Tutorial 5

(Corresponding to Lecture 8 & 9)

Qichao Wang

Hong Kong University of Science and Technology, Department of Economics

28 March 2025
Outline
• PS2 Question 1
• PS2 Question 2
• PS2 Question 3
• PS2 Question 4 & 5
• Summary
Indicators of the labour market condition
Labour market
Labour market equilibrium
Philips curve
• Question 1 - Price markup and natural rate of unemployment
• Question 2 - Labour market demand and natural rate of
unemployment
• Question 3 - Natural rate of unemployment
• Question 4 - The medium-run equilibrium
PS2 Question 1
(Chapter 4, Q7)
Velocity of Money
• The question asks the person’s money holding every morning,
before she needs any of the money she withdraws (time
point)
• She goes to the bank at the beginning of the day she
withdraws money
• Right after she withdraws money, she has full holding of the
money she withdraws
• ATM reduces average money holding as people can withdraw
money more frequently
• Going to ATMs are more convenient than going to bank
counters
• Credit card reduces average money holding as people pay after
spending
• With a credit card, people do not need to withdraw money
before the payment day
• Technology increases the velocity of money
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PS2 Question 2

$𝑌 𝑃𝑌
• Velocity of money: $𝑌 = 𝑀 𝑉 ⇒ 𝑉 = 𝑀 = 𝑀
• Money demand:
𝑖̄
𝑀 = $𝑌 𝐿(𝑖) ⇒ Δ𝑀 = Δ$𝑌 + Δ𝐿 ⇒ Δ𝑀 = 𝜋 + Δ𝑌 + Δ𝐿
• Δ𝐿 here is the money demand curve shifter, Δ𝐿 < 0
represents money demand-related technology advancement
• Money demand declines when such technology advancement
outweighs nominal GDP growth
• Dynamics: Δ𝑉𝑡 = Δ$𝑌 𝑡 − Δ𝑀𝑡 = 𝜋𝑡 + Δ𝑌𝑡 − Δ𝑀𝑡 = −Δ𝐿𝑡

• The increase in velocity of money is possibly from inflation,

increase in real output, and decline in money supply/demand
• An increase in velocity of money implies money
demand-related technology advancement

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PS2 Question 3
Mix of fiscal policy and monetary policy Tutorial 4: Application of IS-LM model

A Initial condition
B Fiscal contraction (𝑇 ↑)
• Goods market: 𝑇 ↑⇒ 𝐶 ↓⇒ 𝑌 ↓⇒ IS curve ←
𝑖𝐴̄
𝑀𝑆
• Money market: 𝑌 ↓⇒ Money demand curve ←⇒ 𝑃 ↓
C Monetary expansion (𝑖 ↓)
• Policy aim: Turn the output back to A (the key of the
question)
𝑌𝐶 =𝑌𝐴
• IS-LM: IS curve ← ⇒ 𝑖 ↓ (IS curve does not shift by a
change in 𝑖)
• Money market: When the output turns back to 𝑌𝐴 , the money
𝑆
demand curve also shifts back, then 𝑀𝑃 ↑ to achieve 𝑖𝐶̄ < 𝑖𝐴̄
• Output stabilization: The definition of “Medium run” in
this course Question 4

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PS2 Question 4 & 5

Effects of fiscal policy and monetary policy on the real economy

(including IS-LM curve shifts) Tutorial 4: Application of IS-LM model

IS LM
Policy Variable 𝑌 𝐶 𝐼 𝑆 𝑖 𝑀
curve curve
Fiscal expansion 𝐺 ↑ or 𝑇 ↓ ↑ ↑ ↑ ↑ − ↑ → −
Fiscal contraction 𝐺 ↓ or 𝑇 ↑ ↓ ↓ ↓ ↓ − ↓ ← −
Monetary expansion 𝑖 ̄↓ ↑ ↑ ↑ ↑ ↓ ↑ − ↓
Monetary contraction 𝑖 ̄↑ ↓ ↓ ↓ ↓ ↑ ↓ − ↑

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Indicators of the labour market condition

• Working age population

• Have a job / Employed in the labour force (𝑁 )
• Not have a job but looking for one / Unemployed in the labour
force (𝑈 )
• Not in the labour force (𝑁 𝐿𝐹 )
• Labour force: 𝐿 = Employed in the labour force +
Unemployed in the labour force = 𝑁 + 𝑈
Unemployed in the labour force
• Unemployment rate: 𝑢 = Labour force =𝑈
𝐿
Labour force 𝐿
• Participation rate: Working age population = 𝐿+𝑁𝐿𝐹
Employed in the labour force 𝑁
• Employment rate: Working age population = 𝐿+𝑁𝐿𝐹
• Employment rate is NOT one minus unemployment rate

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Labour market
Price determination
• 𝑃 = (1 + 𝑚) 𝑊 𝒜
𝑃 Price
𝑚 Markup: market power (0 in competitive market)
𝑊 Cost of hiring an additional worker
𝒜 Marginal product of labour
• Production function: 𝑌 = 𝒜𝑁
𝑁 Number of employed workers
𝑊
• Marginal cost of production: 𝒜
Wage determination
• 𝑊 = 𝒜𝑃 𝑒 𝐹 ( 𝑢 , 𝑧 )
(−) (+)
𝑒
𝑃 Expected future price level
𝑧 Other factors of real wage per unit of production (labour
union, UI, etc)
• 𝑃 𝑒 = 𝑃 in the medium run

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Labour market equilibrium

• Natural (equilibrium) rate of unemployment (𝑢𝑛 )

• Natural: medium run (we consider the medium-run now)
Tutorial 1: Short, medium, and long run

• Wage determination (Labour supply):

𝑊 = 𝒜𝑃 𝐹 (𝑢, 𝑧) ⇒ 𝑊𝑃 = 𝒜𝐹 (𝑢, 𝑧)
• Price determination (Labour demand):
𝑃 = (1 + 𝑚) 𝑊 𝑊
𝒜 ⇒ 𝑃 = 1+𝑚
𝒜 Question 2

1
• Equilibrium: 𝐹 (𝑢𝑛 , 𝑧) = 1+𝑚
• 𝑧 ↑⇒ 𝑢𝑛 ↑
• 𝑚 ↑⇒ 𝑢𝑛 ↑ Question 1

• Labour market clears at (( 𝑊 ∗

𝑃 ) , 𝑢𝑛 )

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Philips curve

Philips curve
• 𝜋𝑡 = 𝜋𝑡𝑒 + (𝑚 + 𝑧) − 𝛼𝑢𝑡
• Negative correlation between inflation (𝜋) and unemployment
(𝑢)
• Assumption: 𝜋𝑡𝑒 = 𝜋̄
Price Wage
setting 𝑊 setting 𝑒
• Derivation: 𝑃𝑡 = (1 + 𝑚) 𝒜 = (1 + 𝑚) 𝒜𝑃𝑡 𝐹𝒜(𝑢𝑡 ,𝑧) =
log
(1 + 𝑚)𝑃𝑡𝑒 (1 − 𝛼𝑢𝑡 + 𝑧) ⇒ log(1 + 𝜋𝑡 ) =
log(1 + 𝜋𝑡𝑒 ) + log(1 + 𝑚) + log(1 − 𝛼𝑢𝑡 + 𝑧) ⇒ 𝜋𝑡 =
𝜋𝑡𝑒 + (𝑚 + 𝑧) − 𝛼𝑢𝑡 = 𝜋̄ + (𝑚 + 𝑧) − 𝛼𝑢𝑡

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Accelerationist Philips curve
• Assumption: 𝜋𝑡𝑒 = 𝜋𝑡−1
• 𝜋𝑡 = 𝜋𝑡−1 + (𝑚 + 𝑧) − 𝛼𝑢𝑡
• Δ𝜋: Acceleration of price
Natural rate of unemployment Question 3 Question 4

𝑚+𝑧
• 𝑢𝑛 = 𝛼
• Plug in to the Philips curve: 𝜋𝑡 = 𝜋𝑡𝑒 − 𝛼(𝑢𝑡 − 𝑢𝑛 )
• 𝑢𝑡 − 𝑢𝑛 : unemployment rate gap
Different versions of Philips curve Lecture 9, p34

• Baseline / Fixed expectation / Accelerationist

• Unemployment rate / Unemployment rate gap
• Textbook: 𝜋𝑡 = 𝜋̄ − 𝛼(𝑢𝑡 − 𝑢𝑛 )

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Question 1 - Price markup and natural rate of
unemployment

(Chapter 7, Q3)
Suppose that the markup of goods prices over marginal cost is 5%,
and that the wage-setting equation is: 𝑊 = 𝑃 (1 − 𝑢), where 𝑢 is
the unemployment rate.
a. What is the real wage, as determined by the price-setting
equation?
b. What is the natural rate of unemployment?
c. Suppose that the markup of prices over costs increases to 10%.
What happens to the natural rate of unemployment? Explain the
logic behind your answer.

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a. What is the real wage, as determined by the price-setting
equation?
According to price setting equation, real wage:
𝑊 1 1
𝑃 = 1+𝑚 = 1+5% = 0.952
b. What is the natural rate of unemployment?
Wage setting-equation: 𝑊 = 𝑃 (1 − 𝑢)
⇒𝑢=1− 𝑊 𝑃 = 1 − 0.952 = 0.048 = 4.8%
c. Suppose that the markup of prices over costs increases to 10%.
What happens to the natural rate of unemployment? Explain the
logic behind your answer.
The real wage changes: ( 𝑊 ′ 1 1
𝑃 ) = 1+𝑚′ = 1+10% = 0.909
The natural rate of unemployment changes:
𝑢′ = 1 − ( 𝑊 ′
𝑃 ) = 1 − 0.909 = 0.091 = 9.1%
As the markup (a measurement of monopoly power) increases,
firms produce less and demand less labour.

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 on the vertical axis, and the level of employment (rather than the constant returns to labor in production. Had we assumed, more
unemployment rate) on the horizontal axis. We do this in Figure 1. conventionally, that there were decreasing returns to labor in
Employment, N, is measured on the horizontal axis. The level production, our price-setting curve would, like the standard

Question 2 - Labour market demand and natural rate of

of employment must be somewhere between zero and L, the labor
force. Employment cannot exceed the number of people available
for work (i.e., the labor force). For any employment level N, unem-
ployment is given by u = L - N. Knowing this, we can measure
labor demand curve, be downward sloping: As employment
increased, the marginal cost of production would increase,
forcing firms to increase their prices given the wages they pay.
In other words, the real wage implied by price setting would

unemployment
unemployment by starting from L and moving to the left on the decrease as employment increased.
horizontal axis. Unemployment is given by the distance between L But in a number of ways, the two approaches are different:
and N. The lower is employment, N, the higher is unemployment,
■ The standard labor supply relation gives the wage at which a
and by implication the higher the unemployment rate, u.
given number of workers are willing to work. The higher the
Let’s now draw the wage-setting and price-setting relations

(Chapter 7, Q6) and characterize the equilibrium.

■ An increase in employment (a move to the right along the
wage, the larger the number of workers who are willing to work.
In contrast, the wage corresponding to a given level of
employment in the wage-setting relation is the result of a
horizontal axis) implies a decrease in unemployment and process of bargaining between workers and firms or unilat-
a. Why does the wage-setting relation in Figure 1 have an upward
therefore an increase in the real wage chosen in wage setting.
Thus, the wage-setting relation is now upward sloping. Higher
eral wage setting by firms. Factors like the structure of col-
lective bargaining or the use of wages to deter quits affect
employment implies a higher real wage. the wage-setting relation. In the real world, they seem to

slope? As 𝑁 approaches 𝐿, what happens to the unemployment

■ The price-setting relation is still a horizontal line at
W>P = 1>(1 + m).
play an important role. Yet they play no role in the standard
labor supply relation.
■ The equilibrium is given by point A, with “natural” employ- ■ The standard labor demand relation gives the level of

rate? ment level Nn (and an implied natural unemployment rate

equal to un = (L - Nn)>L).
employment chosen by firms at a given real wage. It is
derived under the assumption that firms operate in competi-
tive goods and labor markets and therefore take wages and
prices—and by implication the real wage—as given.
Wage In contrast, the price-setting relation takes into account
setting the fact that in most markets firms actually set prices. Factors
such as the degree of competition in the goods market affect the
price-setting relation by affecting the markup. But these factors
aren’t considered in the standard labor demand relation.

Real wage, W/P

1 A Price ■ In the labor supply–labor demand framework, those who
11m setting are unemployed are willingly unemployed. At the equilibrium
real wage, they prefer to be unemployed rather than work.
In contrast, in the wage- and price-setting framework,
unemployment is likely to be involuntary. For example, if
firms pay an efficiency wage—a wage above the reservation
wage—workers would rather be employed than unemployed.
N u Yet, in equilibrium, there is still involuntary unemployment.
This also seems to capture reality better than does the labor
Nn L supply–labor demand framework.
Employment, N These are the three reasons why we have relied on the
wage-setting and price-setting relations rather than on the
Figure 1 labor supply–labor demand approach to characterize equi-
Wage and Price Setting and the Natural Level of Employment librium in this chapter.

172 The Medium Run The Core

b. The price-setting relation is horizontal. How would an increase

in the mark-up affect the position of the price-setting relation in
Figure 1? How would an increase in the mark-up affect the natural
rate of unemployment in Figure 1?
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a. Why does the wage-setting relation in Figure 1 have an upward
slope? As 𝑁 approaches 𝐿, what happens to the unemployment
rate?
When the unemployment rate falls (𝑁 approaches 𝐿), the
bargaining power of workers increases.
b. The price-setting relation is horizontal. How would an increase
in the mark-up affect the position of the price-setting relation in
Figure 1? How would an increase in the mark-up affect the natural
rate of unemployment in Figure 1?
1
When the markup 𝑚 increases, the real wage 1+𝑚 declines.
The increase increases the natural rate of unemployment.

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Question 3 - Natural rate of unemployment
(Chapter 8, Q3)
The natural rate of unemployment
a. The Phillips curve is 𝜋𝑡 = 𝜋𝑡𝑒 + (𝑚 + 𝑧) − 𝛼𝑢𝑡 .
Rewrite this relation as a relation between the deviation of the
unemployment rate from the natural rate, inflation, and expected
inflation.
b. In the previous chapter, we derived the natural rate of
unemployment. What condition on the price level and the expected
price level was imposed in that derivation? How does it relate to
the condition imposed in part a?
c. How does the natural rate of unemployment vary with the
markup?
d. How does the natural rate of unemployment vary with the
catchall term 𝑧?
e. Identify two important sources of variation in the natural rate of
unemployment across countries and across time.
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a. The Phillips curve is 𝜋𝑡 = 𝜋𝑡𝑒 + (𝑚 + 𝑧) − 𝛼𝑢𝑡 .
Rewrite this relation as a relation between the deviation of the
unemployment rate from the natural rate, inflation, and expected
inflation.
When finding the natural rate of unemployment, actual and
expected inflation rates are assumed to be equal: 𝑢𝑛 = 𝑚+𝑧 𝛼
Plug 𝑢𝑛 into the Philips curve: 𝜋𝑡 − 𝜋𝑡𝑒 = −𝛼(𝑢𝑡 − 𝑢𝑛 )
b. In the previous chapter, we derived the natural rate of
unemployment. What condition on the price level and the expected
price level was imposed in that derivation? How does it relate to
the condition imposed in part a?
𝑃 = 𝑃 𝑒 , or 𝜋𝑡 = 𝜋𝑡𝑒
c. How does the natural rate of unemployment vary with the
markup?
When the markup increases, the natural rate of unemployment
increases.
d. How does the natural rate of unemployment vary with the
catchall term 𝑧?
When 𝑧 increases, the natural rate of unemployment increases.
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e. Identify two important sources of variation in the natural rate of
unemployment across countries and across time.
• The generosity of unemployment insurance benefits
• Changes in the job-search mechanism
• The proportion of population in jail
• The proportion of young
• The proportion of temporary/flexible employment
• The power of the labour union
• The minimum wage
• Employment protection
• Technology

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Question 4 - The medium-run equilibrium
(Chapter 9, Q3)
The medium-run equilibrium is characterized by four conditions: Output
is equal to potential output 𝑌 = 𝑌𝑛 and the real policy rate 𝑟𝑛 must be
chosen by the central bank so:
The unemployment rate is equal to the natural rate 𝑢 = 𝑢𝑛 . The real
policy interest rate is equal to the natural rate of interest 𝑟𝑛 where 𝑟𝑛 is
defined as the policy rate where
𝑌𝑛 = 𝐶(𝑌𝑛 − 𝑇 ) + 𝐼(𝑌𝑛 , 𝑟𝑛 + 𝑥) + 𝐺
The expected and actual rate of inflation 𝜋𝑒 is equal to the anchored or
target rate of inflation 𝜋.̄ This implies the nominal policy rate 𝑖 = 𝑟𝑛 + 𝜋.̄
a. If the level of expected inflation is formed so 𝜋𝑒 equals 𝜋,̄ characterize
the behavior of inflation in a medium-run equilibrium.
b. Write the IS relation as 𝑌 = 𝐶(𝑌 − 𝑇 ) + 𝐼(𝑌 , 𝑟 + 𝑥) + 𝐺. Suppose
𝑟𝑛 is 2%. If 𝑥 increases from 3 to 5%, how must the central bank change
𝑟𝑛 to maintain the existing medium-run equilibrium. Explain in words.
c. Suppose 𝐺 increases permanently. In what direction must the central
bank change 𝑟 to maintain the existing medium-run equilibrium? Explain
in words.
d. Suppose 𝑇 decreases permanently. In what direction must the central
bank change 𝑟 to maintain the existing medium-run equilibrium? Explain
in words.
e. Discuss: In the medium run, a fiscal expansion leads to an increase in
the natural rate of interest. 5:17
a. If the level of expected inflation is formed so 𝜋𝑒 equals 𝜋,̄
characterize the behavior of inflation in a medium-run equilibrium.
Philips curve: 𝜋 = 𝜋𝑒 − 𝛼(𝑢 − 𝑢𝑛 ) = 𝜋̄ − 𝛼(𝑢 − 𝑢𝑛 )
If the unemployment rate 𝑢 = 𝑢𝑛 , inflation does not deviate from
𝜋̄ in the medium run.
b. Write the IS relation as 𝑌 = 𝐶(𝑌 − 𝑇 ) + 𝐼(𝑌 , 𝑟 + 𝑥) + 𝐺.
Suppose 𝑟𝑛 is 2%. If 𝑥 increases from 3 to 5%, how must the
central bank change 𝑟𝑛 to maintain the existing medium-run
equilibrium. Explain in words.
If the risk premium (𝑥) increase by 2%, the medium-run real
interest rate (𝑟𝑛 ) has to decline by 2% to just offset the change so
the medium-run equilibrium holds.

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c. Suppose 𝐺 increases permanently. In what direction must the
central bank change 𝑟 to maintain the existing medium-run
equilibrium? Explain in words.
When government spending increases, there is a positive output
gap. To turn the output back to the potential output, the central
bank has to implement monetary consolidation to increase 𝑟 to the
extent that 𝑌 just declines back to 𝑌𝑛 .
d. Suppose 𝑇 decreases permanently. In what direction must the
central bank change 𝑟 to maintain the existing medium-run
equilibrium? Explain in words.
Same as in (c)
e. Discuss: In the medium run, a fiscal expansion leads to an
increase in the natural rate of interest.
If a fiscal expansion is accompanied by a monetary consolidation to
stabilize the output at the potential level, the natural rate of
interest targeted by the CB has to increase.

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