You will type answers to questions in Word as much as possible. If an answer requires graphs or
equations you will handwrite those two parts of an answer. Be careful to graph things clearly and in
detail. Handwritten equations should be clearly and carefully written.PLZ USING OWN WORDS
1. A common assumption in macroeconomics is that the natural rate of unemployment and the full
employment level of output are unaffected by inflation. However, there are numerous theories
for which higher inflation may raise output and lower unemployment in the long run, and some
empirical evidence to support these effects. One such theory assumes nominal wages are
downwardly rigid. In other words, firms may be in a position to want to lower nominal wages
but there is some market force that does not allow them to. In fact there is ample empirical
evidence that labor markets behave in this way.
A. To get a sense of this mechanism, first GRAPH a Classical labor market model with a labor
supply curve, a labor demand curve, and a unique equilibrium point.
B. Suppose for some reason the real wage is above equilibrium. Combine our earlier
assumption that the nominal wage cant fall with the assumption that the price level cant
rise and GRAPH the resulting real wage line. How do these quantities of employment, labor
supply, and unemployment relate to those quantities when the labor market is in the
Classical equilibrium (for each one is it higher, lower, the same, ambiguously related)?
C. This analysis can be extended to when the price level rises. With fixed nominal wages, the
more price rises the lower is the real wage. Therefore unemployment is lower. The faster
price rises the greater the rate of inflation. Hence, this theory yields an inverse relationship
between unemployment and inflation in equilibrium (or the long run).
Can our equilibrium labor market model that we derived from wage setting and price
setting explain this effect? For that model, (see the slides) the natural rate of
unemployment is linearly related to the markup (mu) and factors that affect wage
bargaining (z) and a positive parameter (a) as follows:

Assume wage bargaining power is negatively related to the inflation rate:
z = H – e
where e is a positive parameter. H represents all other factors that positively affect the
wage bargaining power of workers.
We could show, using the production function (in logarithmic form) and an identity
between labor supply, employment and the unemployment rate that output (y) can be
written as a negative function of the unemployment rate:
y = J (1-)u
with J representing all other factors in the production function (capital, labor supply, and
productivity) and is the parameter from the Cobb-Douglas production function. Full
employment output occurs when unemployment is equal to its natural rate.
How does an increase in inflation affect the natural unemployment rate and full
employment output? (positive, negative, zero, or ambiguous). For each of these you must
derive relevant expressions and discuss them. And finally, does the real wage decline with
higher inflation as our first graphical analysis suggests it should? (Hint: to answer this very
last question use economic reasoning. Deriving an equation is tedious and unnecessary)