Answer Happy

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 Ld is given by MPL = w, where MPL = AF'(L) is the 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. Suppose that owing to frequent shifts in monetary policy, arrangements to index nominal wages W automatically to prices P begin to be adopted in the econ- omy. Assume that a 1% increase in P automatically increases W by some posi- tive amount, but by less than 1%. (d) [3 marks] Using the labour-market diagram, show what effect the indexa- tion of wages has on the aggregate supply curve. (e) [3 marks] Do shocks to aggregate demand such as the example in part (a) have larger or smaller effects on the price level and real GDP with indexa- tion of wages than without indexation? Explain. (1) [4 marks] Do shocks to aggregate supply such as the example in part (b) have larger or smaller effects on the price level and real GDP with indexa- tion of wages than without indexation? What are the implications for the desirability of wage indexation? Explain.