Assume that an economy’s production function is Y = 1000L^1/2, so that when the

Question

Assume that an economy’s production function is Y = 1000L^1/2, so that when the marginal product of capital is equated to the real wage the labor demand curve is L = 250,000 (P/W)^2 . The labor supply curve is 31,250 (W/P). The real wage that solves these equations is W/P = 2.

Assume that the expected price level is 10, so that a nominal wage contract setting the wage at 20 is agreed to, making the expected real wage 2. If the price level turns out to be 10, then 62,500 workers will be hired and output will be 250,000.

#1: . If the actual price level turns out to be 20, what will the actual real wage be?

#2: According to the labor demand curve, how much labor will be demanded if the actual real wage is at the level given?

Explanation / Answer

Q1. Nominal wage (WN) = 20

Actual Price level (PA) = 20

Calculate Actual real wage (WA) -

WA = WN/PA = 20/20 = 1

The actual real wage is 1.

Q2. Calculate labor demanded at actual real wage (WA) -

L = 250,000 * (PA/WN)2 = 250,000 * (20/20)2 = 250,000 workers

There will be demand for 250,000 workers.

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