Consider the worker-misperceptions model of short-run aggregate supply. Profitmaximizing firms hire labour up to the point where MPL=w, where w is the real wage and MPL is the marginal product of labour, which declines with higher employment L. The real wage is w=W/P, where W is the nominal wage and P is the price level. Firms are fully informed about both W and P when they make hiring decisions. Workers are assumed to supply more labour when they think real wages are higher, but they observe only their money wage W, not the price level P. Workers form expectations P of the price level rationally, whichithey use to calculate an expected real wage we=W/Pe. (a) [4 marks] Noting that labour supply car be expressed as a function of the actual real wage w=W/P and the ratio of actual and expected price levels P/P, use the labour-market diagram with supply and demand curves to show how the short-run aggregate supply curve (SRAS) is derived for a given level of price expectations Pe. (b) [4 marks] Suppose the central bank unexpectedly decreases the money supply. Use the AD-SRAS diagram to find the effects on the price level and real GDP Y. Would your answers be different if there were a credible announcement in advance of the monetary policy change? Briefly explain. The economy is hit by shocks to aggregate demand unrelated to monetary policy. Assume these shocks are not directly observed by workers, but are known to the central bank. Suppose the goals of the central bank are to avoid fluctuations in the price level P and real GDP Y. (c) [3 marks] After an aggregate demand shock, explain why adjusting the money supply so as to keep the price level P (or inflation) constant achieves both of the central bank's objectives. Now consider an unanticipated temporary negative supply shock not directly observed by workers, but known to the central bank. The shock reduces firms' demand for labour at a given level of real wages w. (d) [4 marks] Explain why it is not possible to use monetary policy to achieve both objectives of avoiding fluctuations in the price level P and real GDP Y. What should the central bank do if the most important objective is stability of (i) the price level, or (ii) real GDP? Suppose instead the negative supply shock is permanent and everyone knows about it. Assume the central bank's main objective is stabilizing real GDP rather than the price level. (e) [5 marks] Does the model predict that the central bank will be able to use monetary policy to achieve its objective? is there a better monetary policy target the central bank could aim for in this situation? Carefully explain Consider the worker-misperceptions model of short-run aggregate supply. Profitmaximizing firms hire labour up to the point where MPL=w, where w is the real wage and MPL is the marginal product of labour, which declines with higher employment L. The real wage is w=W/P, where W is the nominal wage and P is the price level. Firms are fully informed about both W and P when they make hiring decisions. Workers are assumed to supply more labour when they think real wages are higher, but they observe only their money wage W, not the price level P. Workers form expectations P of the price level rationally, whichithey use to calculate an expected real wage we=W/Pe. (a) [4 marks] Noting that labour supply car be expressed as a function of the actual real wage w=W/P and the ratio of actual and expected price levels P/P, use the labour-market diagram with supply and demand curves to show how the short-run aggregate supply curve (SRAS) is derived for a given level of price expectations Pe. (b) [4 marks] Suppose the central bank unexpectedly decreases the money supply. Use the AD-SRAS diagram to find the effects on the price level and real GDP Y. Would your answers be different if there were a credible announcement in advance of the monetary policy change? Briefly explain. The economy is hit by shocks to aggregate demand unrelated to monetary policy. Assume these shocks are not directly observed by workers, but are known to the central bank. Suppose the goals of the central bank are to avoid fluctuations in the price level P and real GDP Y. (c) [3 marks] After an aggregate demand shock, explain why adjusting the money supply so as to keep the price level P (or inflation) constant achieves both of the central bank's objectives. Now consider an unanticipated temporary negative supply shock not directly observed by workers, but known to the central bank. The shock reduces firms' demand for labour at a given level of real wages w. (d) [4 marks] Explain why it is not possible to use monetary policy to achieve both objectives of avoiding fluctuations in the price level P and real GDP Y. What should the central bank do if the most important objective is stability of (i) the price level, or (ii) real GDP? Suppose instead the negative supply shock is permanent and everyone knows about it. Assume the central bank's main objective is stabilizing real GDP rather than the price level. (e) [5 marks] Does the model predict that the central bank will be able to use monetary policy to achieve its objective? is there a better monetary policy target the central bank could aim for in this situation? Carefully explain
