One type of event that would shift the short-run aggregate supply curve is an increase in the price of a natural resource such as oil. An increase in the price of natural resources or any other factor of production, all other things unchanged, raises the cost of production and leads to a reduction in short-run aggregate supply. Reasons for Wage and Price Stickiness Wage or price stickiness means that the economy may not always be operating at potential. Rather, the economy may operate either above or below potential output in the short run.
Correspondingly, the overall unemployment rate will be below or above the natural level. Many prices observed throughout the economy do adjust quickly to changes in market conditions so that equilibrium, once lost, is quickly regained.
Prices for fresh food and shares of common stock lonh-run two such examples. Other prices, though, adjust more slowly. Nominal wages, the price of labor, adjust very slowly. We will first look at why nominal wages are sticky, due to their association with the unemployment rate, a variable of great interest in macroeconomics, and then at other prices that may be sticky.
Aggregate Demand and Aggregate Supply
Wage Stickiness Wage contracts fix nominal wages for the life of the contract. The length of wage contracts varies from one week or Shirt month for temporary employees, to Shoft year teachers and professors often have lobg-run contractsto three years maacroeconomic most union workers employed under major collective bargaining agreements. The existence of such explicit contracts means that both workers and firms equilibrikm some wage at the time of negotiating, even though economic conditions could change while the agreement is still in force.
Think about your own job or a job you once had. Chances are you go to work each day knowing what your wage will be. Your wage does not fluctuate from one day to the next with changes in demand or supply. You may have a formal contract with your employer that specifies what your wage will be over some period. Or you may have an informal understanding that sets your wage. Your wage is an example of a sticky price. One reason workers and firms may be willing to accept long-term nominal wage contracts is that negotiating a contract is a costly process. Both parties must keep themselves adequately informed about market conditions.
Where unions are involved, wage negotiations raise the possibility of a labor strike, an eventuality that firms may prepare for by accumulating additional inventories, also a costly process.
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Even when unions are not involved, time and energy spent discussing wages takes away from time and energy spent producing goods and services. In addition, workers may simply prefer knowing that their nominal wage equilinrium be fixed for some period of time. Some contracts do attempt to take into account changing economic conditions, such as inflation, through cost-of-living adjustments, but even these relatively simple contingencies are not as widespread as one might think. One reason might be that a firm is concerned that while the aggregate price level is rising, the prices for the goods and services it sells might not be moving at the same rate.
Also, cost-of-living or other contingencies add complexity to contracts that both sides may want to avoid. Even markets where workers are not employed under explicit contracts seem to behave as if such contracts existed.
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In these cases, wage stickiness may stem from a desire to avoid the same uncertainty and adjustment costs that macrodconomic contracts avert. Finally, minimum wage laws prevent wages from falling below a legal minimum, even if unemployment is rising. Unskilled workers are particularly vulnerable to ,ong-run in aggregate demand. Price Stickiness Rigidity of other prices becomes easier to explain in light of the arguments about nominal wage stickiness. Since wages are a major component of the overall cost of doing business, wage stickiness may lead to output price stickiness. During this time, they can evaluate information about why sales are rising or falling Is the change in demand temporary or permanent?
Will competing firms match price changes? In the meantime, firms may prefer to adjust output and employment in response to changing market conditions, leaving product price alone. Quantity adjustments have costs, but firms may assume that the associated risks are smaller than those associated with price adjustments. Another possible explanation for price stickiness is the notion that there are adjustment costs associated with changing prices. In some cases, firms must print new price lists and catalogs, and notify customers of price changes.
Doing this too often could jeopardize customer relations. Yet another explanation of price stickiness is that firms may have explicit long-term contracts to sell their products to other firms at specified prices. For example, electric utilities often buy their inputs of coal or oil under long-term contracts. Taken together, these reasons for wage and price stickiness explain why aggregate price adjustment may be incomplete in the sense that the change in the price level is insufficient to maintain real GDP at its potential level. These reasons do not lead to the conclusion that no price adjustments occur.
But the marcoeconomic require some time. During this time, the economy may remain above or below its potential level of output. Equilibrium Levels of Price and Output in the Short Run To illustrate how we will use the model of aggregate demand and aggregate supply, let us examine the impact of two events: The first reduces short-run aggregate lonng-run the second increases aggregate demand. Both events change equilibrium real GDP and the price level in the short run. A Change in the Cost of Health Care In the United States, most people receive health insurance for themselves and their families through their employers. When the aggregate demand curve shifts, the price level at which it intersects with the long-run aggregate supply curve the equilibrium point changes, but output and thus real GDP holds steady.
Though price levels here represented by P1 through P4 may vary under long-term equilibrium, potential output remains the same and the long-run aggregate supply curve LRAS is therefore a vertical line. Because potential output holds steady under long-term equilibrium, greater aggregate demand naturally leads to higher price levels.
Long-Run Macroeconomic Equilibrium
When producers can charge more for their goods and services, they will, and greater aggregate demand allows them macroeconmoic do so. This reflects the assumption held by most economic theory that all actors in an economy will make whatever decisions maximize their profits. Conversely, when aggregate demand falls, producers must charge less to sell the same quantity of goods and services. Despite shifts in aggregate demand, real GDP expressed in terms of base-year dollars stays at the same level.
As the aggregate demand curve AD1 curve shifts to AD2 or AD3it intersects the long-run aggregate supply LRAS curve at different places; these intersections represent the price level created by the aggregate demand under long-term equilibrium, shown as P1, P2, and P3. This will subsequently shift the aggregate supply curve to the right. The level of output will, therefore, increase to the initial level when the economy was at full employment, with low price levels. This is due to the differences between current prices and the anticipated prices by the resource providers.
The unemployment rate will be lower than the naturally expected level. Price levels will decline in the long-run to the point consistent with full employment. Prices will then increase. Therefore, inflation is the main effect of the increased aggregate demand. Decrease in the Short-Run Aggregate Supply A decrease in the short-run aggregate supply lowers the available resources.