Question

25. Unions temporarily gain additional bargaining power. Show the short-run impact on an AS-AD graph. Also show the long-run result, if monetary policy is not accommodative.

Answer 1

More bargaining power of unions will lead to higher nominal wage. Production cost will increase, so firms will reduce output. Aggregate supply will fall, shifting SRAS curve leftward, increasing price level and decreasing real GDP, thus causing Stagflation in short run.

In long run, in absence of accommodative monetary policy, prices and wages will adjust, so aggregate demand will increase. AD curve will shift rightward, intersecting new SRAS curve at further higher price level, but restoring real GDP to potential GDP.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. Higher wages shifts SRAS0 left to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP y1 in short run. In long run, AD0 shifts right to AD1, intersecting SRAS1 at point C with further higher price level P2 but real GDP restored at Y0.