Question

a) Draw a wage curve and profit curve diagram in which the unemployment rate in equilibrium is 6%. Suppose there is an exogenous increase in aggregate demand. Using your diagram, explain carefully why inflation may occur during such an upswing in economic activity.

b) Suppose that the expected inflation rate in the economy was 0 and that this occurred at an unemployment rate of 6%. Suppose now that the government tried to boost aggregate demand to hold unemployment at 3%. Using the concept of the Phillips Curve explain why this situation may lead to increasing inflation.

c) Recently, in the wake of the EU referendum, the pound’s value has fallen considerably. This is likely to increase the costs of firms in the UK. Using your diagram from part (a) above, discuss what happens when input costs rise for firms.

Answer 1

a) Point X is the equilibrium between the Wage curve & Profit curve.

:Labour supply Price-setting curve Wage-setting curve No work done: wage is too low for adequate effort 0 1 2 4 5 9 7 Employed Unemployed Employment in %age, N

All of the points in the shaded area below the wage-setting curve are labeled ‘no work done’ because in this region the real wage is insufficient to motivate workers to work. In this situation, there is no work done and no profits, so nobody is hired: the only outcome possible in the long run if the real wage is below the wage-setting curve is zero employment. These shaded points are not feasible.

The equilibrium of the labour market is where the wage- and price-setting curves intersect. This is a Nash equilibrium because all parties are doing the best they can, given what everyone else is doing. Taking the economy as a whole, at the intersection of the wage and price setting curves (point X):

• The firms are offering the wage that ensures effective work from employees at least cost (that is, on the wage-setting curve). HR cannot recommend an alternative policy that would deliver higher profits.
• Employment is the highest it can be (on the price-setting curve), given the wage offered. The marketing department cannot recommend a change in price or output.
• Those who have jobs cannot improve their situation by changing their behaviour. If they worked less on the job, they would run the risk of becoming one of the unemployed, and if they demanded more pay, their employer would refuse or hire someone else.
• Those who fail to get jobs would rather have a job, but there is no way they can get one—not even by offering to work at a lower wage than others.

In case where the aggregate demand increases. That means the average inflation increases, which would eventually decrease the employment rate. Graphically, we can see from below point Y represents that average labour cost and price would increase. The firms would be willing to pay more to enhance their profits.

Labour supply Average product of labour, A Price-setting curve Wage-setting cu No work done: wage is too low for adequate effort 1 4 Employed Unemployed Employment in %age, N

b) Using the Philip Curve in the graph below . X axis shows the employment in %age and Y axis shows Inflation %age. If the government wants to hold unemployment at 3%, then the inflation will increase to 2%, An increase in inflation means that average real income of the people has now increased and enabling them to demand more.

1 2 4 Unemployment %

c) Where the pound value has decreased, means the input cost would increase and eventually the price has to be decreased to maintain the profitability by selling more units of output, which has to be achieved with less of labour. This would increase the unemployment rate,from 6 % of employment rate decreases to 5%.

lLabour Supply Average product of labour Price setting curve Wage Curve No work done:Wage is too low for adequate 1 2 4 Employment Unemployment Unemployment Rate