This paper incorporates a labour market with matching frictions and wage rigidities into the new Keynesian business cycle model. In particular, the article analyses the effects of monetary policy shocks and how transmission process of the monetary policies is affected by labour market frictions. The model of discussion allows the interaction of real wage rigidities with adjustments in hours affecting inflation and inflation dynamics through marginal cost. In addition, the article explains that wage rigidity determines the response of unemployment and inflation to interest rate innovation. When wages are more rigid they tend to generate persistent inflation shocks in the economy (Houben 200). Moreover, labour market fundamentals like employment turn over and bargaining power will determine the monetary policy shocks on unemployment.

Labour markets in Europe are still rigid in many aspects. Generous unemployment benefits, high firing costs and strong unions are the main contributors to sluggish labour market adjustments (Holden 74). However, wage rigidity is substantially controlled, by the inability of instantaneous wage fluctuations which is affected through collective wage bargaining power. Therefore, frictions and rigidities in the labour market are significant in determining sluggishness in firms’ price setting behaviour and marginal cost.

What is of emphasis in this paper is the role that is played by the labour market to determine firms’ marginal cost and link directly the dynamics of inflation to adjustments in the labour market. This phenomenon is explained by the Mortensen and Pissarides labour market model, according to (Kamlani 456). This model matches the New Keynesian business cycle to the prevailing market conditions.

 In a recent research, a lot of questioning has been raised on the extent and degree of nominal wage rigidity and its consequences. This means that wage rigidity seems to be a main characteristic of the labour market in many countries. Various researches done on wage rigidity conclude that wages are not entirely flexible. For instance, down ward rigidity is of market relevance as labour unions and labour market institutions define lower bound s of wage evaluation and not upper bounds. However, downward rigidity is also a potential result of unemployment in some labour markets.

Especially in the US most studies have been conducted on down ward rigidity in nominal wages. The discussion on nominal wage rigidity focuses on the down ward rigidity and inflation. Effect of rigidity may be detected at higher rates of inflation, but down ward rigidity has a serious implication on the optimal rate of inflation.

However, fiscal policy flexibility is a necessary package for Europe. Even with endogenously strong shock absorbers, such as real wage flexibility, fiscal policy can speed up stabilization process in response to demand shocks. Therefore if, wages are rigid as they are in Europe, fiscal policy cannot eliminate the adverse effects of asymmetric supply shocks.

Wage Rates and the Supply and Demand for Labour

This article explains where there might be unemployment in the economy. Unemployment is the situation in the economy, where people are willing to offer labour at the prevailing or lower wage rates, but the opportunities to offer the employment are not there. Therefore, with this natural beginning on unemployment, let us argue on what determines wage rates in the economy (R).

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In economics, one of the basic principles is the notion that is the value or price of anything, is determined by its supply and demand. Like any other commodity in the market, there exist the forces of demand and supply. The figure in the model below shows the behaviour of demand and supply influence the labour market. The curve SS shows the supply curve and DD shows demand curve. The horizontal axis indicates the quantity of labour employed while the vertical axis shoes the nominal wage rate per unit of labour. In this model it is assumed that the general price level is constant.

In the labour market, demand for labour is always negatively in all types of production for two reasons. First, an increase in the wage levels will increase the cost of production, thus, forcing producers to increase the selling prices. As the prices increase, the demand for the commodity is reduced as consumer purchasing power is reduced. Hence, firms will reduce their production to match the low sales. Therefore, less labour will be involved in production, due to low production level. Secondly, since increases in wages make labour more expensive relative to capital, firms will opt for capital.

If the wage is free to respond to market forces it will shift to We, where the labour demand equals its supply. However, when the wage is above We, there will be more labour for employment than the industry can manage to hire. Therefore, the prevailing wage rates will be dropped as workers are abundant and they accept any wage offer. And when the wages go below We, it will be profitable for industries to hire more labour than the supply in the market. There will be pressure to increase the wage rate by each firm in the economy to obtain additional workers.

Unemployment can only happen in the economy if the prevailing wage rate is above the equilibrium level, and some institutional and structural forces keep it from being bid down. For example with figure: 2, Wu is the wage level at which might be fixed by a labour union. Consequently, workers willing to accept We but below Wu, will not be employed. However, it is not a full indication of unemployment in the economy. This is because, pressure will be created on the wage levels by the unemployed labour to bid down wages or else find employment in the non-unionized sector.

Due to effect of wealth on increased wages the aggregate supply curve of labour may not always be positively sloped. People are induced by higher wages to work harder, since; leisure is costly in terms of the foregone income. Workers substitute income for leisure. Wealthier people take more leisure and does less work hence increase in wage beyond a certain level raise wealth and desired leisure by increased opportunity of leisure cost. This is the core reason as to why enormous growth of per capita income.

 All individuals with marginal product of labour less than minimum real wage don’t find employment in the economy.

Industrialized economies like Canada and US are less than one third unionized. In addition, minimum wage levels are in force, but they are low to only displace the unskilled workers.

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