The Natural Rate of Unemployment - Research Proposal Example

Assessment Essay Contents Contents 2 Answer 2 a) 3 Answer 2 b) 7 References 8 Answer 2 a) The flexibility in the aggregate income of the population is calculated with the help of the sticky wage model in which the aggregate demand and the aggregate supply curve is being used. While in the long run the aggregate supply curve is a horizontal line prices being flexible in the long run, in the short run the AS curve is a vertical line indicating rigidity in the prices in this shorter span of time. The positively sloped aggregate supply curve shows the trade off that takes place between inflation and unemployment in the economy. The models of aggregate supply show that relation as depicted in the following equation. This is the chief functional form of the aggregate supply equation. The equation states that as the output undergoes a deviation from the natural rate the existing level of prices also undergoes a deviation from the expected price level of the economy. α is the percentage of the changes in the output as a response to adjust in the price level of the economy. 1/α represents the slope of the aggregate AS curve. The sticky wage model of aggregate supply would determine the determination of the wages in the short and the long-run. The model can be explained with the help of the diagram below. According to this model the workers and the firms undertake negotiation in order to decide on the nominal this. This negotiation is done irrespective of the expected price level of the economy. The nominal wage is the determined as the product of the target real wage rate and the expected level of price in the economy. Most of the economists are of the opinion that the nominal wage in the economy is sticky in the short run. With a sticky nominal wage in the economy, the prices would increase from P to P0. This would reduce the real wage rate in the economy. Since the wages are the prices for labour the demand curve for labour would be a downward sloping curve and the supply curve would be an upward rising one. The now the labour market would comprise of the employed and the unemployed labour force. Thus the total labour in the economy would be L = N + U. Therefore the level of unemployed in the economy would be L - N, where L is the total labour force, N is the employed and U is the unemployed. Therefore the natural rate of unemployment in the economy would be U* / L. Figure 1: Equilibrium in the Demand and Supply of Labor Source: Chamberlin and Yueh, 2006, pp. 331-338 Now the wage setting relation establishes a negative relationship between the real wage that exists in the economy and the rate of unemployment existing in the economy. This relation can be represented by the downward sloping curve that is shown in the diagram below. As the rate of unemployment in the economy would increase the wages that the labourers would demand would be less (Broughton, 2009. pp. 3-5). This established the fact that the rate of unemployment would be low if there is ample competition between the employed and the unemployed. In such a case, each set of people would be willing to remain employed at much lower prices. This means that the bargaining power of the workers would decline with an increase in the level of unemployment in the economy. Source: Blanchard, 2013, p. 130 In this particular figure the real wage has been measured in the vertical axis and the horizontal axis measures the rate of unemployment in the economy. Thus the higher the unemployment in the economy, the bargaining power of the workers would decline and thus the wage would be set at a lower rate. On the other hand the prices would be independent of the rate of unemployment in the economy. Thus it would be a horizontal straight line. The equilibrium rate of unemployment would be determined at the point of intersection of these two lines. The real wage would be set at the point 1/ (1+µ) and the rate of unemployment would be at the point u. The natural rate of unemployment would be determined when the labour market would be in equilibrium. This would happen when the demand for labour would be equal to the supply of labour in the labour market. Therefore the competition in the labour market would lower the natural rate of unemployment. Answer 2 b) In case of intervention by the government the wages that otherwise would have been set by the market forces would be determined by the government. Therefore the wage line would be a horizontal straight line that would determine the level of unemployment in the economy. Now the people who would be employed would depend on the power of the labour unions. The unions who are socially and politically in a stronger footing would be able to maintain a better position of power in the economy (Blanchard and Katz, 1997, pp. 51-72). Thus the rate of employment would depend on the monopoly power of the labour unions. On the other hand, the rate of unemployment in the economy would increase because the bargaining power of the union would be strong. This would lead to increase in the level of the wages of the existing set of employed population with a decrease in the number of employed. If the government does not try to make an attempt to reduce the level of unemployed in the economy, the taxes revenue would decline and the unemployed in the economy would have to be paid the unemployment benefits would lead to an increase in the economic costs for the government. On the other hand, the government can also make the competitive forces in the economy more effective. This would distribute the bargaining power of the labour force. Hence the people would be ready to work at much lower wages. This is turn would increase the participation rate in the economy and would lower the rate of unemployment. Therefore the main objective of the policymaking for the government should be the achievement of the full employment equilibrium. References Blanchard, O., 2013. Macroeconomics. London: Prentice Hall. Blanchard, O and Katz, L., 1997. “What We Know and Do Not Know about the Natural Rate of Unemployment”, Journal of Economic Perspectives, Vol. 11(1), pp.51-72. Broughton, A., 2009. “Wage formation in the EU”, Institute for Employment Studies (IES). Available at: http://www.eurofound.europa.eu/docs/eiro/tn0808019s/tn0808019s.pdf [Accessed 2nd December 2013] Chamberlin,G. and Yueh, L. Y., 2006. Macroeconomics. Mason: Cengage Learning EMEA. Read More