Question

Describe the sticky wage and sticky price theory. How does it affect price leves, expectation and output.

Answer 1

Answer :-

Economic models that assume wages are flexible predict that anyone willing to work at the going wage can always find a job. However, this is not true because of unemployment; thus, we consider that wages are sticky and adjust slowly to changes in the market.

Sticky-wage Theory:-.

An unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production.

If nominal wages are unchanged as the price level falls, firms will be forced to cut back on employment and production. Over time, as expectations adjust, the short-run aggregate-supply curve will shift to the right, moving the economy back to the natural rate of output.

Sticky-price Theory :-.

An unexpected fall in the price level leaves some firms with prices that are temporarily too high, which reduces their sales and causes them to cut back production.

Many output prices are sticky in the short run due to menu costs. Firms set output prices in advance based on expected price level. If the Fed unexpectedly increases the money supply, in the long run, price level will rise. In the short run, firms without menu costs can raise prices immediately, but firms with menu costs wait to raise prices. This means the prices of firms with menu costs are relatively low, which increases qty demanded for their products. These firms respond by increasing output & employment.