Week_7_AS-AD_Model_in_Long_Run - 1 ECMA06 The AS-AD Model...

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1 ECMA06 – The AS-AD Model in the Long Run into the Model Outline Discuss how wages enter the AD-AS model. 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 . Discuss the natural adjustment mechanism and counter- cyclical fiscal policy under different settings. Introducing money in our model.
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2 The Effect of a Change in Wages in the AD-AS Model So far we have not included wages in the AD-AS model. In this section, we will discuss wages affect the AD and AS curves. Effect of a Change in Wage on AD AD shows the combination of Y and P such that AE = Y. Aggregate expenditure, AE is 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 A change in wage has no effect on AD. Why? A rise in wages, for example, raises workers’ income, but it also lowers shareholders’ income (profit falls). Overall no change in (total) real income no change in AE.
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3 ECMA06 – The AS-AD Model in the Long Run Effect of a Change in Wage on AS Wages are major production costs to firms. in wages in production costs in firms’ profits in firms’ willingness to supply a shift in AS curve. Example: Suppose wages : Wages , 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 Similarly, AS curve shifts to the right when wages fall.
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4 The (Natural) Adjustment Mechanism from the Short Run to the Long Run We argue that if Y* in the short run ≠ Y FE , there will pressure for wages to change to ensure that Y* = Y FE in the long run. Case 1: Adjustment Mechanism in a Deflationary Gap When, the economy is in a deflationary gap (Y* < Y FE ), there will be pressure for wages to fall. Question: Why there is pressure for wages to fall? Answer: There is lots of unemployment at the initial wage (i.e., the initial wage is too high). At initial wage (w 0 ), there is excess supply of labour. Implications: Unemployed workers offer lower wages in order to get a job. Firms should pressure existing workers to accept lower wage because of plenty alternate workers.
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5 ECMA06 – The AS-AD Model in the Long Run Graphical Analysis – A Deflationary Gap AE Y = AE Suppose Y* < Y FE : AE(P 0 ) A 45 ° Y Y* Y FE P AS 0 P 0 A’ AD Y Y* Y FE
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6 Numerical Example –A Deflationary Gap The AS-AD model with a flat AS curve (a deflationary gap):
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This note was uploaded on 12/21/2011 for the course ECONOMICS ECMA06 taught by Professor Dr.atamazaheri during the Spring '10 term at University of Toronto- Toronto.

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Week_7_AS-AD_Model_in_Long_Run - 1 ECMA06 The AS-AD Model...

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