Answer to Question #51177 in Macroeconomics for Matt

Question

Assume that workers, employers and investors all believed that inflation in the coming year would equal the annualized rate of inflation experienced in the past 6 months. Also assume that workers had been receiving nominal wage gains of 5% during a several year period where the annual inflation rate was 2%. Now assume that a decline in the unemployment rate below NAIRU creates conditions where workers push for an annual real wage increase of 4%. Also assume that labor productivity growth declines to 1% per year as unemployment is squeezed below normal frictional & structural levels.

a) What rate of nominal wage growth will workers seek at the new low unemployment rate?

b) How fast will firms have to raise prices given your answer in (a) in order to protect profit margins?

c) If the rate of inflation in (b) occurs and the Fed allows AD to grow fast enough to maintain the unemployment rate below NAIRU for another year, what rate of nominal wage growth will workers
seek in the following year?

d) If the rate of inflation in (b) had persisted for 6 months or more, how large an increase in the federal funds rate would be needed to increase the level of real interest rates in the economy?

Answer 1

a) The new rate of nominal wage growth at the new low unemployment rate is 5 + 4 = 9%
b) The firms have to raise prices before the wage increase in order to protect profit margins.
c) If the rate of inflation in (b) occurs and the Fed allows AD to grow fast enough to maintain the unemployment rate below NAIRU for
another year, the rate of nominal wage growth in the following year is
9% too.
d) If the rate of inflation in (b) had persisted for 6 months or more, an increase in the federal funds rate of 9 - 2 = 7% would be
needed to increase the level of real interest rates in the economy.