Question

a) What is the shape of the aggregate supply (AS) curve if

(i) nominal wages and prices are flexible and competitively determined?
  

(ii) nominal wages are downwardly rigid?

Answer 1

(a) The aggregate supply (AS) curve represents the total output that will be produced for given prices, supplied by the firms in the ecnonomy. That is why the AS curve is usually positively sloped. In modern view, the long run AS curve is vertically shaped, parallel to the price axis, reason being that in the long run, the economy adjusts to the increase/decrease in price and what matters is the real GDP/output. But the short run, the AS may vary due to various assumption.

(i) If nominal wage and price is flexible, and not rigid/sticky, then we may say that the firms are fully aware of the price level, and that their expected inflation is quite accurate, and quick as well. In that case, the AS curve will be vertical, and would shift only if there is a shift in the real variables.

(ii) As according to the sticky-wage model, if nominal wages are downwardly rigid, as may be due to the fact that wages depends on the contract, and they don't fluctuate in the short run due to change in prices, the AS curve will be upward sloping. The reason is that, as the price rises, and wages remains the same due to contracts for a short time, and due to rise in prices, worker's real wage decreases, and hence firms produces more, along with the incentive of rising prices.