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Considerthe ASAD model of a closed economy with zero on going inflation in the medium run. The aggregate demand curve is determined by the IS-LM model. The aggregate supply curve is derived from the imperfect competition model of the labour market (the WS-PS model where firms have perfect foresight, monopoly power, and use a linear technology with constant returns to labour; workers expect zero inflation in every period, and their wage requests are an increasing function of wage-push factors like unions' bargaining power). The economy is initially in the potential equilibrium. Assume a permanent increase in the bargaining power of unions. Fiscal and monetary authorities perfectly forecast this shock and decide to neutralize immediately its consequences for the price level by enacting a "policy of price stability" that successfully eliminates all fluctuations in the general price level in every period. Therefore, the economy is subject to two simultaneous shocks – the increase in workers bargaining power and the price stabilization policy – that leave the price level unchanged in every period. Answer all the questions below.
a) Assuming that interventions are successful,what happens to output, employment and the real wage in the short and in the medium run? Carefully explain the economic mechanisms at work and complete your answer by mentioning what would have been the effects on output, price level and real wages, both in the short and in the medium run, if there were no policy interventions
b) Compare two opposite ways in which the Government and the Central Bank may coordinate in implementing the "policy of price stability": consider a first scenario in which the Government intervenes using fiscal policy, while the Central Bank does nothing; and a second, opposite scenario in which only the Central Bank intervenes using monetary policy, while fiscal authorities do nothing. Briefly describe the different instruments that authorities would use and the different consequences for the economy of their interventions in the two scenarios
