Online Quiz

Question 1: How can the Keynes and the Pigou models of the labor market can be plugged into a
reduced form of general equilibrium to test the predictions of each model? Please use equations to describe
the models of the labor market and the reduced form model of the goods and the money market.

Ans:
Pigou classical model via klien gives its point of view beginning with the

following two equations:

S (r)= I (r) where investment is a function of interest rate

M = V * p * y this shows the money supply

What he says is that as money supply is constant when wages fall the income

of the worker falls and the expenditure one does for consumption also fall

relative to supply of money which leads to the fall in rises and hence the

interest rates also fall. When interest rate falls the investment, function comes

in action and falling rates cause investment to rise, which leads to rising

output and employment also increases. So, the conclusion is that Pigou says

that cutting the wage will increase employment and output.

Moving to the Keynes argument we need to flip pious model.

According to Keynes, investment is a function of the income, because people

consumption and savings depends upon their incomes which finally decides

upon the level of investment needed.

He begins with the equation.

S( y) = I (y)

Which means we can get to the following equations:

M = + fn ( p) +ve function of price

M= - L fn (r ) -ve fn of r

According to this model If wages are reduced prices would fall and as prices

fall money demand will reduce and interest rates can rise. Rising interest

rates leads to lower demand for money. As investment is now function of

income so it is interest rate inelastic. This means that increasing r will lead to

falling investment, falling out put and falling employment.

Question 2: How can you use nonlinearities to show formal employment, informal
employment and formal unemployment reduction in labor force participation?
Ans:
Previously we had done linear labor market. Where the demand for labor was a downward
sloping curve and supply was upward sloping.
Wage

Firm profit
W1 supply

W2

N1 N2 employment
We can see in this diagram as the wages are falling the demand for labor is increasing. Here’re there is
linearities.
Moving to the no linearities we have the following graph.
Demand of labor Back ward bending supply curve

w1

reservation wage

w2
Formal employment informal employment
N1 N2

We can see a backward sloping supply curve. We have a reservation wag below which as wages fall
employment rises. The diagram show supply curve for informal sector workers it states that currently at
w1 the wage rate is competitive and hence the market labor force is N1. N1N2 represents the informal
sector workers whereas N1 is the formal sector workers.
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