Answer to Question #219907 in Macroeconomics for Collins

Question

1. Consider a labour market where both price setters and wage setters have some market
power. Briefly explain the relationship between labour market behavior and the AS
schedule.
2. Suppose that the economy starts at the natural level of output and that due to reforms in
job protection laws in favor of workers, the AS shifts from its original position.
a. What is the short-run effect on output and prices?
b. What happens to output and prices over time (i.e. in the medium run)?
3. Suppose that the government is running a budget deficit and decides to reduce it by
increasing revenue through increased taxes while leaving its spending unchanged.
(a) Explain the short run and medium run effects of this policy.
(b) Is this decrease in budget deficit always good for investment? Explain.

Answer 1

1. According to macroeconomic theory the fact that wage growth lags productivity growth, indicates that supply of labor has outpaced demand. When this happens there is downward pressure on wages as workers compete for scarce jobs. If demand outpaces supply there is upward pressure on wages as workers have more bargaining power and likely to get higher paying job while employees must compete for scarce labor.

2$($ a$)$ In short run period there is stickiness of wages and prices that may prevent the economy from operating at potential output .

$($ b$)$ In the medium run output is too high and price is higher than expected.

3$($ a$)$ A budget deficit will cause decrease in aggregate demand which results in a decrease in real GDP and income.

$($ b$)$ A decrease in budget deficit is not always bad. As the economy improves due to deficit spending, the outlook for business also improves and this can lead to increased investment, an effect known as crowding in.