Question

Assume expectations of both prices and productivity are accurate, use the PS/WS relations, graphically illustrate and explain the effects of an increase in the productivity on the natural rate of unemployment.

Answer 1

Given:

Wage setting relation: W = p e F(u,z)

Price setting relation: P = (1+μ )W/A

as expectations of both prices and productivity are accurate,

pe = P

From wage setting relation we get:

W/P = F(u,z)

From price setting relation we get:

W/P = A/(1+μ )

Solving wage setting relation and price setting relation simultaneously we get,

F(u,z) = A/(1+μ )

An increase in the productivity results in an increase in the real wage rate due to which the price setting line shifts upward and natural rate of unemployment falls.