Question 2- A decrease in the mark-up, m

Assume that the economy starts at the natural level of output and unemployment and there is a

simple production function, Y= 1.5N, where Y is output, and N is employment. Now suppose there is

a permanent decrease in the firms' price mark-up (m) over their marginal cost from 20% to 10%.

a) Explain the meaning of the wage-setting (WS) and price-setting (PS) relations. Write down the WS

relation and PS relation for this economy (what is the marginal cost in this economy?) Show what

happens to the unemployment rate in the medium run when the price mark-up becomes

permanently lower. Why does this happen? Use a graph in your answer. (4 marks)

b) Explain what happens to medium-run equilibrium output. (1 mark)

c) Assume the central bank has an inflation target. Explain using an AS-AD diagram what happens to

output and inflation in the short run and in the medium run equilibrium when m decreases

permanently. (4 marks)

d) What will happen to consumption and investment in the new medium run equilibrium compared

to the original one? (1 mark)