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Practice question during lecture 3 ...

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4. Suppose economy is in long run equilibrium. [Only one diagram is required for this question, draw and label clearly to show all relevant points and moves] [4 marks] Use the model of aggregate demand and aggregate supply to illustrate the initial equilibrium (call it point A). Be sure to include both-short run and long-run aggregate supply.

SRAS: Short-Run Aggregate Supply

2

AD: Aggregate Demand

1

P1

A 2 1

Y1

[4 marks] The central bank raises the money supply by 10%. Use the diagram you drew in part a) to show what happens to output and price level as the economy moves from initial equilibrium A to the new short-run equilibrium (call it point B).

Explanation: According to economists, an 2 1 P2

B A

P1

2 1

Y1

Y2

increase in the money supply would affect the Aggregate Demand curve (AD1). An increase in the money supply lowers the interest rate in the short run. This event makes lending—and borrowing, cheaper. Thereby, this shifts the AD curve to the right, marking a new short-run equilibrium at point B. At this point—B, the new short-run equilibrium sits at both a higher price level and output.

[4 marks] Show how economy moves from the short run equilibrium (point B) to the new longrun equilibrium (call it C) and explain why it moves to C.

Explanation: The Long run equilibrium of the 2 1 P3

C

P2

economy is found—at point C—where the aggregate demand curve intersects with the longrun aggregate-supply curve. When the economy reaches this long-run equilibrium, wages, prices and perceptions will have adjusted so that the

B

short-run aggregate-supply (SRAS1-SRAS2)

A

curve crosses this point as well. Additionally, the 2 1

output level also returns back to its long-run or “natural” level (Y2-Y3). This phenomenon can be explained by the Shifts Arising from Changes in Expected Price Level. As a result of an increase in

Y3 Y2

the expected price level (P2-P3), the quantity of goods and services supplied is diminished (Y2Y3), shifting the curve to the left—at point C.

[4 marks] According to sticky wage theory of aggregate supply, how do nominal wages at point A, compare to nominal wages at point B? How do nominal wages at point A compare to nominal wages at point C? According to the sticky wage theory of aggregate supply, the nominal wages at A compared to B, are fixed. This is because the nominal wages workers receive cannot change readily. This slow adjustment may be ascribed to the slow change in the social norms and notions of fairness, which influence wages. The wages at point A compared to C, are lower because of the higher expected price level shift. When workers expect a higher price level, they are more inclined to negotiate high nominal wages. As a result, the higher product costs—for any price level—lower the quantity of goods and services supplied. [4 marks] According to sticky wage theory of aggregate supply, how do real wages at point A compare to real wages at point B? How do real wages compare to real wages at point C? The real wages at A compared to B, are higher. Due to the slow change in wages for the reasons mentioned above—in the previous question, the real wages fall when the price level increases

at point B. This is predicated on the fact that real wages measure purchasing power, and that power diminishes when price levels rise. At point C compared to A, the nominal wages are then adjusted for the higher price level, making them higher than at A. After the adjustment, the real wages inevitably rise, as the nominal wages change in conjunction with the higher price level.

[5 marks] Judging by the impact of the money supply on nominal and real wages, is this analysis consistent with the proposition that money has real effects in the short run but is neutral in the long run? This is actually not consistent with the proposition. According to the sticky-wage theory, the short-run wages don’t change, contrary to the proposed short-run changes. The factors that instill changes in wages—social and contractual— don’t line up with the classical theory. Simply put, wages don’t adapt quickly to changes in monetary policy. This aberration is also seen in the long-run trend, where money has real effects in the long run change in real wages. As output returns to its long-run or “natural level”, nominal wages increase and real wages adjust to the higher price level. This such effect increases production costs—at every price level, which in turn leads to potential layoffs and diminished output....