Question

Using AD-BT-ERU diagram (assuming ERU curve is a downward-sloping curve, and PS curve is flat), analyze these following shocks to the equilibrium unemployment, real
exchange rate, trade balance, and real wage (W/Pc).
a. A rise in productivity
b. A fall in union bargaining power
c. An increase in world output

Answer 1

The AD-BT-ERU models of economics gives a consolidated explanation of the Balance of Trade (referred to as BT), the side of Demand (referred to as AD) and the supply side of the Imperfect competition (referred to as ERU). This consolidated model states that the prices are fixed in the short run and that the output is determined by the Demand for the product. In the average or medium run, the prices and wages tend to bring about an equilibrium which results in the inflation being constant, and in the longer run, the economy gradually moves towards Balance of economy, thereby stabilizing the Balance of Trade.

  

(a) As shown in the diagram, the ERU curve is a downward sloping curve, which forms the basis for the intersection with the Trade Balance (BT Curve) and the Demand curve (AD curve ) . As given, let us assume that there is a rise in productivity. The rise in productivity will raise the bar of the ERU which will also impact the BT and AD in the sense that it will tend to increase the productive demand form the market and will lead to a better Trade balance. The rate of employment which enjoyed an equilibrium position would tend to destabilize, as the rise in productivity would mean that the required number of demanded products can now be produced by an even lesser number of workers or laborers. This will tend to reduce the real wage rate of the laborers in the economy since the firms will now want to pay lesser for those laborers which are extra for it. For those number of laborers which are more productive and directly contribute to the better productivity of the firm may receive a better pay out, but since the overall productivity has risen, the firms may tend to keep their wage rate to the productive group at either a constant level or reduce it. The Balance of trade would see a positive shift, as due to rise in productivity, the increased demand for the products would shift the BT curve higher.

(b) Another critical factor which determines the overall economic condition as per the AD-BT-ERU model is the bargaining power of the unions in the firms. If the Unions fail to properly bargain their wage rate in accordance to the rise in in productivity or in accordance to their average productivity, the firms would tend to lower the wage rate of the laborer’s and keep the union in check. The Union failing to convince the firms to maintain or increase their average wage would result in the laborers receiving a lower rate of rate and it may also lead to a situation where the firms may tend to cut the jobs of the few extra workers or laborers. This will have a direct impact at the increased level of unemployment and it will further rise. Therefore, the role of the firms in the AD-BT-ERU model is of paramount importance in maintaining the balance of trade and the level of wage rate in the economy and in the control of unemployment.

(c) When the average world output increases, this would mean that the demand for the products would reduce, as the other economies or external firms are now producing higher number of products. This will directly impact the prices of the products, as since the demand falls, the excess of the products would now need to be sold at a lower rate. This will also destabilize the balance of trade, as the economies would now tend to lower their prices. However, in the longer run, the BT curve may become stabilized again, owing to the economic condition of the market. The increased worldwide productivity would shift the Demand curve lower (AD2), and since the firms are now facing a less profitable market, this will tend to lower the wage rate of the workers and also push up the level of unemployment in the economy.