Tuesday, April 20, 2010

Exchange Rates and the BOP


Okay- final bit, and then we can all write our exams and promptly forget everything we ever needed to know about economics! =D

What is a balance of payments? It's a summary account of all the receipts and payments in and out of Canada (or any other country) in relation to the rest of the world (including payments made for both goods and investments). It clocks Canadian money moving back and forth across the border. Receipts are money going into Canada, and payments are money going out of Canada.

The balance of payments includes both current and capital accounts. Because these two accounts always balance out, the balance of payments will always be 0. You'll see why in a little bit.


-There is more money going in than out
-This is favorable
-We also call this "credit"
-More receipts than payments

-There is more money leaving than entering the country
-This is unfavorable
-We also call this a debit
-More payments than receipts

When foreign consumers buy Canadian exports, this creates a receipt (money enters Canada from the outside)
When domestic consumers buy foreign imports, this creates a payment (money leaves Canada)

-These are holdings held by the BoC
-It includes gold, foreign exchange, and SDRs
-SDRs are special drawing rights, and they are the IMFs substitute for gold



Basically, a bunch of different sub-accounts which measure trade flows

1: The Current Account (The BOP for goods)
-This encompasses exports, imports, and investment incomes
-The Trade Account is a subcategory of the current account, and it includes an account for merchandise, and an account for services. This account stacks up exports and imports and measures the difference difference
-The Capital Service Account measures the net investment income and unilateral money transfers. This measures the difference between Canadian interest and dividends on foreign bonds and investments, and Foreign interest and dividents on Canadian bonds and investments

2: The Capital Account
-This encompasses money spend on long and short term capital investments, including stocks, bonds, realty, factories and other investment devices
-Financial capital imports are A CREDIT (this may be confusing)! This is when foreigners bring money into Canada in order to purchase Canadian assets. Subsequently, financial capital exports are capital outflows: when Canadians bring money out of Canada in order to purchase foreign assets.
-Finally, the Capital account also includes the official financial account, which measures receipts and payments of Canadian dollars due to the selling and buying of foreign exchange. Selling foreign exchange constitutes a receipt of Canadian dollars, and thus counts as a receipt on the balance of payments. Essentially, the official financial account balances out the other two accounts: when Canadians buy a whole lot of foreign goods and investments, for instance, the BoC accommodates this by selling off foreign exchange for Canadian dollars (which thus counteracts the account deficit caused by other categories)
-An increase in official receipts means that the Bank of Canada is selling Canadian dollars in order to buy foreign exchange. This creates a negative balance effect (it counts as a debit on the balance sheet)
-An decrease in official receipts means that the BoC is selling foreign exchange in order to buy Canadian dollars. This creates a positive balance effect (it counts as a credit on the balance sheet)


Current accounts = X - M + Returns to Investments
Capital Accounts = Capital in - Capital out, + Official Financing Account (which is Can$ in - Can$ out)

As you can see, the OFA always balances out all other payments and receipts, so the Balance of Payments is always 0! Sometimes, news media will talk about exchange deficits or credits, and when they are doing this, they are usually omitting the OFA.

So... if there are more exports than imports, foreigners are short of Canadian dollars, so the BoC will sell Canadian currency to foreigners (and in doing so, increase its holdings of foreign currency). This counts as a negative entry in the OFA: in this way, the BoC provides the excess Canadian money that foreigners require to buy Canadian exports.


-The BOP always balances
-BOP balances or deficits are balanced out by the OFA
-There is nothing inherently good or bad about balances. A deficit is not necessarily bad, and a surplus is not necessarily good!



Okay- foreign exchange can be seen as a marketable good, just like anything else. As such, we have the FOREIGN EXCHANGE MARKET

External Value is how much domestic currency is worth in foreign terms (the foreign price of domestic currency)

Exchange Rate is how much foreign currency is worth in domestic terms (the domestic price of foreign currency)

ER = 1/EV & EV = 1/ER

Depreciation means that the external value is going down
Appreciation means that the external value is going up

What determines external value (and by association, exchange rates)???


Remember: People supply currency in order to purchase imports or to facilitate capital exports (domestic investiture into foreign markets) and people demand currency in order to purchase domestic exports, or to facilitate capital imports (foreign investiture into domestic markets)...

Basically, supply of any currency increases as that currency becomes valued more (because high valued currencies can buy more imports, and translate into larger foreign investments), while demand for any currency shrinks as that currency appreciates (because this makes exports from that country more expensive, and capital in-flows less effective)

As such, currency prices tend to settle at an equilibrium value!

Remember, however, that demand and supply can shift here to affect the equilibrium price level!
Supply of currency will increase if
-There is heightened demand for imports
-There is heightened domestic demand for investment in foreign markets
-Domestic prices are higher than foreign prices

Demand for currency will increase if
-There is a heightened demand for exports
-There is a heightened foreign demand for investment in domestic markets
-Foreign prices are higher than domestic prices


Surpluses, Deficits, and the EV

For surpluses, exports are higher, imports are low, demand for domestic currency is high, supply of it is low, and thus the currency appreciations

For deficits, exports are lower, imports are high, demand for domestic currency is low, supply of it is high, and this the currency depreciates

You can verify this by moving the supply and demand curves around!


PRICES AND EXCHANGE RATES: Exchange rates facilitate the rule of one world price!

Domestic Prices = the exchange rate * Foreign Prices

And this translates into a stabilization mechanism- I'll show you!

When external value is higher, domestic prices become cheaper for international goods (due to the above formula), and as such, exports decrease, imports increase, and we are left with a BOT deficit (which brings the EV back down again)

The reverse is true for when the domestic value is lowered.

As such, the balance of trades and the exchange rate are interdependent and cyclical!



Sunday, April 18, 2010

Trade Policy

This chapter looks at the policies which either facilitate or impede free trade in the world!

As economists, we usually are in favor of free trade. We recognize that free trade offers many benefits to different countries!

Why is free trade a good idea?
-The law of comparative advantage
-When there is regional specialization and trade, the world production of all products rises
-This maximizes the world's average standard of living (world GDP per capita)

On the other hand, some countries may attempt to instill protectionist policies (policies which counteract free trade in order to protect domestic firms from international competition). These can include both TARIFFS and NON TARIFF BARRIERS (NTBs, such as quotas, customs procedures, anti-dumping duties and countervailing duties).

Why might nation choose certain degrees of protectionism?


1: To improve the terms of trade! If a country is large enough, it can force the world price downward for goods it imports by imposing a Tariff

2: Infant Industry Protection. Some countries may set up trade barriers in order to protect domestic firms from international competition, with the hopes that these industries will grow to the point where they can realize economies of scale. The idea here is that under protection, infant industries will eventually "grow up" to the point where they will be able to compete on the international market without need of protectionism. A problem with this is that not all industries develop to this level of competency while under protection. Canada's national policy of 1876 was an example of infant industry protection directed at improving Canadian manufacturing.

3: Learning by doing. This sort of goes along with infant industry protection, but along with protecting developing industries from international competitors, protectionism can also simply give those industries time to operate, which gives personnel time to gain mastery over certain procedures. In this way, countries can turn comparative disadvantages into comparative advantages.

PROBLEM! Not every industry which gets chosen for protection will ultimately grow up to be an international "winner", so each time the government placed an industry under protection, they are effectively gambling (as protectionism exacts economic costs) on their choice. If governments do this frequently, statistically, they are likely to choose more losers than winners, which would be quite costly.


4: Protectionism can allow certain key industries to earn economic profits and thus innovate more. As such, Canada has strategic trade policy in place with regards to Bombardier (if you remember, they're the company which made the olympic torches)


1: There are advantages from diversification. Countries which are only specialized in a narrow range of products may use protectionism in order to diversify their economies (which gives local firms a "safe space" to expand into new industries, thus increasing the range of products produced domestically). This can be useful in that it buffers the volatility and risk posed by price changes and new technologies by spreading production to several different sectors. The idea here is not to "put all of your eggs in one basket" (although, often, this is more of a political argument than an economic argument)

2: Protectionism lets governments protect favored groups! In Canada, competitive advantage favors skilled labour over unskilled labour, and as a result, free trade may lower the wages of unskilled laborers (who are now competing with wage slaves from overseas). Here, protectionism can redistribute income to certain productive groups, but at the expense of the collective standard of GDP. There is a deadweight loss!



1: "We've got to keep our money at home"
The Premise: If I buy a domestic good, by country will have both the good AND the money used to buy that good
Why it's incorrect: Domestic money is only useful for buying domestic goods. If you are buying foreign products, the money you spend on those products eventually gets used to buy Canadian products- it flows between the two trading countries

2: "We've got to protect ourselves from low-cost foreign labour"
The Premise: Low wage foreign goods will eliminate domestic goods from the market, and thus lower the domestic standard of living.
Why it's incorrect: This goes against the law of comparative advantage. Even if a foreign country can produce all goods at a lower cost than Canada, it would still be advantageous to trade, as trade will lower the opportunity cost of having certain products.

3: "Exports are good, and imports are bad"
The Premise: Exports add to domestic GDP, while imports take away from domestic GDP
Why it's incorrect: Standard of living is dependent on consumption, not production. If a country exports a lot of goods, but derives its comparative advantage by paying its workers very low salaries, then those workers will not be able to consume very many products, on average, and thus that country's standard of living will probably be quite low.

4: "Protectionism creates local jobs"
The Premise: Protecting the domestic market can help save local jobs, and thus combat unemployment
Why it's incorrect: Protectionism reduces employment in other sectors which may have local comparative advantages, and thus, while it may increase employment in one sector, the overall economic effect is inefficient.



TARIFFS: Import Duties- these are a tax on imports. They increase costs for domestic consumers, but benefit domestic producers (who can sell at higher than the world price) and the government (who receives tax revenue). Tariffs create a deadweight social loss for the economy as a whole.

Originally, at the world price, Canada will import 1500 units of this product, and domestic producers will supply the other 500 units needed to satisfy demand.

Once the tariff raises the prices, Canada only imports 500 units of the product, and domestic producers supply the other 1000 units needed to satisfy domestic demand (as you can see, demand has decreased due to the higher price).

Consumer lose surplus represented by sections C, D, E, & F due to the Tariff
Producers gain surplus represented by section C due to the Tariff (the increase in price times the increase in production, minus the costs incurred by increasing production)
The government gains section E due to the Tariff (the quantity of foreign imports at the Tariff price, multiplied by the amount of the Tariff)



An import quota is like a quantity ceiling- it restricts the quantity of products which a country will import
With a voluntary export restriction, the exporter agrees to limit the amount of exports it will send to any one country.
This incurs costs for domestic consumers, but benefits domestic producers
The net result is a deadweight social loss which is greater than that which results from a Tariff!

At the world price, Canada will import Q4 - Q1, and domestic producers will supply Q1
Let's say that a quota restricts domestic imports to Q3 - Q2. If this happens, then the domestic price must rise to P1, where the quota exactly satisfies the excess demand which domestic producers cannot meet.

Consumers lose surplus equal to E, F, G, H, & I due to the quota,
Producers gain surplus equal to E due to the quota
Since there is no taxation here, the higher price on the quota goods causes foreign producers to gain surplus equal to G & H


Usually, in trade barrier situations, exporters prefer a quota (so they can gain the extra revenue section) while importing governments prefer a tariff (so they can gain the extra revenue section).



1: Antidumping Duties
-Dumping is the practice of selling a good in a foreign country at a price below domestic prices at a reason other than costs
-This is like price discrimination (remember from micro) but on an international level
-Usually, it is only temporary, in order to sell off excess supply, or to weaken local industries and force reliance on foreign imports
-It is seen as anti-competitive, and many people believe that it is an unfair form of competition
-Antidumping duties (taxes to bring "dumped" imports back up to the domestic price level) are often used to compensate for this
-Recently, however, these have been abused and used as a non-trade barrier
-When Antidumping Duties are used, the domestic price becomes the price floor, regardless of the foreign price (which can lead to an inflexibility in domestic prices compared to the world price)
-As such, if the world price falls below the average costs for domestic producers, they are protected
-Often, the system requires foreign accusers to prove that dumping is occurring in order for antidumping duties to be instated

2: Countervailing duties: a tariff imposed as a trade remedy to counteract foreign governments subsidizing their industries
-Governments wishing to impose countervailing duties must prove that there is a foreign subsidy being used to bolster a certain foreign industry, and that it is significantly harming the prospects of domestic producers
-The U.S. is currently placing countervailing duties on Canadian softwood lumber.



GATT- The general agreement on trades and tariffs: an effort to reduce international protectionism

The Uruguay Round- reduced tariffs by 40%, but failed to deal with European and Canadian agricultural subsidies (eventually, they ended quotas, but replaced them with Tariffs in a process called Tariffication)

WTO- World trade organization- it has 148 members, it is a global organization which deals with the rules of trade, and it endeavors to lower trade and non-trade barriers. It also includes a formal dispute settlement mechanism

Doha Round- tried to reduce agricultural subsidies

The Battle for Seattle- People protested that human, labour, and environmental rights were not being addressed by the WTO. Interestingly, 3rd world countries often argue against considering these in trade deals

MAI- Multilateral agreement on investment: similar to WTO, but for investments

Free trade Area- Goods and services may move freely among member countries, but each member nation still sets barriers against foreign imports on an individual basis (like NAFTA) PROBLEM: Certain Tariffs have grandfather clauses, and thus persist despite agreements.

Customs Union- A free trade area, but with a common set of barriers against foreign imports (like Mercosur: Brazil, Uruguay, Paraguay, and Argentina)

Common Market- A customs union in which factors of production (i.e., workers) may move freely among member nations (like the EU)


Saturday, April 17, 2010

Gains from International Trade

OKAY! Let's talk turkey about international trade.

Over time, while world GDP had been increasing at a fairly constant rate, world trade has increased exponentially!

Canada is, itself, involved in quite a bit of international trade (we export and import quite a lot of goods)

David Rciardo was an economist of lore (1772-1823), and he was a major proponent of international trade. He wrote "Current comparative advantage is a major determinant of trade under free-market conditions."

Economists who advocated world trade often promoted teachings which led to real changes, such as England repealing its corn laws and moving towards a more open economy (an open economy is one which engages in international free trade, and realizes certain advantages from this, known as the gains from trade).

GAINS FROM TRADE: These are increases in total economic output due to efficiency advantages resulting from local economies engaging in specialization and trade of goods in which they have a comparative advantage.

COMPARATIVE ADVANTAGE: A situation where one local economy can produce a certain good at a lower opportunity cost than other economies (i.e., if it is less expensive for Canada to grow wheat than it is for Haiti to grow wheat, then we would state that Canada has a comparative advantage in wheat)

WHAT IS THE LOGIC BEHIND INTERNATIONAL TRADE? It's the same logic which states that interpersonal trade will be beneficial!
-When there is no trade on an interpersonal level, each individual has to be self-sufficient: they must provide for all of their own needs
-Trade allows individuals to specialize in providing goods and services which they can produce or provide efficiently, and then trade those for goods and services which they are less proficient at providing.

For an example, if I am a Doctor, I could be very very good at fixing coronary blockages, but terrible at fixing pipes. Trade means that I can simply make money by acting as a doctor, and then trade this money to "borrow" a trained plumber, thus saving me hours of frustration and reading complicated instructions. In this situation, both me and the plumber are providing the services which we are most efficient in, and because I don't have to waste time learning how to fix pipe and he doesn't have to waste time memorizing human anatomy, the overall economic output between the two of us is higher! We are more efficient when we can divide and conquer! =D

Well... interregional and international trade follows the same logic!

There are two different sources of gains from international trade:

1- The fact that different local economies have different resource endowments (and therefore can benefit from specializing in producing products which fit well with regional endowments, both natural and acquired)

2- The fact that international trade leads to a larger market for products means that local firms can realize reductions in production costs due to increased production (they are able to achieve economies of scale)


ABSOLUTE ADVANTAGE: This is when one country (or economy), compared to another, can produce more of a good from the same inputs

So, lets say that given the same inputs...

Canada can produce 10 bushels of wheat or 6 lengths of cloth
England can produce 5 bushels of wheat or 10 lengths of cloth

Canada has an absolute advantage over England in terms of wheat, and England has an absolute advantage of Canada in terms of cloth. Here, we have a situation of reciprocal advantage (each country is more adept at producing a different good), and thus it will be advantageous for England and Canada to trade!


Because each unit of input which Canada switched from cloth production to wheat production leads to 6 fewer cloths, but 10 more wheat. Similarly, each unit of input which England switched from wheat production to cloth production leads to 5 fewer wheat and 10 more cloth. The net effect of this is that the world production of both wheat and cloth has increased if both the countries specialize in what they are best at producing: there are worldwide gains from specialization.

But English and Canadian consumers want to purchase both goods... so unless these countries are able to trade, this specialization would not be practical.



Lets say that using one unit of input...

Canada can produce 100 bushels of wheat or 60 lengths of cloth
England can produce 5 units of wheat or 10 length of cloth

Here, Canada has can absolute advantage in both wheat and cloth (so Canada is more efficient at producing either of these products). Some people might think that Canada should thus not engage in trade... but they would be WRONG! Dead WRONG!

Canada can produce 20 times as much wheat at England, but only 6 times as much cloth using one unit of input. From this, we can surmise that Canada has a COMPARATIVE ADVANTAGE in wheat, while England has a comparative advantage in cloth.

Each country should trade goods in which it has a comparative advantage. Trade, in this case, increases the world's per-capita GDP. Comparative advantage is a necessary and sufficient condition for trade. Absolute advantages (in the absence of comparative advantages) do no lead to gains from trade.

How do we figure out which product a country has a comparative advantage in?

Easy! You just calculate the opportunity cost of producing any one good. Given the previous example, the OC of producing 100 bushels of wheat in Canada is 60 lengths of cloth, so the opportunity cost of each bushel of wheat is 0.6 lengths of cloth. Similarly, the OC of producing is length of cloth is 1.67 bushels of wheat for Canada. The opportunity cost for England of producing 1 length of cloth is 0.50 bushels of wheat, and the opportunity cost for England of producing 1 bushel of wheat is 2 lengths of cloth!

The opportunity cost of wheat is lower in Canada than in England, so Canada has a comparative advantage in wheat
The opportunity cost of cloth is lower in England than in Canada, so England has a comparative advantage in cloth

The point: opportunity cost depends on relative costs, no absolute costs!


*to note: increased production does not necessarily lead to increased consumption, and standard of living depends on consumption rather than production (so a country could produce a whole lot of products, but if its workers make very low factor incomes, and are hence unable to consume many goods, that country's standard of living may still be extremely low.)


If Canada can produce 100 wheats or 60 cloths given one unit of input
and England can produce 10 wheats or 6 cloths given one unit of input

Canada has the same absolute advantage of England in terms of both products, but each country has the same opportunity costs in terms of producing each good. Because of this, specialization and trade will NOT lead to any gains for either country, nor will it increase world output of either product.

There are other reasons in addition to comparative advantage that can make it beneficial to engage in specialization and trade

Basically, whenever OC's differ for the same products between different countries, specialization (and subsequent trade) leads to an increase in net production of goods, and as a result, a decrease in costs, because of...

1: Economies of Scale- Trade creates a larger market for domestic producers (who, after international trade, provide products for consumers around the world instead of just domestically)

2: Product Differentiation- A large international market for any type of product leads to further specialization, or product differentiation. For an example, in Europe, each country specializes in intra-industry trade. Between Canada and the U.S., each country specializes in a different type of car.

3: Learning by doing- Larger international markets lead to specialization, which leads to "accumulated experience". For an example, the silicon valley area of the United States has gained a reputation for computerized innovation, and as a result of that specialization, people from that area gain experience over time, and become better-equiped to compete in that industry.

Economies of Scale = Production moves to the bottom of the LRAC
Learning by Doing = The entire LRAC shifts downward, so any level of production costs less



1: Natural Factor Endowments
-This is how traditional economists explained comparative advantages
-What each country is "born with"
-This includes both natural resources and climates, as well as social patterns and institutional set-ups
-This natural resource advantage translates into cost advantages (i.e., a very fertile country will not incur as many costs growing food as an arid country)

2: Acquired Comparative Advantages
-This is a newer idea: what each country DEVELOPS can lead to a comparative advantage in certain products
-For an example, social fixtures such as education, healthcare, and social services can create more productive workers
-Research and development can also lead to innovations and localized experience which gives certain nations comparative advantages in certain sectors (like Canada and aerospace engineering, or Korea and shipbuilding)



We know that countries should specialize and then trade in goods in which they have a comparative advantage.

So... do countries actually export those goods in which they have a comparative advantage? The answer is YESSSSSSS!

THE LAW OF ONE WORLD PRICE: Internationally traded goods sell at the same price, regardless of which country they are sold in, assuming
-zero transport costs
-it is actually the same good
-competitive markets
-the good is tradable

World price simply equates global supply and demand for any product to determine the equilibrium price


If one country has a comparative advantage in a certain product which would potentially lead to a lower domestic price for this product than the world price level, instead of simply selling the product at the domestic price level, that country will sell that product on the world market at the (higher) world price level: the domestic excess supply will get sold off on the international market.

THE THEORY OF COMPARATIVE ADVANTAGE IS STILL RELEVANT~!! Sources of those competitive advantages may have changed over the years, but the basic premise of this theory still holds true!


TERMS OF TRADE: These determine how the gains from trade are shared- in other words, how will the gains in world per-capita GDP be shared among the trading nations.

The Terms of Trade = the ratio of (the price of exports / the price of imports)
The relative international price of imports (how many imports can be purchased per unit of export)

If the terms of trade increase, this is favorable for the nation in question, because they are able to get more imports per export. The reverse is true if the terms of trade decrease.

Unfavorable terms of trade will not be conducive to trade! Basically, if the terms of trade make it so that the OC of obtaining imports is equal to or greater than the OC of producing a product domestically, the country in question will not trade for that product! There needs to be a win-win situation (terms of trade which allow for both countries to enjoy lowered OCs) in order to trade to occur.


International Trade and the PPC:

When there is trade, consumption can differ from production! This means that trade can facilitate changes in production which allow for patterns of consumption which lie outside the PPC!

The slope of the dotted line = the terms of trade (tt)

Basically, given any point on the original PPC, international trade allows that country to trade products with another country at a rate which differs from that given on the PPC (which is usually convex). As you can see, if the country in the diagram specializes and trades, it can reach point B!

By specializing (changing production), countries can optimize their production in order to best take advantage of good terms of trade!

NOTE: Which country wins depends on the terms of trade (the slope of the line). Also, the consumption pattern (the point on the CPC) which each country settles into will depend on their preferences between the two products being compared.
Also, most countries have increasing OCs with increased specialization, and thus they have convex PPCs

That's all for now!

Wednesday, April 14, 2010


Okay- I'm really behind in these online notes, but I'm going to catch up as much as I possibly can tonight.

Unemployment is scary stuff! Here we go!

-In the long run, increases in the labor force should be matched by changes in employment (so as the population grows, more people should get hired for more jobs)
-In the short run, changes in the labor force may not match population growth

In Canada, the supply of labour has increased because of increases in the population (probably due to immigration), an increased rate of labor force participation, and an increase in education. Demand for labor has also increased due to new technology and economic growth. In most years, new jobs are created to replace old jobs and provide new jobs for the growing labor force.

In a typical year in Canada, employment increases by 1/4 million jobs.


-In Canada U was 12% in 1980, and 8% in 2008
-During booms, unemployment falls, and during recessions, unemployment rises. Doh
-In Canada, employment is rising, BUT the labor force is growing at a FASTER RATE, so in Canada, the unemployment rate has increased
-The proportion of employment in the service sector has increased (it is now about 75%)
-The proportion of employment in the goods sector has decreased

-According to Naomi Klein, North America produces "brands, no products"
-A lot of labour is outsourced these days
-There is a rise in the amount of low-skill service labor these days (i.e., McJobs)
-There is greater transience in the workforce: people move from job to job more
-Schedules are crappier, and employees receive fewer benefits
-There is less company loyalty, so quality suffers (the Wal-mart greeter makes about $11,000 working full time, so you can bet your ass she's not really that happy to see you)
-The best way to operate here is to see yourself as a movable asset: "Me Inc." sell yourself and you will be happy- attach yourself to any one company and you will not be happy

What are some reasons for these negative changes?
-Low ability levels
-The entry level for better jobs has significantly increased
-Flexible hours are now the norm
-Part-time workers have less legal protection (and are thus preferred)

-The labor market can be seen in terms of flows in about of unemployment, rather than as a simple unemployment rate
-We should examine gross rather than net flows (because this gives us more information about the nature of the labor market)

-Voluntary vs. Involuntary: Technically, voluntary unemployment does not exist, as that individual has technically left the workforce.
-Not all unemployment is bad!

Unemployment: All individuals who are willing and able to work at the going rate, but are unable to find a job

When there is a great deal of involuntary unemployment, we end up with something like the great depression:
-On a small scale, this causes personal hardship and psychological suffering for those who lose their jobs
-On a large scale, this decreases national output per capita, and by association, the standard of living- there is a loss in potential output


Why does it happen? It happens because there is a recessionary gap! (doh)

If Y = Y*, U =0
If Y < Y*, U > U*

Cyclical Unemployment is unemployment in exess of frictional and structural unemployment!

We could see the labour market as any other market where there is supply and demand for labour at different prices.
Demand = the willingness of firms to hire at any given wage rate
Supply = willingness of workers to work at any given wage rate
The price of labor is the real wage rate (w)

As the graph should demonstrate, labor markets are pretty flexible, because wages can shift upward and downward. With wage flexibility, real wages and employment change with economic cycles.

This graph shows that eventually, employment reaches an equilibrium! In other words, there should be no involuntary or cyclical unemployment in the long run...

There are two theories which examine gap unemployment


-We assume here that markets are flexible and that they will eventually clear
-This theory predicts that there will be no cyclical unemployment (but they're wrong! There is cyclical unemployment!)

Here's the logic: since wages are flexible, the labor market will always reach an equilibrium where the amount of labour supplied equals the labor demanded at the going wage rate. Here, no one is involuntarily unemployed, and thus, there is no cyclical unemployment. There are only people who are voluntarily unemployed (i.e., frictional and structural unemployment)

NAIRU, here, can occur due to

Exogenous demand shocks
-Changes in technology or tastes
-Changes in the demand for labour

Exogenous supply shocks
-Changes in the willingness to work
-Changes in the supply of labour

In this model, it is the NAIRU which fluctuates, since the unemployment rate is alwats the NAIRU

NOTE* Real wages ARE flexible and markets DO eventually clear, so this model isn't entirely wrong...

But there are PROBLEMS:
-According to this theory, real wages should change rapidly with the business cycle. This does not happen. Real wages remain relatively constant even as the economy fluctuates
-An unemployed person would be shocked to learn that economists veiw him or her as "voluntarily" unemployed
-This model seems to show that there is no need for stabilization policy, but in reality, we know that there IS!

thankfully, we have...

NEO-KEYNESIAN LABOUR MARKETS (aka, how they actually work)
-Here, labour markets are inflexible and do not clear... at least not in the short run
-This is because of STICKY WAGES! The wage rate does not change fast enough to equate the supply and demand of labour (because wages are not perfectly flexible), as a result, we get unemployment in slumps, and labour shortages in booms.
-Only when the supply and demand of labour are equal is there no involuntary unemployment: it is here that the market clears!

-Demand for labor decreases
-Wages want to fall to their new equilibrium level
-But wages stick at a higher level than the equilibrium
-So there is excess supply of labour, and thus unemployment

-Demand for labor increases
-Wages want to rise to a new equilibrium level
-But wages will not immediately increase to that new equilibrium level: it takes time for that to happen
-In the meantime, there will be excess demand, and therefore a labor shortage

We know that wages are much more likely to be "sticky downward" (they take longer to fall than to rise). Why is this?

-Long-term employment contracts: workers and employers respond to other factors like job security by creating long term contracts: here, wages are planned over the long-term and are thus insulated from short term fluctuations. The fringe benefits of these contractual agreements can be mutually beneficial, as they give employees long term stability, and ensure employers that they will have trained employees invested in the company over a longer period of time

-Menu costs: Changing wages in any way invokes administrative costs

-Efficiency wages: this is when employers pay employees higher wages than the equilibrium wage necessary to hire them, because they believe that the higher wages will act as a motivator, and cause workers to become more efficient

-Unions: unions negotiate on behalf of workers who are already embedded in the workforce, and thus often make it difficult to negotiate for higher wages

-Psychological factors: people find it psychologically difficult to give up wages (even if the price level is dropping, so real wages are effectively still the same)


In summary, Neo-Keynesians assume that markets may not clear, and thus there CAN be involuntary unemployment


In the short run, the Neo-Keynesian are correct: sticky wages can create excess supply or demand of labour... HOWEVER, all of the factors which contribute to sticky wages will not persist in the long run, so eventually, the labour market DOES clear, and wage flexibility eliminates involuntary unemployment. Thus, in the long run, both Classical and Keynesian theories predict that unemployment will be at U*

(The only differences is that for classical economists, there is no short run- that time frame is not taken into account)


-Wages are flexible, so the labour market will always clear
-U is always at U* and there is no gap unemployment (no involuntary unemployment)
-Aggregate demand shocks will have no effect on unemployment, because aggregate supply reacts

-Wages are sticky, and markets will not clear immediately
-U is not always at U*, so there can be gap unemployment (involuntary unemployment)
-Aggregate supply and demand shocks cause gaps


The Non-Accelerating-Inflationary-Rate of Unemployment (NAIRU)

There are 2 components to NAIRU: Frictional and Structural Unemployment

FRICTIONAL UNEMPLOYMENT (Job turnover, or search unemployment)
-This refers to the length of time it takes someone to either find their first job or a new job

STRUCTURAL UNEMPLOYMENT (Mismatching of supply and demand of labour)
-It can be supply-side (ie: a worker's skills are needed in an economy, but in a different city, persay)
-It can be demand-side (ie: there are jobs available, but they require more training than the current workforce has accumulated)

-Structural Unemployment may just be long run frictional unemployment
-Both are similar in that the number of unfilled jobs is equal to the number of people looking for work

NAIRU = The Non-Accelerating-Inflationary-Rate of Unemployment
-This is the rate on unemployment when inflation does not accelerate
-In other words, this is the normal, or natural rate of unemployment
-Here, we only have frictional and structural unemployment
-There is no cyclical unemployment at U*
-But "there is always some unemployment at full employment"
-This is the rate of unemployment when the supply and demand of labour are equal
-This is the rate of unemployment at Y*, or Yfe

NEWSFLASH: NAIRU can change over time! How does this happen???

1: Demographic Changes
-Baby boomers and shadow baby boomers, for example, entered the labour market and created a larger flow of voluntary unemployment, thus increasing NAIRU
-Historically, increased female participation in the workforce (where females historically have had a higher unemployment rate than men) will increase NAIRU
-Immigration may affect this as well

2: Labour Market Flexibility
-The speed at which wages adjust to supply and demand changes is slowing down over time
-It is more costly for firms to hire new workers these days, and due to unions and legal issues, it often takes them a longer amount of time to commit to hiring or laying off workers
-Unions and the psychology of concessions also play a role here

3: Government Policy
-Any government policy that reduces labour market flexibility will increase the NAIRU
-EI decreases search costs (the opportunity cost of searching for a new job) and will therefore increase average job search times, thus contributing more to NAIRU
-Severance Pay increases the cost of firing a worker, but at the same time, also makes companies less willing to hire new workers in the first place (its a higher risk, so firms must be more discerning)

4: Globalization and Technological Changes
-Rightsizing, restructuring, retooling, and rationalizing, global competition, and freer trade have increased structural unemployment, many would argue (mature industrial nations such as Canada are expected to provide high level services and technology, while countries with cheaper labour are expected to provide lower level manufacturing and production, but this can often lead to a mismatch between available worker skills and desired potential employee assets)

5: Hysteresis (A lagged effect)
-This theory suggests that the future NAIRU is a function of the current actual rate of unemployment
-This is seen more in European countries with an insider-outsider model to the workforce: in these countries, people who are already employed use their insider power to keep outsiders out
-Recessions prevent on-the-job training and thus reduce the amount of "learning by doing" which can occur, and as a result, when a recession is over, the group of people who would otherwise have gained skills due to simply being employed are left without employable skills, and may thus continue to struggle to find employment


OKUN's LAW!!!!!!!!!!!!!!!!!!!!!!!!!!

A 1% Change in the cyclical unemployment rate is associated with a 2% change in the recessionary gap!

So... if the economy goes into a recession and is producing output at 12% below its potential level, than we know that cyclical unemployment has risen by 6%. Similarly, if cyclical unemployment were in increase by 3%, we could predict that output would decrease to 6% below Y*

HOW TO ESTIMATE NAIRU: You need to know Y*, the current output level, and the actual unemployment rate

1: Find Y* (potential output level)
2: Calculate the recessionary gap as a percentage of Y*: (Y-Y*)/Y* multiplied by 100
3: Take 1/2 of the recessionary gap you just calculated. This is the cyclical unemployment rate
4: Subtract the cyclical unemployment rate from the actual unemployment rate. The difference is the normal U-rate, or NAIRU!




Reducing Frictional Unemployment:
-Here, the goal is to decrease turnover time
-Governments could create giant posting boards to match potential employers with potential workers (i.e., Canada Manpower, workopolis, craigslist)

Reducing Structural Unemployment
-The goal here is to make the supply and demand of labour match
-Government initiatives to retrain and relocate workers can help here
-Eliminating resistance to change (i.e., tariffs and subsidies) can help, as these instruments perpetuate the status quo, and may deter people from getting the skills needed to operate in the new global labor market (i.e., if a tariff is supporting a failing industry, then that tariff is also going to deter people employed in that industry from getting the retraining they require to become employed once that industry inevitably topples)
-Aiding change is key here

Reducing Cyclical Unemployment
-The goal here is to bring Y back to Y* by increasing aggregate demand
-This accomplished using fiscal and monetary policy
-YAY! Gap-busting! =D =D

That's all for unemployment. I hope all of you who read this are successful at avoiding summer employment....