Q. Model of labor market in AS-AD model?

Remember the model of labor market in AS-AD model with constant wages. On the y-axis, we had real wage and on x-axis, we had L. The response curve had two parts, one horizontal part and a downward sloping part. On horizontal part, prices where constant and L was determined by aggregate demand. Real wages in this part of response curve may be referred by (W/P)_MAX as real wages can never be higher than this level. On the downward sloping part of the response curve, P is no longer constant and L is determined by P. On this part of curve, real wage is lower than (W/P)_MAX. We also determined that real response curve is a smooth version of this one.

With inflation, reaction curve won't change. The reason for this is that we have real wages on y-axis. If wages increase by 10% whereas prices increase by 10%, real wage won't change.  

In our model of labor market with inflation, there is still a maximum real wage (W/P)_MAX. As long as we are to left of point B, there is no reason for firms to change the growth rate of prices (which is given by p = p_W) and real wage will remain constant. In order to persuade firms to go past the L_B, real wages should fall below (W/P) _MAXit means that prices should increase faster than wages: p>p_W.  Though, we should be careful with the notation: 

• With no inflation, we said that said prices were constant on horizontal part. With inflation, we should say that we have neutral inflation (p = p_w) on horizontal part.
• With no inflation, we said prices increase as L increase on downward sloping part. With inflation, we should say that prices increase faster than wages as L increase on this part.

Figure: The labor market with inflation