Question

. List and discuss 3 reasons why wages may be downwardly sticky.

Draw the demand and supply of labor graph to demonstrate how downwardly sticky wages can create unemployment during a contraction in the economy. Explain your graph with words.

Answer 1

Classical economists believed that government interference is not required to set recession right. Flexible wages and price would correct recession itself. During the fall in aggregate demand, demand for labor also falls, thus competition among the labors would pull down the wage rate and firms would starts employing more labors.

But keynes did not accept such proposition and gave theory of sticky wages where wage rate does not fall with fall in aggregate demand and it causes volunatary unemployment.

Following is diagram:

Fall in demand to D1 must have reduced the wage rate but due to:

• Minimum wage act.
• Efficiency wage
• Labor union
• Money illusion

firms are not able to reduce the wage rate from W0 to lower level. Hence, supply does not rise to accommodate unemployed population. Hence, now equilibrium is established at lower level signifying large scale unemployment.