Question

2.   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?

b) What is the importance of the slope of the AS curve from the standpoint of
    stabilization policy?                                                                         

Answer 1

The aggregate supply curve would be vertical if nominal wages and prices are flexible and are determined in the competitive market. This is because any event in the market will immediately bring changes in the nominal wages so that there will be no Real effect on the output

Aggregate supply curve would be upward sloping because nominal wages are not going to decline whenever there is a decline in the price level. This keeps nominal wages sticky in the short run. if price level is also sticky in the short run then the area supply curve would be horizontal

The shape of the aggregate supply curve determine the appropriate policy response. In classical theory where aggregate supply is considered to be vertical government intervention is not required because any change in the the market will immediately bring changes in the nominal wages so that real output remains unaffected. In keynesian theory aggregate supply curve is horizontal which indicates that there will be no self correction by the economy in the form of adjusting nominal wages so that government intervention becomes an exigency.