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Lecture

Lecture notes for week 7


Department
Economics for Management Studies
Course Code
MGEA06H3
Professor
Iris Au

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THE AS-AD MODEL IN THE LONG RUN & BRINGING MONEY INTO THE MODEL
Outline
x Discuss the adjustment mechanism from the short run to the long run.
x Discuss how the economy will correct itself to its long-run equilibrium if Y in the short run (Y*) YFE.
x Introducing money in our model.
The Effect of a Change in Wages on AS and AD Curves
x The question we ask: Is there a natural adjustment mechanism that can eliminate inflationary or deflationary gap in the long run?
x The theory says YES, inflationary or deflationary gap can be eliminated by change in (nominal) wages in the long run.
x Question: How changes in nominal wages affect the AD and AS curve?
Case 1: A Rise in (Nominal) Wages
Effect on AD (setting AE = Y):
AE = C (Y – T + TR) + I (r) + G + X (E) – IM (E, Y)
x Since wages do not enter the AE function, a change in wages would have no effect on AE Æ No effect on AD.
x Note: A rise in wages raises workers’ income, but it lowers shareholders’ income (profit falls) Æ overall no change in (total) real
income Æ no change in AE Æ AD does not shift when wages increase.
Effect on AS:
x When wages rise, production costs increases Æ firms profit decreases.
x For any given price level, firms’ profit decreases Æ firms’ willingness to supply decreases Æ AS curve shifts to the left.
Case 2: A Fall in (Nominal) Wages
Effect on AD:
AE = C (Y – T + TR) + I (r) + G + X (E) – IM (E, Y)
x Since wages do not enter the AE function, a change in wages would have no effect on AE Æ No effect on AD.
x Note: A fall in wages lowers workers’ income, but in raises shareholders’ income (profit rise) Æ overall no change in (total) real
income Æ no change in AE Æ AD does not shift.
Effect on AS:
x When wages fall, production costs decreases Æ firms’ profit increases.
x For any given price level, firms’ profit increases Æ firms’ willingness to supply increases Æ AS curve shifts to the right.
The (Natural) Adjustment Mechanism from the Short Run to the Long Run
x We argue that there is pressure for wages to change if Y* does not equal YFE in the short run.
x Question: What is the actual adjustment mechanism if there is a deflationary gap? An inflationary gap?
Case 1: Adjustment Mechanism in a Deflationary Gap
x Question: What happens to wages in the long run if there is a deflationary gap (Y* < YFE)?
x Answer: Since there is lots of unemployment (the initial wage is too high), there will be pressure for wages to fall.
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x Question: Why there is pressure for wages to fall?
x Answer: At w0, there is excess supply of labour.
o Unemployed workers offer lower wages in order to get a job.
o Firms should pressure existing workers to accept lower wage because of plenty alternate workers.
Numerical Example—A Deflationary Gap
The AS-AD model with a flat AS curve (a deflationary gap):
AD: P = 300¼ Y
AS: P = (20 + 0.1Y) (w / 100), initial wage (w0) = 100
x Note: We modify the AS function slightly to include wages. The rationale is wages are a major cost of production, a rise in wages
requires a rise in price if firms are to supply the same level of Y.
x Initial short-run equilibrium:
Y* = 800 P = 100
Equilibrium: AS = AD
Æ
20 + 0.1Y = 300 – ¼ Y = Y* = 800
Now, suppose the full-employment level of output is 900 (i.e., YFE = 900).
How does the economy adjust itself back to YFE? What happens to the price and wages in the long run?
Step 1: Solving for P from AD
Sub Y = YFE = 900 into AD:
P = 300¼ (900) = 75 (P decreases by 25)
Step 2: Solving for w from AS
Sub Y = 900 and P = 75 into AS
75 = (20 + 0.1 (900)) (w /100)
Æ
7500 = (20 + 90) w
Æ
7500 = 110w
Æ
w = 68.18 (w decreases by 31.82)
Case 2: Adjustment Mechanism in an Inflationary Gap
x Question: What happens to wages in the long run if there is an inflationary gap (Y* > YFE)?
x Answer: The labour market is tight (wages set too low and there is excess demand for labour); there is pressure for wages to rise
(firms compete to grab each other good workers, good workers try to look for better paying jobs).
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