Macroeconomics theory – Econ 202 – 2 questions

Question 1: Over recent decades in the U.S. economy there have been a set of changes that,

together, have reduced worker bargaining power (reduced ‘z’). These changes include declining

unionization rates and a declining inflation-adjusted minimum wage. (15 points)

a. Use the baseline version of the labor market model (i.e. in which the markup depends

only on the degree of competition between firms and not on relative bargaining power) to

graphically analyze the effect of these changes in labor market institutions on the natural

rate of unemployment and real wages.

Because our labor market model is based on the relative bargaining power of workers and

employers, a reasonable extension of our model also allows the mark-up to change when

bargaining power changes.

b. If the mark-up also depends on bargaining power, does the mark-up increase or decrease

when worker bargaining power falls? Why?

c. In this case, show the effect of declining unionization rates using the graphical labor

market model. What happens to real wages and unemployment? Explain briefly.

d. Compare your answers to (a) and (c). Which version of the model do you find more

convincing and why? (Explain in 1-2 sentences).

Question 2: Describing the relationships in the Phillips curve (10 points)

Consider the following general form of the Phillips curve:

π” = π”

$ + (m + z) − αu”

a. If there is an increase in the markup, what happens to inflation? Explain why.

b. If there is an increase in unemployment, what happens to inflation? Explain why.

Question 3: Anchored versus adaptive expectations and the Phillips curve (15 points)

Suppose the Phillips curve is given by:

�. = �.

/ + 0.1 − 2�.

a. What is the natural rate of unemployment?

Assume that inflationary expectations are anchored at 0%. Suppose that the rate of

unemployment was initially equal to the natural rate. In year t, the authorities decide to bring the

unemployment rate down to 3% and hold it there forever.

b. What is the rate of inflation in years t, t + 1, t + 2 and t + 5?

c. Do you think that, in year t+5, people will still expect inflation to be 0%? Why or why

not? (Hint: think about how people are likely to form expectations of inflation).

Now suppose that in year t + 6 inflationary expectations become adaptive. Suppose that the

government is still determined to keep u at 3% forever.

d. What is the inflation rate in years t + 6, and t + 7?

e. Continue to assume inflationary expectations are adaptive. What happens to inflation

when unemployment is kept below the natural rate of unemployment? What happens to

inflation when unemployment is kept at the natural rate of unemployment?