Question

Supposed there is a contemporaneous fall in the labour productivity and the trade union power become more stronger.
(i) Using a WS-PS curve (wage setting-price setting), explain the effects on the labour market.
(ii) Using IS-PC-MR, explain how the central bank reacts upon a changes in the labour market equilibrium.

Answer 1

ANS (i) Supply-side policies refer to those that shift the wage- or price -setting curves. Changes in unemployment benefits, minimum wages, union and employment protection legislation, child care policy and participation by the government in negotiations with union's and employers' associations may shift the WS- curve. Changes in competition policy or in taxes may shift the PS-curve. Taxation has effects on both the aggregate demand and supply sides of the economy; on the one hand, it may be used to stabilize aggregate demand and on the other hand; it has supply-side implications. It has also been suggested that government expenditure programmes on training or education may be able to reduce equilibrium unemployment by raising productivity. In many instances, supply-side policies are implemented to support government objectives other than those associated with macroeconomic stabilization. For example, the government may seek to alter the distribution of income, to reduce child poverty, to boost innovation and entrepreneurship, etc. It is nevertheless important for the consequences for employment and inflation of such policies to be examined.

There are basically two factors that shift the WS- and PS -curves:-

- Wage push factors that shift the WS curve, and

- Price -push factors that shift the PS curve.

The diagram showing the WS-PS curve can be drawn in the following manner:-

Here, we have used W as the money wage and P as the price level without worrying about their precise definition. This entails measuring W as the post-tax money wage paid to the employee and to measure P _c as the consumer price index. i.e inclusive of indirect taxes.

P_c =P *( 1+ t₀ )

This means that when we show W/P_c on the axis of labour market diagram, this is the real consumption wage. The difference between the real consumption wage and the real product wage is called the tax Wedge.

Ans (ii) Let us take an economy in which policymakers are faced with a vertical Philips curve in the medium run and by a trade-off between inflation and unemployment in the short run. In setting out a 3-equation model, we make two ad-hoc but empirically based assumptions, the first relates to the persistence of inflation and the second to the time lags in the reaction of the economy. At this stage, we simply assume that the inflation process is persistent, in line with a wealth of empirical evidence. In terms of adjustment lags, we assume that it takes one year for monetary policy to affect output and a year for a change in output to affect inflation.

The first step is to present two of the equations of the 3-equation model. The standard IS curve is shown in the top part of the diagram as a function of the real interest rate. The real interest rate is the short-term real interest rate, r. The central bank can set the nominal short-term interest rate directly, but since the expected rate of inflation is given in the short run, the central bank is assumed to be able to control r indirectly. In the lower part of the diagram the vertical Philips curve at the equilibrium output level y_e is shown, We think of labour and product markets as being imperfectly competitive so that the equilibrium output level is where both wage- and price- setters make no attempt to change the prevailing real wage or relative prices.

For convenience, the "short-run " Philips curve is shown in linear. Each Philip's curve is indexed by the pre-existing or inertial rate of inflation,$\small \pi ^{1}=\pi -1$ They take the standard simple form in which inflation this period is equal to lagged inflation plus a term that depends on the difference between the current level of output and that at which the labour market is in equilibrium. Thus, the IS, PC and MR curve can be drawn in the following manner:-