Question

Question 1: (a) The Wage Setting Relation is given by: WS: W-1"F(u, z) Explain the effect of an increase in the unemployment rate, u, on nominal wage, W. Be sure to explain both intuitively using words and using the above equation. (b) The Price Setting Relation is given by: PS: P (1 m)W Explain the relationship between monopoly power and the markup, m. (c) Re-arrange PS and show that an increase in the markup leads to a decrease in the ral w

Answer 1

A. Increase in unemployment rate,u, leads to fall in nominal wage,W. When unemployment rate increases the bargaining power of the workers fall. They are willing to accept lower wages also. Higher unemployment level also allows firms to offer lower wage and still get enough labor. Hence increase in unemployment rate leads to fall in nominal wage.

W=Pe F(u,z)

Nominal wage W depends on three factor

Pe= Expected price level

u= unemployment rate

z= catchall variable i.e all the other variables affecting wage rate.

u is negatively related and z is positively related to W.

Keeping everything else constant an increase in unemployment rate will lead to decrease in wage rate.

B. PS:P= (1+m)W

P/W=(1+m)

W/P=1/(1+m)

↑m →↑(1+m) →↓1/(1+m)→ ↓W/P

Markup is what the firm can charge over amd above the cost.

Hence when the markup increases real wage decreases