Question to consider- Exam 2

# Coordination problems suppose there is an increase in

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reactions to, or imperfect information about changes in prices. Coordination Problems: Suppose there is an increase in the money stock. Ultimately, prices will go up in the same proportion as the money supply, and output will be unchanged. But if any one firm raises its prices in proportion to the increase in the money stock, and no other firm does, then that single firm will lose business to the others. But, if all firms raised their prices in the same proportion, they would move immediately to the new equilibrium. But because the firms in the economy cannot get together to coordinate their price increases, each will raise prices slowly as the effect of the change in the money stock are felt through an increased demand for goods at existing prices. Coordination problems can also help explain why wages are sticky downward, that is, why they do not fall immediately when aggregate demand declines. Any firm cutting its wages while other firms do not will have its workers become annoyed and leave the firm. Fixed Contracts: Wages are usually set in nominal terms and may be fixed contractually for months or even years. If contracts are not negotiated at the same time, wages will be even stickier. Workers will be afraid to adjust their wages too much, as it will create too big a difference between their wages and the wages of others; nominal wages will therefore not be adjusted far enough to insure full employment in any single negotiation. Output will be able to deviate from potential output for many rounds of negotiation. If everyone could adjust their wages simultaneously and by the same amount, the economy would immediately jump to full-employment and output would be unable to

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deviate from potential output for any longer than the period of time between contract renegotiations. 4). The AD curve is downward sloping because higher prices reduce the value of the money supply, which reduces the demand for output. 1). Mathematical: M x V = P x Y MV is constant in the short run: PY is constant also. With the money supply constant, any increase in Y must be offset by a decrease in P, and vice versa. The inverse relationship between output and price gives the downward slope of AD. An increase in the money supply shifts AD upward for any given value of Y. 2). Wealth Effect: The AD curve is drawn under the assumption that the government holds the supply of money constant. As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services. If the price level falls, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services then before. This is because real money balances increases.

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