Week_7 - ECMA06 The AS-AD Model in the Long Run 1 The AS-AD...

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ECMA06 The AS-AD Model in the Long Run 1 The AS-AD Model in the Long Run & Bringing Money into the Model Outline Discuss the adjustment mechanism from the short run to the long run. Discuss how the economy will correct itself to its long-run equilibrium if Y in the short run (Y*) Y FE . Introducing money in our model. The Effect of a Change in Wages on AS and AD Curves The question we ask: Is there a natural adjustment mechanism that can eliminate inflationary or deflationary gap in the long run? The theory says YES , inflationary or deflationary gap can be eliminated by change in (nominal) wages in the long run. Question: How changes in nominal wages affect the AD and AS curve?
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ECMA06 The AS-AD Model in the Long Run 2 Case 1: A Rise in (Nominal) Wages Effect on AD: AE = C(Y T + TR) + I(r) + G + X(E) IM(E, Y) Since wages do not enter the AE function, a change in wages would have no effect on AE No effect on AD. Note: A rise in wages raises workers’ income, but it lowers shareholders’ income (profit falls) overall no change in (total) real income no change in AE. Effect on AS: When wages rise, production costs firms’ profit . For any given price level, firms’ profit firms’ willingness to supply AS curve shifts to the left. P AS(w 0 ) Y
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ECMA06 The AS-AD Model in the Long Run 3 Case 2: A Fall in (Nominal) Wages Effect on AD: AE = C(Y T + TR) + I(r) + G + X(E) IM(E, Y) Since wages do not enter the AE function, a change in wages would have no effect on AE No effect on AD. Note: A fall in wages lowers workers’ income, but it raises shareholders’ income (profit ris e) overall no change in (total) real income no change in AE. Effect on AS: When wages fall, production costs firms’ profit . For any given price level, firms’ profit firms’ willingness to supply AS curve shifts to the right. P AS(w 0 ) Y
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ECMA06 The AS-AD Model in the Long Run 4 The (Natural) Adjustment Mechanism from the Short Run to the Long Run We argue that there is pressure for wages to change if Y* does not equal to Y FE in the short run. Question: What is the actual adjustment mechanism if there is a deflationary gap? An inflationary gap? Case 1: Adjustment Mechanism in a Deflationary Gap Question: What happens to wages in the long run if there is a deflationary gap (Y* < Y FE )? Answer: Since there is lots of unemployment (the initial wage is too high), there will be pressure for wages to fall. w LS Labour Market LD L
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ECMA06 The AS-AD Model in the Long Run 5 Question: Why there is pressure for wages to fall?
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