Unit 1-3 economics

Intermediate Macroeconomics I: Foundations of Aggregate Income Determination

Course Information

• Course Credit: 4
• Semester: III (B.A. Hons. Economics DSC-8), IV (B.A. Programme - Minor Paper DSC)
• Curriculum: UGCF-2022 and National Education Policy 2020
• University: University of Delhi
• Department: Department of Distance and Continuing Education, Campus of Open Learning, School of Open Learning

Editorial Board & Content Writers

• Editorial Board: Prof. J. Khuntia, Mr. Devender

• Content Writers: Ms. Mandeep Kaur, Mr. Rajesh Kumar, Mr. Swarup Santra

• Academic Coordinator: Deekshant Awasthi

• ISBN: 978-81-19169-91-7

• Emails: ddceprinting@col.du.ac.in, economics@col.du.ac.in

• Publisher: Department of Distance and Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi, Delhi-110007

• Printed by: School of Open Learning, University of Delhi

External Reviewers & Reviewer

• External Reviewers: Dr. Anand Kumar, Dr. Sarabjeet Kaur
• Reviewer: Mukesh Kumar

Syllabus Mapping

Unit I: Short-run and Medium-run Equilibrium

• The labor market: Wage determination; wages, prices, and unemployment; natural rate of unemployment; from employment to output.
• Derivation of aggregate supply curve.
• Interaction of aggregate demand and supply to determine equilibrium output, price level, and employment.
  • Lesson 1: Labour Market (Pages 1–15)
  • Lesson 2: Determination of Equilibrium Output (Pages 16–38)

Unit II: Phillips Curve and Theory of Expectations

• Inflation, unemployment, and expectations.
• Phillips Curve: adaptive and rational expectations; policy ineffectiveness debate.
  • Lesson 3: Phillips Curve and Theory of Expectations (Pages 39–59)
  • Lesson 4: Inflation and Phillips Curve (Pages 60–73)

Unit III: Microeconomic Foundations of Macroeconomic Behaviours

• Consumption: Keynesian consumption function; Fisher’s theory of optimal intertemporal choice; life-cycle and permanent income hypothesis; other theories of consumption expenditure.
• Investment: determinants of business fixed investment; residential investment and inventory investment.
  • Lesson 5: Consumption Spending (Pages 74–94)
  • Lesson 6: Theories of Consumption Expenditure (Pages 95–120)
  • Lesson 7: Investment Function (Pages 121–140)

Contents

Lesson 1: Labour Market

• Pages 1–15

Lesson 2: Determination of Equilibrium Output

• Pages 16–38

Lesson 3: Phillips Curve and Theory of Expectations

• Pages 39–59

Lesson 4: Inflation and Phillips Curve

• Pages 60–73

Lesson 5: Consumption Spending

• Pages 74–94

Lesson 6: Theories of Consumption Expenditure

• Pages 95–120

Lesson 7: Investment Function

• Pages 121–140

Glossary

• Pages 141–144

Lesson 1: Labour Market (Dr. Mandeep Kaur)

Learning Objectives

• Understand wage determination in the labour market.
• Learn factors affecting workers' bargaining power.
• Learn about efficiency wage theories.
• Understand the relationship between wages, prices, and unemployment rate.
• Understand factors influencing wages beyond wages and unemployment: employment insurance, employment protection, and minimum wage legislations.
• Understand equilibrium in the labour market via the concept of natural rate of unemployment.
• Make linkages between employment and output level.

Introduction

• Increased demand leads to firms increasing the output level.
• Increased level of output needs increased employment.
• Higher employment leads to increased wages.
• Increased wages increase production costs, leading to increased prices.
• Increased prices cause workers to demand higher wages to maintain living standards.
• The IS-LM model assumes a constant price level, but abandoning this assumption provides insights into wages, prices, and output in the medium and long run.
• The module aims to understand wage determination based on prices and employment and the relationship between employment and output in the medium run.
• The unemployment rate is defined as the proportion of unemployed people in the labor force.
• NSSO defines activity status based on working, available for work, and neither seeking nor available for work.
• Unemployment in India is measured by:
  • Usual Status Approach: Estimates of persons unemployed for a major part during the 365 days preceding the date of survey.
  • Weekly Status Approach: Estimates of persons unemployed for an hour on any day of the week preceding the date of survey.
  • Daily Status Approach: Estimates of persons not employed for even one hour in a day.

Wage Determination

• Wages are set in various ways, including collective bargaining or individual negotiation.
• Bargaining increases with the skills required for the job.
• Reservation wage is the wage level where a worker is indifferent between working and unemployment.
• Above reservation wages, wages depend on labour market conditions.
• Wage determination is explained by:
  • Bargaining Power of Workers: Workers' power to get wages higher than reservation wages, depending on the level of required skills and the cost to the firm of finding a replacement.
  • Efficiency Wages: Firms providing wages higher than reservation wages to increase worker productivity.

Bargaining Power of Workers

• Workers have bargaining power in wage determination.
• Bargaining power depends on skill level and firm replacement costs.
• Higher skills increase bargaining power as replacement is costlier.
• Labour market conditions also impact bargaining power; lower unemployment rates increase bargaining power.

Efficiency Wages

• Firms pay wages higher than reservation wages to induce higher productivity.
• Higher wages reduce turnover and increase worker productivity.
• Efficiency wage theories conclude that wages depend on worker skill set and labour market conditions.
• High-tech firms pay more to retain skilled workers.

Wages, Prices, and Unemployment

• Wage determination can be represented by the equation:
  • $W = P^e F(u, z)$
  • Where:
    • $W$: Nominal wage rate
    • $P^e$: Expected price level
    • $u$: Unemployment rate
    • $z$: Other variables

The Expected Price Level

• An expected price level increase will proportionally increase nominal wages to maintain constant real wages.
• Workers aim for higher real wages (W/P).
• Firms also expect future price levels to double and will want to double the wages.
• Wages are determined in advance, so the expected price level is the relevant variable.

The Unemployment Rate

• An increase in unemployment rate decreases wages and vice versa.
• Higher unemployment reduces bargaining power and efficiency wages.

Other Factors

• Other factors determining wage rate: unemployment insurance, minimum wages, and employment protection.
• Higher unemployment insurance increases the wage level by increasing worker bargaining power.
• Increased minimum wages also increase the wage rate.
• Increased employment protection increases worker bargaining power, increasing wages.

Natural Rate of Employment

• Wage setting and price setting determine the equilibrium unemployment rate, also known as the natural rate of unemployment.

The Wage Setting Relation

• $W = PF(u, z)$
• $\frac{W}{P} = F(u, z)$
• This implies a negative relationship between real wage rate W/P and unemployment rate u.

The Price-Setting Relation

• Firms set prices based on production costs.
• Assuming only labour as a factor of production, the production function is:
  • $Y = AN$
    • Y is output quantity
    • N is employment
    • A is labour productivity
• Assuming constant labour productivity and constant returns to scale.
• Simplified assumption of A = 1, meaning one worker produces one unit of output.
  • $Y = N$
• Marginal cost of producing one more unit of output is W.
• In imperfectly competitive markets, prices are greater than marginal cost:
  • $P = (1 + m)W$
    • m is the markup of price over cost.
• Price setting relation:
  • $\frac{W}{P} = \frac{1}{(1 + m)}$
• Increasing markup (m) reduces real wages.

Equilibrium Real Wages

• Labour market equilibrium: real wages chosen in wage setting relation equal those chosen in price setting relation.

• The equilibrium rate of unemployment $u_n$ is where the wage setting relation equals the real wage implied by the price setting relation.

• This $u_n$ is called the natural rate of unemployment.

• An increase in unemployment benefits, for example, shifts the wage setting relation curve to the right, increasing $u_n$.

• Also shifts the price setting relation. An increase in markup charged by firms reduces real wages, as implied by the price setting relation, leading to a downward shift of the price setting relation.

• Natural rate depends on policies and institutions.

• Policies increasing unemployment benefits or reducing competition among firms increase the natural rate.

• The natural rate is also called the structural rate as the variables that determine it relate to the economy's structure.

From Employment to Output

• The analysis determines the equilibrium level of unemployment.
• Given unemployment, the level of employment is determined.
• With a production function, the output level is determined.
• The natural rate of employment, therefore, determines the natural rate of output.
• IS-LM analysis determines the equilibrium level of output.
• In the short run, monetary and fiscal policies determine output.
• However, in the long run, output remains at the natural level of employment.

Summary

• The labour force comprises those working and looking for work.
• An unemployment rate is the proportion of unemployed to the labor force.
• The wage rate depends inversely on unemployment rate and directly on the expected price level.
• Wages are set by collective bargaining, employer-employee bargaining, or unilaterally by employers.
• The price-setting relation outlines the inverse relationship between real wages and markup over prices charged by firms.
• Labour market equilibrium happens when the real wage determined in the wage setting relation equals wages derived from price setting relation.
• This equilibrium unemployment rate is the natural rate of unemployment.

Lesson 2: Determination of Equilibrium Output (Dr. Mandeep Kaur)

Learning Objectives

• Understand types of unemployment: frictional, structural, and cyclical.
• Know the causes of each type of unemployment.
• Know constituents of the Natural Rate of Unemployment and the concept of Equilibrium Unemployment.
• Understand implications of the price and wage setting model for the natural rate of unemployment.
• Understand Potential GDP and its relationship with the natural rate of unemployment.
• Derivation of Aggregate Demand Schedule.
• Know shifts in Aggregate Demand.
• Derivation of Aggregate Supply Schedule.
• Understand interaction of Aggregate Demand and Supply to determine equilibrium output and prices.
• Know Classical and Keynesian AS curve; and the impact of AD policies on output and price.

Introduction

• Lesson 1 discussed the natural rate of unemployment.
• This chapter discusses the nature of natural unemployment.
• The unemployment rate measures the percentage of people who want to work but do not have a job.
• Individuals above 16 are categorized as employed, unemployed, or not in the labor force.
• ILO defines the unemployed as those without work during a reference period (four weeks), available for work and seeking work.
• The labour force is defined as the sum of employed and unemployed.
• Three types of unemployment viz. the structural, the frictional and the cyclical unemployment.
• The natural rate of unemployment is generally believed to be greater than zero because it will almost always be some unemployment in the economy.
• An important assumption of IS-LM analysis is that of fixed price level.
• The aggregate demand and aggregate supply model determines the equilibrium output and the price level.

Measures to assess performance of the labour market:

• The unemployment rate is the ratio of unemployed to the labour force.
• Unemployment Rate = Unemployed/Labour Force
• The labour force participation rate is the ratio of labour force to the total adult population.
• Over the years, the labour force participation rate of women has been increasing, while men have decreased.
• Rising of the