Sticky-wage theory of aggregate supply as a result of the decrease in the money supply

The first explanation of the upward slope of the short-run aggregate-supply curve is the sticky-wage theory, an economic concept describing how wages adjust slowly to changes in labor market conditions.

This theory is the simplest of the three approaches to aggregate supply Opens in new window, and some economists believe it highlights the most important reason why the economy in the short run differs from the economy in the long run. Therefore, it is the theory of short-run aggregate supply that we emphasize in the series.

According to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions. In other words, wages are “sticky” in the short run.

To some extent, the show adjustment of nominal wages is attributable to long-term contracts between workers and firms that fix nominal wages, sometimes for as long as 3 years. In addition, this prolonged adjustment may be attributable to slowly changing social norms and notions of fairness that influence wage setting.

An example can help explain how sticky nominal wages can result in a short-run aggregate-supply curve that slopes upward. Imagine that a year ago a firm expected the price level today to be 100, and based on this expectation, it signed a contract with its workers agreeing to pay them, say, $20 an hour. In fact, the price level turns out to be only 95.

• Because prices have fallen below expectations, the firm gets 5 percent less than expected for each unit of its product that it sells.
• The cost of labor used to make the output, however, is stuck at $20 per hour.
• Production is now less profitable, so the firm hires fewer workers and reduces the quantity of output supplied.

Over time, the labor contracts will expire, and the firm can negotiate with its workers for a lower wage (which they may accept because prices are lower), but in the meantime, employment and production will remain below their long-run levels.

Suppose the price level turns out to be 105 and the wage remains stuck at $20. The firm sees that the amount it is paid for each unit sold is up by 5 percent, while its labor costs are not. In response, it hires more workers and increases the quantity of output supplied.

Eventually, the workers will demand higher nominal wages to compensate for the higher price level, but for a while, the firm can take advantage of the profit opportunity by increasing employment and production above their long-run levels.

In short, according to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are based on expected prices and do not respond immediately when the actual level turns out to be different from what was expected.

This stickiness of wages gives firms an incentive to produce less output when the price level turns out lower than expected and to produce more when the price level turns out higher than expected.

1. All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.
2. Economists analyze short-run economic fluctuations using the model of aggregate demand and aggregate supply. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.
3. The aggregate-demand curve slopes downward for three reasons. First, a lower price level raises the real value of households’ money holdings, which stimulates consumer spending. Second, a lower price level reduces the quantity of money households demand; as households try to convert money into interest-bearing assets, interest rates fall, which stimulates investment spending. Third, as a lower price level reduces interest rates, the dollar depreciates in the market for foreign-currency exchange, which stimulates net exports.
4. Any event or policy that raises consumption, investment, government purchases,  net exports or an increase in the money supply at a given price level increases aggregate demand. Any event or policy that reduces consumption, investment, government purchases, net exports or a decrease in the money supply at a given price level decreases aggregate demand.
5. The long-run aggregate-supply curve is vertical. In the long run, the quantity of goods and services supplied depends on the economy’s labor, capital, and technology, but not on the overall level of prices.
6. Three theories have been proposed to explain the upward slope of the short-run aggregate-supply curve. According to the misperceptions theory, an unexpected fall in the price level leads suppliers to mistakenly believe that their relative prices have fallen, which induces them to reduce production. According to the sticky-wage theory, an unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production. According to the 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. All three theories imply that output deviates from its natural rate when the price level deviates from the price level that people expected.
7. Events that alter the economy’s ability to produce output, such as changes in labor, capital, natural resources, or technology shift the short-run aggregate supply curve (and may shift the long-run aggregate supply curve as well). In addition, the position of the short-run aggregate supply curve depends on the expected price level.
8. One possible cause of economic fluctuations is a shift in aggregate demand. When the aggregate-demand curve shifts to the left, output and prices fall in the short run. Over time, as changes in the expected price level cause perceptions, wages, and prices to adjust, the short-run aggregate-supply curve moves to the right, and the economy returns to its natural rate of output at a new, lower price level.
9. A second possible cause of economic fluctuations is a shift in aggregate supply. When the aggregate-supply curve shifts to the left, the short-run effect is falling output and rising prices―a combination called stagflation. Over time, as perceptions, wages, and prices adjust, the price level falls back to its original level, and output recovers.

I. Economic activity fluctuates from year to year.

A. Definition of Recession: a period of declining real incomes and rising unemployment.

B. Definition of Depression: a severe recession.

II. Three Key Facts about Economic Fluctuations

A. Fact 1: Economic Fluctuations Are Irregular and Unpredictable

B. Fact 2: Most Macroeconomic Quantities Fluctuate Together

C. Fact 3: As Output Falls, Unemployment Rises

III. Explaining Short-Run Economic Fluctuations

A. How the Short Run Differs from the Long Run

1. Most economists believe that the classical theory ( MV=PY) describes the world in the long run but not in the short run.

2. Beyond a period of several years, changes in the money supply affect prices and other nominal variables, but do not affect real GDP, unemployment, or other real variables.

3. However, when studying year-to-year fluctuations in the economy, the assumption of monetary neutrality is not appropriate. In the short run, most real and nominal variables are intertwined.

B. The Basic Model of Economic Fluctuations

1. Definition of Model of Aggregate Demand and Aggregate Supply: the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend.

2. We can show this model using a graph.

a. On the vertical axis is the overall price level in the economy.

b. On the horizontal axis is the overall quantity of goods and services.

c. Definition of Aggregate-Demand Curve: a curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

d. Definition of Aggregate-Supply Curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level.

IV. The Aggregate-Demand Curve

A. Why the Aggregate-Demand Curve Is Downward Sloping

1. Recall that GDP (Y) is made up of four components: consumption (C), investment (I), government purchases (G), and net exports (NX).

2. Each of the four components is a part of aggregate demand.

3. The Price Level and Consumption: The Wealth Effect

a. A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more.

b. The increase in consumer spending means a larger quantity of goods and services demanded.

4. The Price Level and Investment: The Interest-Rate Effect

a. The lower the price level, the less money households need to buy goods and services.

b. When the price level falls, households try to reduce their holdings of money by lending some out (either in financial markets or through financial intermediaries).

c. As households try to convert some of their money into interest-bearing assets, the interest rate will drop.

d. Lower interest rates encourage borrowing by firms that want to invest in new plants and equipment and by households who want to invest in new housing.

e. Thus, a lower price level reduces the interest rate, encourages spending on investment goods, and therefore increases the quantity of goods and services demanded.

5. The Price Level and Net Exports: The Exchange-Rate Effect

a. A lower price level in the United States lowers the U.S. interest rate.

b. American investors will seek higher returns by investing abroad, increasing U.S. net foreign investment.

c. The increase in net foreign investment raises the supply of dollars, lowering the real exchange rate.

d. U.S. goods become relatively cheaper to foreign goods. Exports rise, imports fall, and net exports increase.

e. Therefore, when a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, and U.S. net exports rise, thereby increasing the quantity of goods and services demanded.

6. All three of these effects imply that, all else equal, there is an inverse relationship between the price level and the quantity of goods and services demanded.

B. Why the Aggregate-Demand Curve Might Shift

1. Shifts Arising from Consumption

a. Americans become more concerned with saving for retirement and reduce current consumption. This will decrease aggregate demand.

b. When the government cuts taxes, it encourages people to spend more, resulting in an increase in aggregate demand.

2. Shifts Arising from Investment

a. The computer industry introduces a faster line of computers and many firms decide to invest in new computer systems. This will lead to an increase in aggregate demand.

b. If firms become pessimistic about future business conditions, they may cut back on investment spending, shifting aggregate demand to the left.

c. An investment tax credit increases the quantity of investment goods that firms demand, which results in an increase in aggregate demand.

d. An increase in the supply of money lowers the interest rate in the short run. This lead to more investment spending, which causes an increase in aggregate demand.

3. Shifts Arising from Government Purchases

a. Congress decides to reduce purchases of new weapon systems. This will decrease aggregate demand.

b. If state governments decide to build more state highways, aggregate demand will shift to the right.

4. Shifts Arising from Net Exports

a. When Europe experiences a recession, it buys fewer American goods which lowers net exports. Aggregate demand will shift to the left.

b. If the exchange rate of the U.S. dollar increases, U.S. goods become more expensive to foreigners. Net exports fall and aggregate demand shifts to the left.

V. The Aggregate-Supply Curve

A. The relationship between the price level and the quantity of goods and services supplied depends on the time horizon.

B. Why the Aggregate-Supply Curve Is Vertical in the Long Run

1. In the long run, an economy’s supply of goods and services depends on its supplies of resources along with the available production technology.

2. Because the price level does not affect the determinants of output in the long run, the long-run aggregate-supply curve is vertical at the natural rate of output.

C. Why the Long-Run Aggregate-Supply Curve Might Shift (Remember that I focus on the short-run changes, therefore, you should not expect to see many LRAS shifts on my tests.)

As a result, it has shifted the long-run aggregate-supply curve to the right.

b. Opening up international trade has similar effects to inventing new production processes. Therefore, it also shifts the long-run aggregate-supply curve to the right.

E. Why the Aggregate-Supply Curve Is Upward Sloping in the Short Run

1. The Misperceptions Theory

a. Changes in the overall price level can temporarily fool suppliers about what is happening in the markets in which they sell their output.

b. As a result of these misperceptions, suppliers respond to changes in the level of prices and thus, the short-run aggregate-supply curve is upward-sloping.

c. Example: The price level falls unexpectedly. Suppliers mistakenly believe that as the prices of their products fall, it is a drop in the relative price of their product. Suppliers may then believe that the reward of supplying their product has fallen, and thus they decrease the quantity that they supply. The same misperception may happen if workers see a decline in their nominal wage (caused by a fall in the price level).

d. Thus, a lower price level causes misperceptions about relative prices, and these misperceptions lead suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

2. The Sticky-Wage Theory

a. Nominal wages are often slow to adjust in the economy due to long-run contracts between workers and firms.

b. Example: Suppose a firm has agreed in advance to pay workers a certain amount and then the price level falls unexpectedly. This implies that the firm is now paying a real wage that is larger than it intended, raising the costs of production. Thus, the firm hires less labor and produces a smaller quantity of goods and services.

c. Therefore, because wages do not adjust to the price level, a lower price level makes employment and production less profitable, leading firms to lower the quantity of goods and services supplied.

3. The Sticky-Price Theory

a. The prices of some goods and services are also sometimes slow to respond to changes in the economy. This is often blamed on menu costs.

b. If the price level falls unexpectedly, and a firm does not change the price of its product quickly, its relative price will rise and this will lead to a loss in sales.

c. Thus, when sales decline, firms will produce a lower quantity of goods and services.

d. Because not all prices adjust instantly to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, which depress sales and cause firms to lower the quantity of goods and services supplied.

F. Why the Short-Run Aggregate-Supply Curve Might Shift

1. Events that shift the long-run aggregate-supply curve will shift the short-run aggregate-supply curve as well.

2. However, people’s expectations of the price level will affect the position of the short-run aggregate-supply curve even though it has no effect on the long-run aggregate-supply curve.

3. A higher expected price level will decrease the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left. A lower expected price level increases the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right.

VI. Two Causes of Recession

A. Long-Run Equilibrium

1. Long-run equilibrium is found where the aggregate-demand curve intersects with the long-run aggregate-supply curve.

2. Output is at its natural rate.

B. The Effects of a Shift in Aggregate Demand

1. Example: Pessimism causes household spending and investment to decline.

2. This will cause the aggregate demand curve to shift to the left.

3. In the short run, both output and the price level fall. This drop in output means that the economy is in a recession.  The short-run point is the intersection of the aggregate demand and the short-run aggregate supply.

4. It is possible that policymakers may want to eliminate the recession by boosting government spending or increasing the money supply. Either way, these policies could shift the aggregate demand curve back to the right.

5. However, even if policymakers do nothing, the economy will eventually move back to the natural rate of output.

a. People will correct the misperceptions, sticky wages, and sticky prices that cause the aggregate-supply curve to be upward-sloping in the short run.

b. The expected price level will fall, shifting the short-run aggregate-supply curve to the right.

6. In the long run, the decrease in aggregate demand can be seen solely by the drop in the equilibrium price level. Thus, the long-run effect of a change in aggregate demand is a nominal change (in the price level) but not a real change (output is the same).  This is always the last step of the government does nothing.  Prices and expected prices will adjust and the SRAS will move into the long-run where all three line intersect.

C. The Effects of a Shift in Aggregate Supply

1. Example: Firms experience a sudden increase in their costs of production or an oil shock.

2. This will cause the short-run aggregate-supply curve to shift to the left.

3. In the short run, output will fall and the price level will rise. The economy is experiencing stagflation.

4. Definition of Stagflation: a period of falling output and rising prices.

5. Policymakers will have a more difficult time with this situation. Policymakers can shift the aggregate-demand curve, but cannot simultaneously offset the drop in output and the rise in the price level. If they increase aggregate demand, the recession will end, but the price level will be permanently higher.

6. If policymakers do nothing, price expectations will adjust, causing the short-run aggregate-supply curve to shift back to the right.

VII  Monetary Policy

VIII Fiscal Policy

   A.  Government Purchases

   B.  Reduction in Taxes

More Monetary Policy

Banks and the Money Supply

A.   The Simple Case of 100-Percent-Reserve Banking

1.   Example: Suppose that currency is the only form of money and the total amount of currency is $100.

                 a.   Definition of reserves: deposits that banks have received but have not loaned out.

  2.   The financial position of the bank can be described with a T-account:

a.   Before the bank was created, the money supply consisted of $100 worth of currency.

                 b.   Now, with the bank, the money supply consists of $100 worth of deposits.

 Definition of reserve ratio: the fraction of deposits that banks hold as reserves.

c.  Now First National decides to set its reserve ratio equal to 10% and lend the remainder of the deposits.

                        The bank’s T-account would look like this:

When the bank makes these loans, the money supply changes.

                    Now, after the loans, deposits are still equal to $100, but borrowers now also hold $90 worth of currency from the loans.

 1.   The creation of money does not stop at this point.

  2.   Borrowers usually borrow money to purchase something and then the money likely becomes redeposited at a bank.

 3.   Suppose a person borrowed the $90 to purchase something and the funds then get redeposited in Second National Bank. Here is this bank’s T-account (assuming that it also sets its reserve ratio to 10%):

4.   If the $81 in loans becomes redeposited in another bank, this process will go on and on.

             5.   Each time the money is deposited and a bank loan is created, more money is created.

  The Fed’s Tools of Monetary Control

1.   Definition of open market operations: the purchase and sale of U.S. government bonds by the Fed.

                     a.   If the Fed wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public in the nation's bond markets.

                     b.   If the Fed wants to lower the supply of money, it sells government bonds from its portfolio to the public in the nation's bond markets. Money is then taken out of the hands of the public and the supply of money falls.

                     c.    If the sale or purchase of government bonds affects the amount of deposits in the banking system, the effect will be made larger by the money multiplier.

                     d.   Open market operations are easy for the Fed to conduct and are therefore the tool of monetary policy that the Fed uses most often.

2.   Definition of reserve requirements: regulations on the minimum amount of reserves that banks must hold against deposits.

                 a.   This can affect the size of the money supply through changes in the money multiplier.

                 b.   The Fed rarely uses this tool because of the disruptions in the banking industry that would be caused by frequent alterations of reserve requirements.

3.   Definition of discount rate: the interest rate on the loans that the Fed makes to banks.

                 a.   When a bank cannot meet its reserve requirements, it may borrow reserves from the Fed.

                 b.   A higher discount rate discourages banks from borrowing from the Fed and likely encourages banks to hold onto larger amounts of reserves. This in turn lowers the money supply.

                 c.    A lower discount rate encourages banks to lend their reserves (and borrow from the Fed). This will increase the money supply.

                 d.   The Fed also uses discount lending to help financial institutions that are in trouble.

How do sticky wages affect aggregate supply?

What happens when wages are sticky?

What does it mean when wages are sticky downward?

Why do sticky wages and prices increase the impact of an economic downturn on?