Question

1. Explain the impact of the following shocks on real wage and the equilibrium unemployment rate in the medium run. Illustrate your answers using the WS/PS diagram:

a. An increase in the price of oil

b. An increase in unemployment benefits

c. An decrease in policy interest rate.

Answer 1

1. An increase in the price of oil results in an increase in μ. So the PS curve shifts down and the equilibrium shifts from A to B with a lower real wage and a higher unemployment rate.

b) An increase in the umemployment benefit would shift the WS curve to the right as it increases the reservation price of the workers. So the real wage would remain unchanged but there would be an increase in the unemployment rate.

c) A decreas in policy interest rate would reduce μ and thus shift PS curve upwards. This would result in change in equilibrium from A to B with higher real wages and reduced unemployment rate.