Question

QUESTION 5

(a) There are three reasons commonly given for the upward slope of the Short Run Aggregate Supply curve. Clearly explain all of them. (3 marks)

(a) Using an AD/AS model, explain the effects on both prices and output in the short and long run, if there is an increase in the overall wage rate in an economy. (7 marks)

Answer 1

The sticky price model presumes overall price level to adjust gradually as firms do not change their prices quite often. A rise in demand does not result in rise in price level but firms start supplying more. This again leads to overproduction. The sticky wage model presumes nominal wages to be fixed by contracts. There is no immediate adjustment in the wages when prices are changed. Workers however, experience their real wage rate falling and so the market fails to restore equilibrium or is very slow. Firms hire more labor at lower real wage rate. Workers also put more effort (more working hours) to earn the same nominal income adjusted for prices. This results in overproduction. Under the misconception model, imperfect information model has a presumption that workers confuse the rise in nominal wages with the rise in real wages which implies that they start supplying more labor hours or work at a lower nominal wage rate. Firms have knowledge of price level so they adjust nominal wage accordingly but workers confuse nominal wage hike with real wage hike. In this way, these theories suggest that AS is upward sloping. However, long run AS proposes the maximum output a nation can produce with all its resources and the available technology in the long run. This is unrelated to price because firms cannot increase production beyond what is considered as maximum for how much is the price. Hence, LRAS curve is vertical.

Prica Prica LRAS SRAS2 LRAS SRAS2 SRAS1 SRAS1 E AD1 AD1 Yi Yf Real GDP Yi Yf Real GDP Increase in the wage rate decreases production. In the short run there is a leftward shift of the SRAS supply which reduces the real GDP but raises the price level. In the long run as price level rises, real wages fall and firms hire more labor, which increases production and shifts SRAS back to its original location. Both real GDP and prices have reached their original long run levels