Explain the mechanisms that underlie the relation between price level and output in aggregate supply. Illustrate the relation diagrammatically and then show and explain the impact of a reduction in the expected price level.

Labour Market to the Aggregate Supply

You should provide an analysis along the lines of the material of the topic on “From the Labour Market to the Aggregate Supply (AS) Relation”. Write a Cobb-Douglas production function to derive labour demand according to
(1— a)HLZ = _//14 Labour supply is given from – N Wt

By using the equilibrium condition Ldt = L, t = L„ you should solve and substitute back in the production technology and, after taking logs and defining composite parameter terms, derive the AS relation yt = y *Apt —Et_ipt).

A very good answer will detail all the steps of the derivation, together with explaining the reasoning behind each step. It will also explain the characteristics of the expressions used (e.g., what are the underlying mechanisms and intuition behind the labour demand and labour supply expressions).

SECTION A
Answer ONLY ONE out of the two questions in this section

(a) Present a model of the labour market and use its equilibrium to derive an aggregate supply relation of the form y, = y * +8(p, where 0 < B <1, y, is the level of output, y * is the natural level of output, A is the price level — all measured in natural logs — while is the expectations operator. [12.5%]

(b) Explain the mechanisms that underlie the relation between price level and output in aggregate supply. Illustrate the relation diagrammatically and then show and explain the impact of a reduction in the expected price level. [10%]

(c) “Can a permanent/anticipated change in monetary policy affect output?” Provide an analysis that addresses this question, by combining the aggregate supply relation, with an aggregate demand relation of the form y, = m, — p,, where m, is the supply of money. [27.5%]