# How is the aggregate demand curve (the AD) affected?

Assume that: the aggregate production function takes the form Y = A N where A is a parameter indic Show more Assume that: the aggregate production function takes the form Y = A N where A is a parameter indicating the productivity level; labor is the only variable factor that affects marginal costs; prices are set according to P = (1 + ) MC where MC is the marginal cost and is the mark-up; nominal wages are set according to W = Pe f(N) where Pe is the expected price level and f(N) is an increasing function of N. Now suppose that the economy experiences an increase in labor productivity A (due to a technological or organizational improvement). a) Show (and explain) how this affects the labor market: the WS the PS the natural level of employment Nn the equilibrium real wage. b) Show (and explain) whether and how this affects the natural level of output Yn. c) Look at the short-run effects (assuming that expectations of the price level Pe have not changed). Obtain an expression for the short-run aggregate supply (AS) relation (P as a function of Y for given Pe). How is that curve affected by the productivity increase? How is the aggregate demand curve (the AD) affected? Is this a demand shock or a supply shock? d) Show what happens in the AS-AD graph indicating the new short-run equilibrium. Show the shortrun changes also in the IS-LM graph and in the labor market. Explain briefly what happens to all the macro variables (and why): output price level interest rates consumption investment employment nominal and real wages. e) Look now at the medium-run effects. Show what happens in the AS-AD graph when price level expectations are revised indicating the final medium-run equilibrium. Show it also in the IS-LM graph and in the labor market. Compare the final levels with the initial ones for all the macro variables: output price level interest rates consumption investment employment nominal and real wages. Explain briefly the adjustment process. Show less

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