Discuss the effects of the policy on equilibrium output and interest rate in the economy using the ISLM-ADAS model in the short run

Question I.

Consider that content with the steady pace of economic recovery, the Federal Reserve Bank decides to undertake a large-scale asset sale resulting in a decrease in money supply.

a. What would be the effect of such a policy on equilibrium interest rate in the money market? Explain why the equilibrium interest rate changes the way it does. Provide a graphical illustration using the appropriate diagram(s). (10 points)

The graph attached herein is a perfect example of how the demand and supply of money in the market looks like. The vertical axis shows the money supply curve which is controlled by the Federall bank. A case example of how is reduces money in the market by doing large scale asset sale, the subsequent decrease is indicated as shift by the curve on the left from MS1 to Ms2 , consequently increasing the money interest rates from r1 to r2

b. Discuss the effects of the policy on equilibrium output and interest rate in the economy using the ISLM-ADAS model in the short run. Explain which market (or markets) is (or are) affected and which curves shift. Illustrate your answer with the appropriate diagrams. (10 points).

When the Federall bank chooses to reduce the money supply it leads to the equilibrium interest rates going up in the market. Say for a certain level call it Y, it leads to an inward shift of the LM curve which then decreases the level of output. The result being that for a certain degree of P the output level is lesser, which the results to to an inward shift the AD curve. In the end, if it is assumed that the AS curve is horizontal. The prices tend not to change and the whole inward shift in the AD curve leads into a decrease and hence a reduction in output. If we also assume that the AS curve in upward sloping, the price reduces in the end and the output falls too though just a little bit.

c. Now discuss the effects in the medium run. You do not need to draw new diagrams; but you should refer to the diagrams in part b above and state which curves shift and in which direction they shift, and what happens to output and the interest rate in the medium-run equilibrium. A branch of the economics profession has argued that money is “neutral”. Does your analysis support this claim? Explain. (10 points) 

In the medium run the level of output is dependent on the supply of conditions and hence the outcome is not affected and the reduction of money supply leads to a fall in prices so that it seems like the money is ‘neutral’

Question II.3 (30 points) 2

a. Describe the factors that influence wage setting. Write down the equation that represents wage setting, describe the effect of each factor in the equation/function, and draw the corresponding diagram. Clearly state the assumptions behind your analysis. (10 points) 

Factors that influence wage setting

The main factors that influence wage setting are supply and demand of labor, prevailing market rate, the organizations ability to pay and the cost of living. Dynamics of supply and demand of labor operate at the national, regional and local levels playing a key role in determining the level and structure of organizational wage. When the demand exceeds the supply for a particular skill, the level of pay for that skill increases. On the other hand, comparable wage is the most common criteria for wage setting. Organizations use the prevailing wage rate in the industry to set their own wage rate leading to conformity to the going wage rate. The financial capability of an organization also determines the wage level and structure for an organization. Organizations with good sales and profitability can pay higher than those with lower sales and profits. The cost of living is used to set the minimum wage. As such, organizations adjust their level of pay depending on the acceptable cost of living index to prevent erosion of the real wage.

Wage setting

wage-setting relation – W/P = F(µ,z)

wage equation – W = PeF(µ,z)

where:

W is aggregate nominal wage,

Pe is the expected price level

µ is the unemployment rate

z is the catchall variable

The natural unemployment rate

Higher unemployment rate

Higher catchall variable

At a particular unemployment rate, the level of unemployment benefits determines the level of real wage, they are directly proportional. Higher z increases the natural rate and higher µ increases the natural rate

b. Briefly describe the “efficiency wage” theory. Explain why a firm would want to pay a wage that is higher than the market wage rate. What theories can motivate such a practice? (10 points) 

The main argument of the “efficiency wage” theory is that in some markets, non-market clearing levels can dictate the level and structure of wages. For example, in order to encourage productivity and efficiency, firms may decide to pay their employees more tha the prevailing market rates. Another reason why forms may pay higher than the prevailing market rate is where the cost of labor is high or the cost of turnover is high and the form is trying to reduce turnover and achieve high employee retention. The cost savings that result offset the increased cost of labor. However, efficiency wages may translate to job rationing and uncleared markets although this does not necessarily mean unemployment.

There are many theories put forward to motivate “efficacy wage”. Some of these are the Shirking Model, the Labor Turnover Theory and the Selection Theory. The Shirking Model asserts that workers may decide to shirk or not shirk which creates a moral hazard problem. This model was proposed by developed by Shapiro and Stiglitz. Workers have a probability may be caught and punished for shirking, mainly through termination. To increase the opportunity cost of shirking, organizations may decide to use efficacy pay making it costly for the employees to lose jobs and hence make shirking unattractive. The Labor Turnover Theory was suggested by Salop, Schlicht and Stiglitz. This theory holds that using efficacy pay rate reduces turnover intentions. High recruitment, retaining and replacement costs makes this option attractive. The Selection Theory was developed by Malcolmson, Stiglitz and Weiss. This theory assumes that workers are heterogeneous in ability which then affects their job performance differently. Workers with higher productivity and effectiveness have higher reservation wages which discourages them from seeking low wage jobs. Firms may offer higher wages to attract and retain the best pool of talent. Other theories suggest that higher wages boost morale, satisfaction, organizational commitment and productivity.

c. The conventional (classical) labor market theory suggests that i) the wage rate adjusts smoothly so that labor supply equals labor demand; ii) wages are set competitively across markets; iii) there is no ‘involuntary’ unemployment (anyone who wishes to work can work). Does this reflect the reality in real economies? If not, explain why. (10 points)

This does not reflect the reality in real economies. Contrary to the classical labor market theory, the wage rate does not adjust smoothly in real economies to equate labor supply and labor demand. Additionally, wages are not automatically set competitively across markets. Moreover, involuntary unemployment and underemployment are inevitable. In a counter statement to the classical labor market theory, Keynes cites the rigidities in the model. Using involuntary unemployment, Keynes asserts that involuntary unemployment exists in virtually all markets. Further, Keynes disputes the concept of wage-price flexibility. He argues that because of the money illusion and institutional factors, money is rigid in the downward direction and flexible in the opposite direction. As such, the labor supply function depends on money wages rather than real wages.