Question 1 Let the aggregate production function simply be Y = N where Y = output, N = employment.

Suppose the price-setting equation is P = ( 1 + m ) W where m is firms' markup over marginal cost (W) and the wage-setting equation is W = Pe ( 1 + ????(1 - 100 u ) + z ) where u is the unemployment rate, W is the nominal wage, P e is the expected price level and z represents other factors affecting wage bargains.

NB: In the medium run equilibrium, P e = P. Assume ????=1, ????=1 ???????????? ????=1

a. Explain the intuition behind the price-setting and wage-setting equations in the medium run. Draw these equations in a WS-PS diagram.

b. What is the real wage as determined by the price-setting equation?