Suppose that in Wageland all workers sign annual wage...

Suppose that in Wageland all workers sign annual wage contracts each year on January 1. No matter what happens to prices of final goods and services during the year, all workers earn the wage specified in their annual contract. This year, prices of final goods and services fall unexpectedly after the contracts are signed. Answer the following questions using a diagram and assume that the economy starts at potential output. a. In the short run, how will the quantity of aggregate output supplied respond to the fall in prices? b. What will happen when firms and workers renegotiate their wages?

Suppose that in Wageland all workers sign annual wage contracts each year on January 1. No matter what happens to prices of final goods and services during the year, all workers earn the wage specified in their annual contract. This year, prices of final goods and services fall unexpectedly after the contracts are signed. Answer the following questions using a diagram and assume that the economy starts at potential output.
a. In the short run, how will the quantity of aggregate output supplied respond to the fall in prices?
b. What will happen when firms and workers renegotiate their wages?

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Key Concepts

Long-Run Adjustment and Wage Re-negotiation

Over time, once contracts are up for renewal, workers and firms will renegotiate wages. This renegotiation process adjusts the nominal wage to a level that is consistent with the new price level, thereby restoring the original real wage. In the long run, once wages adjust, the economy returns to its potential output as the short-run aggregate supply curve shifts back to its original position.

Short-Run Aggregate Supply Response

In the short run, with fixed nominal wages, a decline in the overall price level leads firms to face higher real wages, eroding their profit margins. As a result, firms respond by reducing the quantity of aggregate output supplied. This short-run response is captured by a movement along the short-run aggregate supply curve rather than a shift of the curve itself.

Nominal Wage Rigidity

Nominal wage rigidity refers to the situation where wages are fixed over a period of time, despite changes in the overall price level. In this context, workers sign annual wage contracts that do not adjust to unexpected price changes during the year, which means that a fall in prices increases the real wage until contracts are renegotiated.

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