Question

Question 2 (5 marks) The wage setting relation W PE(u, z) developed in lectures and in Blanchard, for the situation where P=P®, can be drawn in real wage/unemployment space as follows: W/P WS (Wage setting relation) u (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.

Answer 1

(a)

There exists a negative relationship between real wage rate and the unemployment rate. An increase in unemployment rate implies that the firms are hiring less labor. This reduces the bargaining power of the already employment workers.

Firm will therefore can give lower wages to its worker without severe retaliation from the labor union. So, increase in the unemployment rate reduces real wage rate and vice-versa.

(b)

Increase in unemployment benefits increases the real wages of the workers. It also leads to increase in the natural rate of unemployment. As a result, the WS relation curve shifts up (to right).

(c)

A rise in mark up is seen as a decline in the productivity level of the workforce. It reduces the real wage and leads to increase in the natural rate of unemployment. The WS relation curve remains same. Horizonal PS curve shifts down and the unemployment increases.