Assume that workers, employers and investors all believed that inflation in the coming year would equal the annualized rate of inflation experienced in the past 6 months. Also assume that workers had been receiving nominal wage gains of 5% during a several year period where the annual inflation rate was 2%. and worker productivity growth was 3% per year. Now assume that a decline in the unemployment rate below NAIRU creates conditions where workers push for an annual real wage increase of 4%. Also assume that labor productivity growth declines to 1% per year as unemployment is squeezed below normal frictional & structural levels.

a) what rate of nominal wage growth will workers seek at the new low unemployment rate?

b) how fast will firms have to raise prices given your answer in (a) in order to protect profit margins?

c) if the rate of inflation in (b) occurs and the Fed allows AD to grow fast enough to maintain the unemployment rate below NAIRU for another year, what rate of nominal wage growth will workers seek in the following year?

d) if the rate of inflation in (b) had persisted for 6 months or more, how large an increase in the federal funds rate would be needed to increase the level of real interest rates in the economy?