Question

Suppose the 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]

1. [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.

2. [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).

3. [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.

4. [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?

5. [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?

6. [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?

Answer 1

a. Initial curves are - AD1, SRAS1, LRAS at point A equilibrium. Pa - Price, Ya - Output

b. When central bank raises money supply, the price of lonable funds falls. Thi makes borrowing cheaper - investments become cheaper. there is an increase in aggregate spending. The AD curve shifts to AD2 in the short run. New equiibrium is at B where prices are higher at Pb and output is higher at Yb.

c. In the short run wages are sticky and when prices rise in short run, real wages fall and output expands. In long run, wages are not sticky any more. People realize the fall in real wages. Hence in long run, nominal wages are raised and input cost rises. There is also higher expectation of prices due to the current prevailing conditions. This leads to a shift is SRAS. The SRAS1 shifts left to SRAS2. Output returns to initial Ya. Prices are now even higher at Pc. New equilibium is C.

d. According to sticky wage theory, wages are fied by contracts in the short run and do not change in the short run for any price change. So nominal wages remain unchanged from A to B. In long run, wages are flexible. Workers demand higher wages and in light of higher price expectation, sellers increase nominal wages. So nominal wages rises at point C.

e. Prices rise in the short run and nominal wages being fixed - real wages fall at B. While in long run, nominal wages rise but prices also rise at C point. So the impact on real wage is ambiguous. real wages at C are higher than at B, but in comparison to A it is ambiguous. The result depends on the magnitude of change in nominal wage rate and the inflation rate.

f. Here we see, that in long run, money supply led to rise in nominal wages. The impact on real wages is ambiguous. While real wages fall in short run and stimulate output and there are real output growth in short run. While if we think of the aggregate real wage in the long run - the output returns to initial level in the long run, then there it is correct for us to infer that in aggregate the real wages rate has not changed much ( the change is not enough to have any real effect on output). So the proposition is true - there are no real effects in long run. The reason why this proposition is true is becuase of the neutrality of money.