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wage, hence the shift of demand of labour to the right to D(P1). However, supply of labour decreases because workers are free from money illusion and perceive the reduced purchasing power of their wages, hence the shift of supply of labour to the left to S(P1).

The equilibrium is restored in point B with a higher nominal wage which increase cancels out the increase in the price level, thus maintaining the same real wage. This implies the same quantity of labour (L0) employed in the economy and, through the production function - graph (b), the same total output Y0. Hence, in graph (d) we observe that the same level of output Y0 is attained with two different price levels (P0 and P1) , implying a vertical AS curve.

The slope of the AS curve is an important issue in the macroeconomic debate. This is not only a theoretical exercise because the slope of AS determines the effectiveness of economic policies. In this regard, it is useful to distinguish between the long run and the short run (that is defined as the period of time in which, because of imperfections, the price mechanism cannot adjust to the new conditions in the markets).

At least two models are relevant in the short run, both dealing with imperfections in the labour market. They are explained as follows, complementing the information given in the text.

i) The first one is called the sticky-wage model. After the increase in the general price level from P0 to P1, profit maximising firms shift their demand of labour from D(P0) to D(P1); due to rigidities (i.e., minimum wage or contracts signed before the increase in inflation), in the short run workers have to accept to work for a lower real wage and cannot shift their supply of labour which is still S(P0): the new equilibrium in the labour market is in point C - graph (a). There is room for employers to increase employment (and output) from Y0 to Y1 because the marginal cost of labour has decreased. Hence, because of an increase in the price level from P0 to P1, output increases from Y0 to Y1 - graph (b): AS curve is positively sloping - graph (d).

ii). The second alternative model is called the worker-misperception model. After the increase in prices, workers are offered a higher nominal wage.  Because of money illusion, they perceive this increase as an increase in their purchasing power.  Their supply curve shifts to the right and the equilibrium real wage falls.  Again, the decrease in the cost of labour allows firms to produce a higher level of output: AS is positively sloping.

While these imperfections can affect the slope of the AS curve in the short run, this irrational behaviour is unlikely to persist for a long time; eventually workers will respond in the classical manner and the AS curve will be vertical. There is disagreement, however, on the length (and therefore the political relevance) of the short term: it is assumed to be 1-2 years but new-classical economists argue that is much shorter than that.


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