Question

7. Some textbooks discuss the phenomenon of “sticky wages.” This phrase has come to mean that workers are quick to recognize that prices they pay for stuff are increasing and will move quickly to try and get a raise in nominal wages in times of higher than average inflation, but are unwilling to have nominal wages fall or adjust to rates of inflation that are lower than expected.

a) If the economy is in a short run equilibrium associated with a period of expansion, explain why, based on the statement above, the short run might be a very short period of time (a diagram is not required but will probably make it easier to explain) (2 points)

b) If an economy is in a short run equilibrium associated with a period of recession, explain why, based on the statement above, the long run could take a very long time to occur. (same caveat about a diagram) (2 points)

Answer 1

The theory of a sticky wages indicates that wages are a sticky downwards in the sense that workers are not willing to accept a lower nominal wage rate but they are always willing to receive a higher wage rate

In the periods where there is an expansion and the economy the aggregate demand is actually higher than what is required at the long run equilibrium. There is an inflationary gap and this indicates that in the long run with higher price level labour will push for a higher wage rate.

This would be easy because wage rate is not sticky upwards.

But when there is the recession in the economy and there is a recessionary gap the price level is lower and this will result in a lower nominal wage rate. This would be difficult because workers will not accept a lower nominal wage rate. This is the reason why the transition from a short run to the long run takes a long time in case of recessionary GAP but there is a quick adjustment towards full employment equilibrium in case of an inflationary gap.