Question

Explain deeply how does increase in prices affect on price-setting relation & wage setting relation? What happens to real wage and unemployment? Why?

Answer 1

W = P^e F( u z)

The aggregate nominal wage, W, depends on three factors:

• The expected price level, P^e
• The unemployment rate, u
• A catchall variable, z, that stands for all other variables that may affect the outcome of wage setting

Expected price level

Both workers and firms care about real wages (W/P), not nominal wages(W).
 Workers do not care about how many dollars they receive but about how many goods they can buy with those dollars. They care about W/P.
 Firms do not care about the nominal wages they pay but about the nominal wages, W, they pay relative to the price of the goods they sell, P. They also care about W/P.

Unemployment rate

Also affecting the aggregate wage is the unemployment
rate, u.
If we think of wages as being determined by bargaining,
then higher unemployment weakens workers’ bargaining
power, forcing them to accept lower wages. Higher
unemployment allows firms to pay lower wages and still
keep workers willing to work.

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