Question

Suppose 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. 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. 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. 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. 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. 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. 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 equilibrium at A, price - Pa, output- Ya

b. When CB raises money supply in the economy, there is more amount of lonable funds in the economy which reduces the competition for lonable funds and interest rates fall. This increases borrowing and leads to an increase in investment and consumption. Hence there is an increase in aggregate spending (AE/AD). The AD curve shifts right from AD1 to AD2 increasing output to Yb and price to Pb at new equilibrium B.

c. As economy self adjusts in the long run - when wages and prices are not sticky and are free to adjust. The adjustment occurs because, due to increased aggregate spending, prices increase and so real wages fall in the long run. So employes demand higher nominal wages. In the long run nominal wages are not rigid and thus increase in the long run. This increases input costs of firms plus there is an upward expectation for inflation. This causes a left shift in the SRAS curve from SRAS1 to SRAS2. This leads prices to be higher than before at Pc while output returns to the initial level of Ya.

d. In the short run, wages are fixed (fixed by contracts). So wages cannot change due to some macroeconomic influence in the short run. So at A and B, the nominal wage remains unchanged. While in the long run, there is flexibility of wages and other macroeconomic variables (price). As prices have risen, real wages have fallen and higher nominal wages are demanded and paid to hier workers. So at C, nominal wages are higher than at A point.

e. Wages are sticky in the short run i.e nominal wages are fixed at A and B points. The price adjustment is sluggish in the short run. However the sluggish increase in short run prices will decrease real wages at B point (which is why more is produced at B). In long run, prices adjust fully and wages are no longer rigid. Workers demand higher nominal wages now (as real wage has fallen due to price rise). At point C, the real wage has increased (which is why SRAS shifts leftwards) in comparison to point B, while in comparison to point A, the real wage is ambigous(can be more/less or same) at C becuase at A, both nominal wage and prices are lower while at C both nominal wage and prices are higher. The overall magnitude of price and wage change determines the degree of change in real wage. In general we assume the rate of change to be proportional and that there is no real change in the wage.

f. In short run, there is no impact on nominal wages while in long run nominal wages increase. Again in short run real wage fall, while in long run real wages rise up again. So increase in money supply has an impact on nominal variable only and no observable impact on real variables (as output returned to original levels). Hence money neutrality holds here and the proposition is consistent.