VincentCheung
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I am currently studying Okun's Law, aggregate demand and the Phillips curve.

In the short run we are assuming that prices and wages are fixed for reasons such as changing menu's and labels need time.

So given an expansion in the nominal growth of money, there is growth in output. This implies a shift in aggregate demand curve(by LM curve), so this then implies inflation. Does this not contradict our assumption? Or does this mean that the inflation happens in the future following the money stimulation?

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rasclerhys
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This confuses me to an extent also, but we need to think more carefully about our price stickiness assumption.
We assume this because in the short run it is difficult for firms to change prices due to menu costs etc, furthermore wages are sticky downwards (people dont like a nominal wage reduction). But some prices can still change, i.e. we aren't assuming a perfectly horizontal aggregate supply curve which would occur if we assumed that ALL prices were sticky.

If the money supply grows and people have more money in their pockets then they will increase their demand for products and so increase demand causing prices to rise. Therefore we have inflation, but we are still assuming that firms cant increase their prices. If they could increase their prices then they would raise them in this situation which would mean that demand doesn't increase and we have the Classical Dichotomy.

Does this make sense?
Rhys
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VincentCheung
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Oh I have never come across Classical Dichotomy, although I have just searched it and has helped to understand this a little more. This is just the idea that nominal and real values can be analysed separately right? So when prices are flexible then we have Classical Dichotomy?

Although just to ensure I am getting the right idea... In our case, looking past our assumptions there are still SOME firms who can increase their prices so they do so reacting to the increase in demand. Is this essentially what the idea is, that not ALL prices are sticky?
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rasclerhys
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Exactly, in the long run economists generally assume that the Classical Dichotomy holds and so any changes in nominal variables shouldnt affect real variables (although you could argue that hysteresis effects mean this could happen).

Correct If you have a copy of Mankiw (or can get hold of one) then look at his analysis of how the aggregate supply curve is constructed under the assumption of sticky prices; it will show you a mathematical representation of our anaylsis which may help further. Otherwise, you seem to have grasped it

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VincentCheung
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Thank you very much for the help, I understand perfectly now!
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