Module 07 · Chapters 6, 9

The Labour Market

Wage-setting, price-setting, and the natural rate of unemployment.

“The medium-run anchor for AS-AD.”

~35 min· 4 sub-skills·5 exercisesExam frequency · high0% mastered

In the medium run, unemployment converges to the natural rate u_N — the level consistent with neither rising nor falling inflation. u_N is set by the labour market, not by the central bank. This module derives it from two relations: how wages respond to unemployment, and how prices respond to wages.
Wage-setting (WS)
$W \;=\; P^e \cdot F(u, z)$
$W$
nominal wage
$P^e$
expected price level (workers care about real wage)
$u$
unemployment rate; F decreasing in u
$z$
structural factors (UI generosity, unionization) — F increasing in z
Higher unemployment weakens workers' bargaining → wages fall. More generous UI strengthens workers → wages rise.
Price-setting (PS)
$P \;=\; (1 + m)\,W$
$m$
markup over labour cost (tied to product-market competition)
Firms set prices as a markup over the marginal labour cost.
Definition·Real wage and the natural rate
Combine WS and PS to get two expressions for the real wage:
- WS: W/P^e = F(u, z)
- PS: W/P = 1/(1+m)

In the medium run P^e = P, so equilibrium requires F(u_N, z) = 1/(1+m). The unemployment rate that solves this is u_N, the natural rate.
Natural rate condition
$F(u_N, z) \;=\; \frac{1}{1+m}$
u_N depends on labour-market structure (z) and product-market competition (m), not on AD shocks.
Figure · WS-PS in the (u, real wage) plane
Loading Phillips curve…
Downward-sloping WS, horizontal PS. Their intersection gives u_N and the corresponding real wage.
Common misconception
The central bank can permanently lower u below u_N.
Actually**No** — sustained u < u_N produces accelerating inflation. In the medium run u returns to u_N regardless of the CB's choice. Demand policy moves Y in the short run only.
Pitfall·u_N depends on z and m, not on i or G
Comparative statics question: 'if G rises, what happens to u_N?' The answer is nothing (in standard Blanchard / Grassi). u_N is set by labour and goods market structure. Demand affects only the deviation of u from u_N.
Exercise · multiple choice · +8 XP
Discouraged workers
A discouraged worker stops looking for a job. The unemployment rate u:
Exercise · true false · +8 XP
WS curve sign
Higher unemployment weakens worker bargaining and lowers wages.
"Higher unemployment weakens worker bargaining and lowers wages."
Exercise · multiple choice · +8 XP
PS slope
In the (u, real wage) plane, the PS curve is:
Exercise · numerical · +14 XP
u_N from F
F(u, z) = 1 − a·u + b·z with a = 2, b = 1, z = 0.1. Markup m = 0.1. Find u_N.
Your answer (decimal (0.0955 ≈ 9.5%))
Exercise · predict shift · +12 XP
Predict — markup rises
Anti-trust enforcement weakens; firms gain pricing power (m rises from 0.1 to 0.2). What happens to u_N?
Scenario: Δm > 0; structural z and F unchanged.

Mastery check

5 questions · pass with 80%

Answer all five to confirm you've internalised the module. A passing run unlocks the next module.

Q1
Which raises u_N?
Q2
"More generous unemployment insurance raises u_N."
Q3
If discouraged workers re-enter the labour force, what happens to u (short term)?
Q4
From PS: P = (1+m)W. The real wage is:
Q5
"An expansionary fiscal policy lowers u_N."

0 / 5 answered

Exam pitfalls

Mixing up u and u_N — u is the actual rate; u_N is the structural anchor.
Saying demand policy lowers u_N. It doesn't.
Forgetting that PS in (u, w) is **horizontal** — only WS slopes.
Confusing 'markup m rising' with 'wages rising'. Higher m means firms keep more, workers less.