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Expansionary Monetary Policy, Aggregate Demand, and Inflation Adjusted Wages

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Aggregate Demand and Two Different Countries:

The example starts as follows: In Country A, all wage contracts are indexed to inflation. That is, each month wages are adjusted to reflect increases in the cost of living as reflected in changes in the price level. In Country B, there are no cost-of-living adjustments to wages, but the workforce is completely unionized. Unions negotiate 3-year contacts.

Adding Monetary Policy to our Aggregate Demand Problem:

In which country is an expansionary monetary policy likely to have a larger effect on aggregate output? Explain your answer using aggregate supply and aggregate demand curves.

The Effect of the Expansionary Monetary Policy on Aggregate Demand:

When interest rates are cut (which is our expansionary monetary policy), aggregate demand (AD) shifts up due to the rise in investment and consumption. The shift up of AD causes us to move along the aggregate supply (AS) curve, causing a rise in both real GDP and the price level. We need to determine the effects of this rise in AD, the price level, and real GDP (output) in each of our two countries.

What Happens to Aggregate Supply in Country A?:

Recall that in Country A "all wage contracts are indexed to inflation. That is, each month wages are adjusted to reflect increases in the cost of living as reflected in changes in the price level." We know that the rise in Aggregate Demand rose the price level. Thus due to the wage indexing, wages must rise as well. A rise in wages will shift the aggregate supply curve upwards, moving along the aggregate demand curve. This will cause prices to increase further, but real GDP (output) to fall.

What Happens to Aggregate Supply in Country B?:

Recall that in Country B "there are no cost-of-living adjustments to wages, but the workforce is completely unionized. Unions negotiate 3-year contacts." Assuming the contract is not up soon, then wages will not adjust when the price level rises from the rise in aggregate demand. Thus we will not have a shift of the aggregate supply curve and prices and real GDP (output) will not be affected.

The Conclusion:

In Country B we will see a larger rise in real output, because the rise in wages in country A will cause an upward shift in aggregate supply, causing the country to lose some of the gains it made from the expansionary monetary policy. There is no such loss in Country B.

have any further questions about aggregate demand and aggregate supply? Feel free to discuss in the following blog entry.

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