Question

Suppose that in Wageland, all workers sign annual wage contracts each year on January 1. No matter what happens to the prices of final goods and services during the year, all workers earn the wage specified in their annual contract. This year, prices of final goods and services fall unexpectedly after the contracts are signed.

a. In the short run, how will the quantity of aggregate output supplied respond to the fall in prices?
b. What will happen when firms and workers renegotiate their wages?

Answer 1

Answer: Aggregate output will decrease, and wages will be lower when renegotiated.

Explanation: Because lower prices means less supply, a fall in the prices of final goods and services means that it's less profitable for firms to produce the same amount of output as before, because the prices of the goods they're selling are smaller, and so they'll decrease the amount they produce. This also means a decline in the market value of wages, because as aggregate supply drops there'll be more unemployment, and so as workers become less in demand the value of their wages goes down. Thus, when it's time to renegotiate wages will also be lower.