Answer Happy

AF' (L) is the 7. The short-run aggregate supply of goods Y sold at nominal price P is deter- mined by perfectly competitive firms hiring labour L at nominal wage W. The production function is Y = AF(L), where A is a measure of productivity. Firms demand for labour Lª is given by MPL = w, where MPL marginal product of labour and w = W/P is the real wage. Assume initially that the nominal wage is fixed at W = W. In what follows, also assume workers' desired supply of labour L (which is increasing in the real wage w) exceeds the demand for labour Ld at the prevailing real wage. Aggregate demand for goods is determined by the IS-LM model, where the cen- tral bank implements monetary policy by controlling the money supply M. (a) [4 marks] Use the IS-LM model to show the effects of an increase in the money supply for a given price level P, and hence find what happens to the price level P and real GDP Y using the AD-SRAS model. Show the effects on the real wage, employment, and unemployment (the difference between L and Ld) in a diagram representing the labour market. (b) [4 marks] Now suppose the economy is hit by a negative supply shock (lower A). Find the effects on the price level P and real GDP Y. Explain why the impacts of the shock on employment and unemployment are ambigu- OUS. (c) [2 marks] Following the negative supply shock in part (b), if the central bank successfully adjusts monetary policy to stabilize the price level, find the impacts of the shock on employment and unemployment.