Question

Let’s assume that the economy of a country is experiencing sticky wages and sticky prices. What is the new quantity demanded after a decrease in aggregate demand?

a) Increases
b) Decreases
c) Remains unchanged
d) None of the above

Answer 1

Sticky wages and prices cause the wage and price level to remain unchanged after a decrease in aggregate demand.

Step-by-step explanation:

To understand the effect of sticky wages and prices in the economy, consider Figure 25.4 (a) illustrating the overall labor market, while Figure 25.4 (b) illustrates a market for a specific good or service. The original equilibrium (Eo) in each market occurs at the intersection of the demand curve (Do) and supply curve (So). When aggregate demand declines, the demand for labor shifts to the left (to D₁) in Figure 25.4 (a) and the demand for goods shifts to the left (to D₁) in Figure 25.4 (b). However, because of sticky wages and sticky prices, the wage remains at its original level (Wo) for a period of time and the price remains at its original level (Po).