Question

Suppose the economy is currently in short-run equilibrium at point L. In this case, the economy is producing at an output level equal to its potential output. At current prices and wage levels, real wages are what firms and workers expected when they agreed on wage contracts. In the long run, if the price level and the nominal wage are both flexible, wages will [choose one: increase or decrease], which will cause the aggregate supply curve to shift to the [choose one: right or left]. Assuming the other two curves do not change, the economy will reach a new equilibrium at an output of [choose one: higher or lower] and a price level of [choose one: higher or lower].

A) Increase; Right; Higher
B) Decrease; Right; Higher
C) Increase; Left; Lower
D) Decrease; Left; Lower

Answer 1

Wages increase in the long-run neoclassical analysis due to a labor shortage, shifting the SRAS curve to the left. The new equilibrium is reached at the same level of real GDP but with higher prices, indicating higher overall production costs.

Step-by-step explanation:

Based on the scenario that the economy is currently at its potential output and considering long-run adjustments, the correct response is wages will increase, which will cause the aggregate supply curve to shift to the left. This happens because, in the long-run neoclassical analysis, economic output above potential GDP leads to unemployment below its natural rate, creating a labor shortage. Consequently, employers bid up wages to attract and keep workers. However, because wages are a major input to production costs, this will result in a higher cost of production. The higher wages will eventually increase production costs, and the short-run Keynesian aggregate supply curve (SRAS) will shift to the left, moving the economy to a new equilibrium with the same level of real GDP but a higher price level. Therefore, assuming the demand curve and long-run aggregate supply do not change, the economy will reach a new equilibrium at an output of lower and a price level of higher, which aligns with choice C) Increase; Left; Lower.