Now, let’s reenact the Volcker disinflation in an alternate universe where wages are more flexible and workers are much more willing to accept slower growing wages when the inflation rate falls. This will make the SRAS steeper, as we saw in our original discussion of short-run aggregate supply.
Our model economy is thus as follows:
SRAS: Inflation = Expected inflation + 2 × (Real growth rate – Potential growth rate)
AD: Money growth = Inflation + Real growth
a. Answer part c of the previous question again, now in this world with a steeper SRAS.
b. Let’s see how far this can go: What if workers pay constant attention to the Fed’s every move and will slow their wage demands the moment they see Volcker tightening the money supply? Answer the previous question with “100” in the place of “2” in the SRAS equation. Feel free to round your answers to the nearest percent.
c. If you were a central banker trying to cut inflation, and you want to keep real growth as close as possible to the potential growth rate, what would you prefer: A steep SRAS (i.e., workers with flexible wages), or a flatter SRAS (i.e., workers with sticky wages)?