22.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run

Wage Stickiness

Wage contracts fix nominal wages for the life of the contract. The length of wage contracts varies from one week or one month for temporary employees, to one year (teachers and professors often have such contracts), to three years (for most union workers employed under major collective bargaining agreements). The existence of such explicit contracts means that both workers and firms accept some wage at the time of negotiating, even though economic conditions could change while the agreement is still in force.

Think about your own job or a job you once had. Chances are you go to work each day knowing what your wage will be. Your wage does not fluctuate from one day to the next with changes in demand or supply. You may have a formal contract with your employer that specifies what your wage will be over some period. Or you may have an informal understanding that sets your wage. Whatever the nature of your agreement, your wage is “stuck” over the period of the agreement. Your wage is an example of a sticky price.

One reason workers and firms may be willing to accept long-term nominal wage contracts is that negotiating a contract is a costly process. Both parties must keep themselves adequately informed about market conditions. Where unions are involved, wage negotiations raise the possibility of a labor strike, an eventuality that firms may prepare for by accumulating additional inventories, also a costly process. Even when unions are not involved, time and energy spent discussing wages takes away from time and energy spent producing goods and services. In addition, workers may simply prefer knowing that their nominal wage will be fixed for some period of time.

Some contracts do attempt to take into account changing economic conditions, such as inflation, through cost-of-living adjustments, but even these relatively simple contingencies are not as widespread as one might think. One reason might be that a firm is concerned that while the aggregate price level is rising, the prices for the goods and services it sells might not be moving at the same rate. Also, cost-of-living or other contingencies add complexity to contracts that both sides may want to avoid.

Even markets where workers are not employed under explicit contracts seem to behave as if such contracts existed. In these cases, wage stickiness may stem from a desire to avoid the same uncertainty and adjustment costs that explicit contracts avert.

Finally, minimum wage laws prevent wages from falling below a legal minimum, even if unemployment is rising. Unskilled workers are particularly vulnerable to shifts in aggregate demand.

Price Stickiness

Rigidity of other prices becomes easier to explain in light of the arguments about nominal wage stickiness. Since wages are a major component of the overall cost of doing business, wage stickiness may lead to output price stickiness. With nominal wages stable, at least some firms can adopt a “wait and see” attitude before adjusting their prices. During this time, they can evaluate information about why sales are rising or falling (Is the change in demand temporary or permanent?) and try to assess likely reactions by consumers or competing firms in the industry to any price changes they might make (Will consumers be angered by a price increase, for example? Will competing firms match price changes?).

In the meantime, firms may prefer to adjust output and employment in response to changing market conditions, leaving product price alone. Quantity adjustments have costs, but firms may assume that the associated risks are smaller than those associated with price adjustments.

Another possible explanation for price stickiness is the notion that there are adjustment costs associated with changing prices. In some cases, firms must print new price lists and catalogs, and notify customers of price changes. Doing this too often could jeopardize customer relations.

Yet another explanation of price stickiness is that firms may have explicit long-term contracts to sell their products to other firms at specified prices. For example, electric utilities often buy their inputs of coal or oil under long-term contracts.

Taken together, these reasons for wage and price stickiness explain why aggregate price adjustment may be incomplete in the sense that the change in the price level is insufficient to maintain real GDP at its potential level. These reasons do not lead to the conclusion that no price adjustments occur. But the adjustments require some time. During this time, the economy may remain above or below its potential level of output.

A Change in the Cost of Health Care

In the United States, most people receive health insurance for themselves and their families through their employers. In fact, it is quite common for employers to pay a large percentage of employees’ health insurance premiums, and this benefit is often written into labor contracts. As the cost of health care has gone up over time, firms have had to pay higher and higher health insurance premiums. With nominal wages fixed in the short run, an increase in health insurance premiums paid by firms raises the cost of employing each worker. It affects the cost of production in the same way that higher wages would. The result of higher health insurance premiums is that firms will choose to employ fewer workers.

Suppose the economy is operating initially at the short-run equilibrium at the intersection of AD₁ and SRAS₁, with a real GDP of Y₁ and a price level of P₁, as shown in Figure 22.9 “An Increase in Health Insurance Premiums Paid by Firms”. This is the initial equilibrium price and output in the short run. The increase in labor cost shifts the short-run aggregate supply curve to SRAS₂. The price level rises to P₂ and real GDP falls to Y₂.

A reduction in health insurance premiums would have the opposite effect. There would be a shift to the right in the short-run aggregate supply curve with pressure on the price level to fall and real GDP to rise.

A Change in Government Purchases

Suppose the federal government increases its spending for highway construction. This circumstance leads to an increase in U.S. government purchases and an increase in aggregate demand.

Assuming no other changes affect aggregate demand, the increase in government purchases shifts the aggregate demand curve by a multiplied amount of the initial increase in government purchases to AD₂ in Figure 22.10 “An Increase in Government Purchases”. Real GDP rises from Y₁ to Y₂, while the price level rises from P₁ to P₂. Notice that the increase in real GDP is less than it would have been if the price level had not risen.

In contrast, a reduction in government purchases would reduce aggregate demand. The aggregate demand curve shifts to the left, putting pressure on both the price level and real GDP to fall.

In the short run, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. Recall, however, that the short run is a period in which sticky prices may prevent the economy from reaching its natural level of employment and potential output. In the next section, we will see how the model adjusts to move the economy to long-run equilibrium and what, if anything, can be done to steer the economy toward the natural level of employment and potential output.