Question

QUESTION 5-1 Chapter 14 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] a. [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. b. [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). c. [4 marks] Show how economy moves from the short run equilibrium (point B) to the new long-run equilibrium (call it C) and explain why it moves to C. ру о gnm d. [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? KO e. [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? ору о py of f. [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? X Dataset

Answer 1

Answer :

Refer to the graph below :

(a) :- 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.

Initial equilibrium at A, Price - P_a , Output Y_a

(b) :- 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).

When CB fund-raises supply in the economy, there is more amount of lonable funds in the economy which lessens the competition for lonable funds and interest rates fall. This increases borrowing and leads to an increase in investment and consumption. Henceforth there is an increase in aggregate spending (AE/AD). The AD curve shifts right from AD₁ to AD₂ increasing output to Y_b and price to P_b at new equilibrium point B.

(c) :- Show how economy moves from the short run equilibrium (point B) to the new long-run equilibrium (call it C) and explain why it moves to C.

As economy self adjusts over the long run - when wages and prices are not sticky and are allowed to adjust. The adjustment happens on the grounds that, because of increased aggregate spending, prices increase thus real wages fall over the long haul. So employes demand higher nominal wages. Over the long run nominal wages are not rigid and consequently increase over the long run. This increases input costs of firms in addition to there is an upward expectation for inflation. This causes a left move in the SRAS curve from SRAS1 to SRAS2. This leads prices to be higher than before at P_c while output comes back to the initial degree of Y_a

(d) :- 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?

In the short run, wages are (fixed by contracts). So wages can't change because of some macroeconomic influence in the short run. So at point A and point B, the nominal wage stays unchanged. While over the long run, there is flexibility of wages and other macroeconomic variables (price).

As prices have risen, real wages have fallen and higher nominal wages are demanded and paid to hier workers. So at point C, nominal wages are higher than at point A.

(e) :- 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?

Wages are sticky in the short run i.e nominal wages are fixed at A and B points. The price adjustment is sluggish in the short run. Anyway the sluggish increase in short run prices will decrease real wages at B point (which is the reason more is created at B). In long run, prices adjust completely and wages are not, at this point rigid. Workers demand higher nominal wages now (as real wage has fallen because of price rise). At point C, the real wage has increased (which is the reason SRAS shifts leftwards) in comparison to point B, while in comparison to point A, the real wage is ambigous(can be progressively/less or same) at C becuase at A, both nominal compensation and prices are lower while at C both nominal wage and prices are higher. The general magnitude of price and compensation change decides the level of progress in real wage.

As a rule we accept the pace of progress to be proportional and that there is no real change in the wages.

(f) :- 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?

In short run, there is no impact on nominal wages while in long run nominal wages increase. Again in short run real wage fall, while in long run real wages ascend once more. So increase in money supply affects nominal variable just and no perceptible impact on real variables (as output came back to unique levels).

Subsequently money neutrality holds here and the proposition is consistent.