Question

5. How does the labor market clear under the neo-classical, frictionless labor-market case when the aggregate supply of labor is upward sloping in the real wage rate? Would your answer to question 4 change in this case?

please find Q4 below :

4. Compare the effects of a once-and-for-all monetary expansion on the economy's output, rate of interest, and the price level under the assumption that the aggregate supply curve is horizontal (the Keynesian case), vertical (the classical case)?

Answer 1

The neo-classical labor market is a simple representation of the economy with a perfectly competitive market without any external frictions. The labor supply curve is upward sloping in real wage. As wage increases, the cost of leisure increase. So, workers are willing to supply more hours. This is shown in fig (1).

The labor demand curve is downward sloping since as wage increases, labor becomes costly and their demand decreases. The equilibrium wage is determined at the intersection of the labor demand and Labour supply curve. This is given in fig (2).

So, Ls = Ls(w/p), Ld = Ld (w/p)

Ls = Ld = L*

Aggregate supply horizontal (Keynesian Case)

In the Keynesian case, the prices and wages are fixed and the short-run aggregate supply (SRAS) curve is horizontal. If there is a monetary expansion, there will be no effect on interest rate and output. This is the zone of liquidity trap. So, when money supply increase, the additional money gets trapped under speculative demand for money. So, the interest rate is not affected and thus the AD curve is not affected, which means price level P will also not be affected. SO, monetary expansion will not impact the labor market in this case. This is shown in fig (3).

Aggregate supply vertical (Classical Case)

In the classical one, the long run aggregate supply (LRAS) is vertical. Due to monetary expansion, price increases, AD increases and this affects the real wages. Higher AD increases nominal wage as well as price level. SO, the real wage remains unaffected. Ultimately, the labor market equilibrium remains undisturbed. This is shown in fig (4).