The short run effect of an unexpected increase in the money supply on unemployment, n

#1
One of my multiple choice exam questions suggests that when there is an unexpected increase in the money supply, in the short run nominal wages rise while real wages fall, and unemployment decreases. I can see why unemployment may decrease, but can't really see why nominal wages would rise while real wages would fall.
I suppose the explanation would be that nominal wages may rise because in the short run aggregate demand AD is likely to increase, leading to higher prices and so results in adjustments in nominal wages to match this, but why does real wages fall though? Would this not require the knowledge of the relative inflation level?
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4 years ago
#2
(Original post by tsp216)
One of my multiple choice exam questions suggests that when there is an unexpected increase in the money supply, in the short run nominal wages rise while real wages fall, and unemployment decreases. I can see why unemployment may decrease, but can't really see why nominal wages would rise while real wages would fall.
I suppose the explanation would be that nominal wages may rise because in the short run aggregate demand AD is likely to increase, leading to higher prices and so results in adjustments in nominal wages to match this, but why does real wages fall though? Would this not require the knowledge of the relative inflation level?
The money velocity equation says that MV=PQ, where M is the money supply, V is the velocity of money, P is the price level and Q is the quantity of output in the economy.

In the short run, we assume the velocity of money (the speed at which it circulates through the economy) is constant, along with the level of output. This means that if there is an increase in M, then there must be an increase in P. This is inflation, which is often a consequence of looser monetary policy. As there has been an increase in the price level, there will be a fall in real wages.
1
#3
@philipd does higher inflation always equate to a higher level of nominal income? If so how do we know that nominal wages rises by more or less than the inflation rate, because if the nominal wage level rises equal to that of inflation, then wouldn't real wages remain unchanged (this is the part that really confuses me, other than that I get why expanding the money supply raises price levels)? After all, the answer says that real wages fall while nominal wages rise. Thanks for the initial reply.
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4 years ago
#4
(Original post by tsp216)
@philipd does higher inflation always equate to a higher level of nominal income? If so how do we know that nominal wages rises by more or less than the inflation rate, because if the nominal wage level rises equal to that of inflation, then wouldn't real wages remain unchanged (this is the part that really confuses me, other than that I get why expanding the money supply raises price levels)? After all, the answer says that real wages fall while nominal wages rise. Thanks for the initial reply.
I think what the question is getting at is that as employment increases, the marginal wage that is paid to the next worker has to be higher than the wage paid to the previous worker. This is because, at the previous wage, they are unwilling to work, and so must be paid a higher wage to incentivise them to join the workforce.

If you simply realise that the aggregate supply of labour curve is upward sloping, like any other supply curve, you will realise that as employment increases, the wage rate is assumed to increase. Of course, it is just a model, and economics is proved wrong all the time, but this is the assumption that is used.
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4 years ago
#5
(Original post by philipd)
I think what the question is getting at is that as employment increases, the marginal wage that is paid to the next worker has to be higher than the wage paid to the previous worker. This is because, at the previous wage, they are unwilling to work, and so must be paid a higher wage to incentivise them to join the workforce.

If you simply realise that the aggregate supply of labour curve is upward sloping, like any other supply curve, you will realise that as employment increases, the wage rate is assumed to increase. Of course, it is just a model, and economics is proved wrong all the time, but this is the assumption that is used.
Can I see the multiple choice question, please?
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#6
Here's a screenshot of it, and the solution is choice A. This was from the CIE A level Economics (9708) Oct/Nov 2011 variant 3. Thanks for the replies btw. I forgot to add that all of this was with respect to monetarist theory.

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4 years ago
#7
(Original post by tsp216)
Here's a screenshot of it, and the solution is choice A. This was from the CIE A level Economics (9708) Oct/Nov 2011 variant 3. Thanks for the replies btw. I forgot to add that all of this was with respect to monetarist theory.

Yeah I think it's getting at the Aggregate Supply of labour being upward sloping, and we are assuming that we are at full employment so an increase in employment must cause an increase in wages.
I'm 95% sure I'm right, but obviously I'm only an A Level student, so this reasoning may be incorrect but I think it's pretty solid.
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#8
That seems to make sense thnx again @philipd
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