Question

Consider the classical IS-LM/AS-AD model under the assumptions of the misperceptions theory.

A) Which graph represent the classical AS-AD model under the assumptions of the misperceptions theory? Which curve represents the SRAS curve? What about the LRAS and AD curves?

B) Assume the economy is starting in general equilibrium. Using the classical AS-AD model with misperceptions, describe what will happen in the short-run and the long-run to output, the price level, and the expected price level, and when there is an unexpected increase in the money supply.

Please tell me which curves will shift and in what direction they will shift for both the short-run and long-run.

Answer 1

A) The misperceptions theory states that in the short run workers suffer from money illusion. This means that when prices rise unexpectedly, firms (who have full information about prices) increase the nominal wages of workers, the workers (who have assymetric information about prices) misinterpret this rise in nominal wages as a rise in real wages. Thus workers supply more labor hours for every rise in wage due to this misperception. This leads to an upward sloping short run aggregate supply (like the one drawn for B) because as price rise, nominal wage raises and workers supply more thinking the rise in wages to be real. So under misperceptions theory SRAS-AD represents the classical AS-AD (as drawn in B).

However this misperception only exists in the short run. In the long run this assymetricity corrects and level of wages return to the initial levels. So the long run aggregate supply is not affected by changes in price level and the LRAS is vertical (as drawn in B)

The aggregate demand curve is unaffected by such misperceptions. Such misperceptions pertain to the labor market only. The AD curve is always downward sloping because of the basic law of demand.

B) An unexpected rise in money supply raises the supply of lonable funds in the market. This causes the price of lonable funds (interest rates) to be lower. This increases borrowing and in turn raises Investment and Consumption spending. Thus the AD curve shifts right indicating a rise in aggregate spending. This causes prices and output to be higher than the initial long run level. This is the short run impact. In short run Aggregate Supply rises along the SRAS curve due to workers misperceptions. However the long run picture is different. In long run this misperceptions don't exist and so in light of rising price expectations, workers demand higher real wages. Firms in the long run have to raise real wages to continue producing a given level of output. This raises their input costs which causes short run aggregate supply to shift to the left. Thus in the long run equilibrium, output returns to the long run output level. However prices become higher than they were before. In the diagram the initial equilibrium is at 1, short run equilibrium is at 2 and long run equilibrium is at 3.