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.