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## The AD curve over timeWith inflation, the AD curve will no longer be stable over time. Instead, it will = 10%.nM If AD1 is AD curve in year 1, AD1 will show us all combinations of where both markets are in equilibrium in year 1. For example, both markets are equilibrium at point A where Y = 100 and P = 10.Y
In year 2, the money supply is higher - it has increased by just 10%. together with the level of GDP we had last year would still give us equilibrium in both markets. Inflation has then been 10% and none of the IS or LM curves have shifted.P In year 2, = 10 must be on AD2. In year 3, by the same arguments, Y = 1101.1 = 121 and P = 10 must be on the AD3 and we see that the AD curve glides upwards by 10% per year - exactly the same rate as the growth in the money supply.Y We must remember that if - if nM is high, a higher inflation is necessary if the same level of GDP is to lead to equilibrium in both markets.nM Even though and P leading to equilibrium in the goods- and money market (all points on the AD curve at precisely the given point in time). Only one point will be an equilibrium point for the entire economy and, as before, the AS curve will help us to find this point.Y ## The Labor MarketRemember the model of labor market in the AS-AD model with constant wages. On the y-axis, we had real wage and on the x-axis, we had was determined by the aggregate demand. Real wages in this part of the response curve may be denoted by (W/P)MAX as real wages can never be higher than this level. On the downward sloping part of the response curve, L is no longer constant and P is determined by L On this part of the curve, the real wage is lower than ( W/P)MAX. We also concluded that the real response curve is a smooth version of this one.P. With inflation, on the y-axis. If wages increase by 10% while prices increase by 10%, real wage will not change.real wages In our model of the labor market with inflation, there is still a maximum real wage (W/P)MAX. As long as we are to the left of point B, there is no reason for firms to change the growth rate of prices (which is given by and the real wage will remain constant. In order to induce firms to go past the LB, real wages must fall below ( W/P)MAX which means that prices must increase faster than wages: nW) > n nWHowever, we must be careful with the notation: • With no inflation, we said that said prices were constant on the horizontal part. With inflation, we must say that we have on the horizontal part.nw) • With no inflation, we said prices increase as as prices increase faster than wages increase on this part.L
## The AS curveSay that the nominal wage in year 1 (at a particular point in time) is equal to 1000. On the horizontal part of the response curve, real wage is constant and equal to its maximum value. Say that (W/P)MAX = 10. On the horizontal part, is the price level in year 1. Firms will employ at most P1 at this real wage. For firms to hire more than LB must be higher than 10. We realize that the AS curve at this point in time, AS1, will look like before. First, it is horizontal along LB, P = 10, then, for higher Y. it is upward sloping.P Suppose that which is an exogenous variable, making wages in year 2 exogenous. As the maximum real wage is given and equal to 10, we conclude that P2 is equal 110 on the horizontal part of the response curve and that P2 > 110 on the downward sloping part. AS2 nW up by 10% as given by the wages inflation. Using the same argument, P3 = 121 on the horizontal part of the response curve at year 3 and so on.glides upwards Just like the AD curve, the AS curve is to glide upwards or downwards depending on whether < 0 when we allow for inflation. As for the AD curve, the AS curve is applicable only at a particular point in time if nw ^ 0. At another point in time, we must draw a new AS curve.nW
## The AS-AD model with inflationWhen we have inflation, both the AD curve and the AS curve will be gliding. "The glide rate" of the AD curve is given by which applies to the AS curve (where both rates are exogenous). Using the AS-AD curves, we can determine the equilibrium price nW (and thus n) at any point in time and we can determine all endogenous variables. For example, we realize that if P = nM both curves glide at exactly the same rate. n , will then be unchanged and nwill be equal to Y nw.
in the AS-AD model with inflation.P |

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