Try to draw the adjustment paths of
• output nominal wages prices interest rates real
  money supply as time progresses
• What is the effects of a decline in aggregate
  supply?

28
An adverse supply shocke.g. an increase in the
price of oil
P
SAS
P
E
MDS
Yp'
Output
29
Change in oil pricee.g. second case in the long
run
Raising oil prices increases costs of
production firms demand for labour shifts to left
P
SAS'
They demand less labour at each wage rate
SAS
P'
In the long run the eq. output and
employment shifts to lett AS to left
P
E
E'
MDS
The new eq is establiched at a higher price and a
lower output the nominal wage increases a bit
Yp'
Output
Y
Real money supply is lower interest rates are
higher