Market Dynamics: Money Demand and Labor Union Impacts
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Money Demand and Central Bank Policy
Impact of Reduced Cash Holdings
a) How does this event affect the demand for money?
If people need to hold less cash, the demand for money shifts to the left, since there will be less money demanded at any price level.
Price Level Changes Without Intervention
b) If the central bank does not respond to this event, what will happen to the price level?
If the central bank does not respond to this event, the shift to the left of the demand for money combined with no change in the supply of money leads to a decline in the value of money (1/P), which means the price level rises, as shown in Figure 1.
Stabilizing the Price Level
c) If the central bank wants to keep the price level stable, what should it do?
If the central bank wants to keep the price level stable, it should reduce the money supply from S1 to S2 as shown in Figure 2. This would cause the supply of money to shift to the left by the same amount that the demand for money shifted, resulting in no change in the value of money and the price level.
Labor Unions and Market Efficiency
Effects of Unionization on Labor Markets
a) Show the effect of the union on the market in which it is formed. In what sense is the quantity of labour employed in this market an inefficient quantity?
Figure 1 illustrates the effect of a union being established in one labour market. When one labour market is unionized, shown in the figure on the left, the wage rises from ω U 1 to ω U 2 and the quantity of labour demanded declines from U1 to U D 2. Since the wage is higher, the quantity supplied of labour increases to U S 2, so there are U S 2 − U D 2 unemployed workers in the unionized sector. The quantity of labour employed in this market is inefficient, since more workers would like to have jobs at the existing wage.
Impact on the Non-Unionized Sector
b) Show the effect of the union on the non-unionized market. What happens to the equilibrium wage in this market?
When those workers who become unemployed in the union sector seek employment in the non-unionized market, shown in the figure on the right, the supply of labour shifts to the right from S1 to S2. The result is a decline in the wage in the non-unionized sector from ω N 1 to ω N 2 and an increase in employment in the non-unionized sector from N1 to N2.