Explain clearly how the natural rate of unemployment is determined in a wage-setting and price-setting model of the labor market
In determining the natural rate of unemployment, analysts focus on evaluating price and wage settings in the labor market. In this regard, they analyze price relations within the scope of an imperfectly competitive market. Analyses of price settings incorporate factors such as the nominal wage, which influence the relationship between the real wage and employment. The Analysis of wage settings focuses on the identification of the nominal wage settings within the labor market. Analysts incorporate factors such as the price level, which determines the relationship between the real wage and employment.
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In addition, they use data on price and wage settings to determine the natural rate of unemployment by reconciling the value of real wage derived from the analysis of price settings with the value obtained from the analysis of wage settings (Doyle 2005, p.309). The reconciliation process disregards normal rigidities, which introduce discrepancies between the actual rate of unemployment and the natural rate of unemployment. Differences in the two types of unemployment rates alter prices and induce wage inflation. Illustration of price and wage settings resembles a demand and supply curve with the wage/price on the horizontal axis, and unemployment (U) on the vertical axis. The analysis of the curve provides an equilibrium point in the labor market, which indicates the natural rate of unemployment. The downward-sloping curve responds to changes in the labor market by shifting upwards or downwards to a new point of equilibrium.
Examine the effect on the natural rate of unemployment of a rise in unemployment benefit
The rise in unemployment benefits has significant impacts on the level of frictional unemployment, which is one of the main components of the natural rate of unemployment. The motivation to take a job varies depending on the ratio of unemployment benefits to employment. In this regard, a high ratio reduces the incentive to work and vice versa. Analyses of unemployment benefits in the United Kingdom in the past 15 years indicate that the natural rate of unemployment has been on a downward trend due to an increasing disparity between unemployment benefits and paid employment. Economists attribute this phenomenon to the fact that wages have been rising faster than the rate of inflation. In this regard, unemployment benefits have considerably declined to force unemployed people to look for jobs. In countries where the level of wages does not correspond to the rate of inflation, the natural rate of unemployment is normally high because people consider the benefits of employment as insignificant.
The level of minimum wage greatly affects the motivation to take jobs. Countries that set high minimum wages have a low natural rate of unemployment since high wages are relatively attractive in comparison to unemployment benefits. High minimum wages encourage most people to seek jobs. On the other hand, setting low minimum wages leads to a high natural rate of unemployment due to a lack of incentives that increase people’s tendency to take jobs (Melvin & Boyes 2011, p.318). Policies meant to reduce unemployment benefits force people to take up jobs thus reducing the natural rate of unemployment. When a country enacts laws meant to encourage unemployed people to take up jobs by retraining them, the ratio between unemployment benefits and paid employment is likely to reduce as more people turn their attention to securing jobs. Evidence shows that provisions in the New Deal, which defined retraining schemes for workers, caused a considerable decline in the natural rate of unemployment.
A fall in price mark-ups by firms
The fall in price mark-ups of firms leads to a decline in the natural rate of unemployment due to the alteration of wage settings. Price mark-ups have an inverse relationship with wages and thus a fall in price mark-ups leads to high wages. In this regard, the point of equilibrium in the labor market shifts upwards. Change in price mark-ups results due to factors such as non-labor costs and increased marketing power, which alter price settings. Firms change price mark-ups in the attempt to set market prices for their products. However, over time, operation costs push firms to adopt practices that change the real-wage rate. High price mark-ups adversely affect real wages thus encouraging the preference of benefits of unemployment (Hall & Lieberman 2009, p.457).
On the other hand, a fall in price mark-ups reflects declining operation costs and cushions workers against firms’ tendency to alter wages in response to the rising cost of operation. In this regard, the natural rate of unemployment improves considerably since the incentive for workers to take up jobs remains relatively high (D’Souza 2008, p.302). Adjustment of price mark-ups reflects market conditions throughout the industry and thus minimizes the tendency by workers and labor unions to demand high wages, which may force firms to adopt measures that increase unemployment rates. Negotiations on nominal wages by workers and labor unions depend on the rate of unemployment. High levels of unemployment cause increased competition for available jobs and thus restrict workers within market rates. On the other hand, low unemployment rates depict high demand for labor supply, which means workers and labor unions can negotiate for high wages based on the benefits of unemployment.
D’Souza, E. 2008. Macroeconomics. Pearson Education: New Delhi.
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Doyle, E. 2005.The Economic System. John Wiley & Sons: Hoboken.
Hall, R. E., & Lieberman, M. 2009. Macroeconomics: principles and applications. Cengage Learning: New York.
Melvin, M., & Boyes, W. 2011. Economics. Cengage Learning: New York.