Introductory Macroeconomics, Hilary Term 2024

Problem Set, Week 7


  • Suppose that wage- and price-setting in the economy can be described by the following equations:

    W = Pe(1 - αu + z)
    P = (1 + μ)W
    where W is the wage, P the price level, Pe the expected price level, u the unemployment rate, μ the mark-up over marginal labour cost, α a parameter, and z an exogenous variable that shifts the wage-setting curve (representing union militancy, for example).

    1. Find the price level when the labour market is in equilibrium.

    2. Some algebra lets us rewrite the solution to (a) as π = πe + (μ + z) - αu, where π is inflation and otherwise the notation is as before. What is the natural rate of unemployment if inflation expectations are adaptive (meaning inflation is expected to continue at last period's rate)?

    3. Suppose an increase in non-labour production costs (for example energy costs) causes firms to increase the mark-up μ. What happens to the natural rate of unemployment?

    4. What does the parameter α represent? How and why does it affect your answer in (c)?

      5. This question is derived from Blanchard & Johnson.


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