Wage Shock

Initially let the economy be in the steady state. In this situation, a wage shock happens: Money wages rise exogenously. In the phase diagram, both the $$ \dot{K}=0 $$ and $$ \dot{w}=0 $$ lines stay put, cf. figure 1. In the short run, firms are to increase prices, thereby contracting real balances. The interest rate jumps up, which reduces the desired stock of capital. For that reason, investment, aggregate demand and output drop. Firms have to lay off some workers, so unemployment comes into existence. In the phase diagram, money wages spring up, whereas the stock of capital remains unaffected.