Question

Suppose the economy is initially at labour market equilibrium with stable prices (inflation is zero). At the beginning of year 1, investment declines and the economy move into recession with high unemployment.

a) Explain why a negative bargaining gap arises?

(b) Assume the negative bargaining gap is -1%. Draw a Philips curve and show the impact of this on inflation.

c) Without a monetary or fiscal policy to counter the negative bargaining gap, what would be the impact on Philips curve within 3 years? draw a diagram and explain in words.

d) Who are the winners and losers in this economy?

e) Evaluate the following statement if it's right or wrong and explain why: "When the economy is in equilibrium in the WS−PS model, there is only voluntary unemployment, because no agent has an incentive to change their behaviour".

Answer 1

1) During recession there is slump in the demand, which induces high unemployment which further reduces the ability of workers to get higher wages. As a result bargaining power of employees fall and even turns out negative as inflation is low (due to fall in prices) and philips curve lie in the negative region. Negative bargaining gap correspondes to wage setting curve below than price setting curve and arises if real wages fall too less of prices charged ( which would be a case as unmeployment increases).

2) Inflation will be negative in this case.

3) Philips curve will reamsin in the downward falling where larger portion remains negative.

4) Due to recession there woulld be lower inflation in the economy, thus interest rate needs to be low to bring economy out of downfall, thus lower interest rate would benefit the borrowers but against lenders. On the other hand workers are worst hit in relation to employer as the wages they would receive tends to be very low due to reduced bargaining power.

5) In the case where WS- PS are in equilibrium the bargaining gap is zero, hence no one wants to change their behaviour. As the real wages offered by employer are accepted by employee at the same time the markup value is large enough to maximises the profit of employer.