Dynamics  of Unemployment and  Real  Wages through Productivity Shocks 

The model  that you  are  studying here  is  in  the  tradition of  the  real  business cycle theory that you have studied in earlier units. As you know,  this kind of a model works out the implications of  shocks to productivity. The model has  the following implications  to employment  and wages. 

1)  A temporary qverse shock to productivity decreases hiring (as it decreases the  marginal productivity  of  labour  and  hence  the  benefit  of  hiring  the marginal unit of labour) and  increases unemployment. As  the shock is,  by definition,  temporary, productivity  and  the  net marginal value  of  labour return  to  their original  level, but,  it can be  shown that  the unemployment rate only slowly returns to normal through increased hiring. Moreover, since it  is  cheaper for  the  firm  to  hire  when  there  are  more unemployed,  a productivity shock has greater effect on unemployment when it is high than when  it  is  low.  This is,  of  course,  implicit  in  the  non-linearity  of  the equation explaining u*, the natural rate of unemployment. 

2)  The model explains why fluctuations  in employment may be associated with smaller fluctuations in real wages. This will happen if 6,  the share obtained by workers, is constant, as is assumed  in the model, and small. Real wages vary  in the model with productivity and high rates of hiring are Associated with high real wages. The model thus explains the observed empirical fact of  a  pro-cyclical increase  in  real wages, but  to  a smaller extent  than  the increase  in employment, if the share obtained by workers is small in relation to that obtained by the hiring firms.