4.3. This question and the next are based on SL, chapter 15, exercise 8 (p474). Show diagrammatically, using the diagrams given below, the effect of a disinflation policy, represented by a shift from AD. to AD. when wages are indexed to past prices. Assume that the way indexation works is that the wage in period t, W, is indexed to the price level in (t- 1), P-1. In other words, W. = xP., where x is the target real wage. We start at long run equilibrium, Wo=xPo. Show as precisely as possible in the diagrams how output, employment and the real wage evolve over time after the inital shift indicated in the AD curve. labour demand curve AS W/P P Po X AD ADO Y L 4.4 Redo 4.3 assuming that wages are set freely rather than being indexed. Assume first that price expectations are static, so pe, - P.), and that (expected) real wages are rigid. Then show what happens if, instead, expectations are rational. You may be able to discover a neat link between the answers to 4.3 and the first part of 4.4. 4.5 (for general discussion) What does the analysis of 4.3 and 4.4 tell us about the desirability of wage indexation