The labour market model and the Phillips curve show that the economy of Country X is in equilibrium with stable prices.

The labour market model and the Phillips curve show that the economy of Country X is in equilibrium with stable prices. Suppose the economy experiences a positive shock to aggregate demand which causes the unemployment rate to fall by 2%.

a. Draw the labour market model and the Phillips curve to show the before and after a positive demand shock situation in country X.

b. What will be the effect of the shock on the bargaining gap and the price level in the scenario above? Briefly explain. (150 words).

c. Now, suppose the inflation rate in the economy is expected to fall from 5% to 2%. Use the Labour market and the Phillips curve to explain the effect on the economy.

Expert Solution

a. Before positive shock economy is equilibrium at point F where AD curve and AS curve intersects at Y * level of output and P* level of price. A positive shock has occurred by fall in unemployment rate into 2% in economy results rightward shift of AD curve into AD1. It will increase the price level into P1. b. After the shock price level increases from P* to P1 . bargaining gap is the difference between the real wage wages that firm wishes to offer in order to provide the workers with incentives to work and the real wage that allows firms that maximizes profit .Here unemployment rate is lower than equilibrium rate. So there would be a positive bargaining gap and there is inflation c. If inflation is expected to fall from 5% to 2 %, then price level decrease to previous level . Short run Philips curve will shift leftward due to fall in inflationary expectation . It will increase the unemployment due to rise real wages . Because labor supply will increase and labor supply curve shift rightward. Unemployment rate will reaches to natural rate of unemployment .

Rahul Sunny answered 2 years ago

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