Medium Run Equilibrium e =, nominal wages depends on the actual price level,, rather than on the expected price level, e. Earlier, we stated that the nominal wage rate was determined as follows: Dividing both sides by, then: e = F( u, z) (, + ) This relation between the real wage and the rate of unemployment is called the wage-setting relation. = F( u, z) (, + ) e The wagesetting relation The price-determination equation is: = ( 1 + µ ) If we divide both sides by, we get: To state this equation in terms of the wage rate, we invert both sides: = ( 1 + µ ) = 1 ( 1 + µ ) The pricesetting relation
Medium Run Equilibrium By equaling e to and by eliminating / from the wagesetting and the price-setting relations, we can obtain the equilibrium unemployment rate, or natural rate of unemployment, u n : F( u, z) = n 1 1 + µ = F( u, z) (, + ) e The wagesetting relation The equilibrium unemployment rate (u n ) is called the natural rate of unemployment. = 1 ( 1 + µ ) The pricesetting relation The natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting and expected price level equals actual price level.
Medium Run Equilibrium ages, rices, and the Natural Rate of Unemployment = F( u, z) (, + ) e The wagesetting relation Note that the real wage implied by price setting is 1/(1 - µ); thus depends on competition and not on the unemployment rate. = 1 ( 1 + µ ) The pricesetting relation The natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting and expected price level equals actual price level.
Equilibrium Real ages and Natural Level of Unemployment An increase in unemployment benefits leads to an increase in the natural rate of unemployment. The wage-setting relation = F( u, z) (, + ) e The price-setting relation = 1 ( 1 + µ ) The positions of the wage-setting and price-setting curves, and thus the equilibrium unemployment rate, depend on both z and u. At a given unemployment rate, higher unemployment benefits lead to a higher S curve. A higher unemployment rate is needed to bring the real wage back to what firms are able to pay. By letting firms increase their prices given the wage, less stringent enforcement of antitrust legislation or more government protection of incumbents leads to a decrease in the real wage. (next page)
Equilibrium Real ages and Natural Level of Unemployment An increase in unemployment benefits leads to an increase in the natural rate of unemployment. An increase in markups decreases the real wage, and leads to an increase in the natural rate of unemployment. The wage-setting relation = F( u, z) (, + ) e The price-setting relation = 1 ( 1 + µ )
Aggregate Supply The aggregate supply relation captures the effects of output on the price level. It is derived from the behavior of wages and prices. Recall the equations for wage and price determination : e = F( u, z) = ( 1 + µ ) e Step 1: Eliminate the nominal wage from: = ( 1 + µ ) F( u, z) In words, the price level depends on the expected price level and the unemployment rate. e assume that µ and z are constant. Step : Express the unemployment rate in terms of output: Y <=> N u U = = L L N L N = 1 = 1 L Therefore, for a given labor force, the higher is output, the lower is the unemployment rate. Y L
Aggregate Supply Step 3: Replace the unemployment rate in the equation obtained in step one: e Y = + F L z ( 1 µ ) 1, In words, the price level depends on the expected price level, e, and the level of output, Y (and also µ, z, and L, but we take those as constant here). The AS relation has two important properties: 1. An increase in output leads to an increase in the price level. This is the result of four steps: 1.. 3. 4. Y N N u u
Aggregate Supply 1. An increase in output leads to an increase in the price level. This is the result of four steps: 1.. An increase in the expected price level leads, one for one, to an increase in the actual price level. This effect works through wages: 1. e. Y N u The upward sloping AS curve goes through point A, where Y = Y n and = e. This property has two implications: hen Y > Y n, > e. hen Y < Y n, < e. e Y = + F L z ( 1 µ ) 1, Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level.
3 Equilibrium in the Short Run The aggregate supply curve AS is drawn for a given value of e. The higher the level of output, the higher the price level. e Y AS Relation = + F L z ( 1 µ ) 1, The aggregate demand curve AD is drawn for given values of Ms, G, and T. The higher the price level is, the lower the level of output. AD Relatio n Y = Y M G T,, The Short Run Equilibrium is given by the intersection of AS and AD. At point A, the labor market, the goods market, and financial markets are all in equilibrium. The Short Run Equilibrium
From the Short Run to the Medium Run Equilibrium output depends on the value of e. The value of e determines the position of the aggregate supply curve, and the position of the AS curve affects the equilibrium. At point A, Y > Y > e is given by the intersection of AS and Y n at point B. n e The Short Run Equilibrium => age setters will revise upward their expectations of the future price level to p e. This will cause the AS curve to shift upward. Expectation of a higher price level also leads to a higher nominal wage, which in turn leads to a higher price level p. e e B Yn
From the Short Run to the Medium Run Y = Y and = The adjustment ends once and wage setters no longer have a reason to change their expectations. In the medium run, output returns to the natural level of output. n e If output is above the natural level of output, the AS curve shifts up over time, until output has decreased back to the natural level of output. e3 = 3 3 3 Medium run equilibrium (A 3 ): AS crosses AD and = e (=> Y=Y n )
From the Short Run to the Medium Run In the short run, output can be above or below the natural level of output. Changes in any of the variables that enter either the aggregate supply relation or the aggregate demand relation lead to changes in output and to changes in the price level. In the medium run, output eventually returns to the natural level of output. The adjustment works through changes in the price level. e3 = 3 3 3