Question

. Question 2 (5 marks) The wage setting relation W = PECU. z) developed in lectures and in Blanchard, for the situation where P=pe, can be drawn in real wage/unemployment space as follows: t t W/P WS (Wage setting relation) t + (a) (b) Explain why an increase in the unemployment rate would be associated with a lower real wage rate. Explain what effect an increase in the unemployment benefit rate would have on this wage setting relation. Explain the effect an increase in firms' markup would have on the natural rate of unemployment. (c)

Answer 1

A)

An increase in the unemployment rate will mean that there will be lots of working force population in the economy and hence the firms have more substitutes for the labor. Hence the bargaining power of the firm will be high and hence there will be lower real wage rate.

B)

An increase in the unemployment benefit means that their reservation wage has been increased hence if there will be low wage they will not go to work. Here the bargaining power of labor is high. Hence at every unemployment rate their real wage will increase. Hence the wage setting curve will shift upward and there will be new high equilibrium real wage rate.

C)

price setting relation :-- W/P = 1/(1+m), where, m is the markup

hence the price setting curve is horizontal line at W/P = 1/(1+m)

if there is increase in markup maybe because of monopoly or cartel the natural level of unemployment will increase to the new level.

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