Okay, today, we're going to have a look at what happens to our economic model when we allow factor prices (this usually refers to wages) to vary. Up until this point, we've been assuming that factor prices remain constant, but in real life, that isn't necessarily the case.
Here are some things you'll probably need to know about wages and the economy, and how they relate to demand shocks:
If the economy is in a recessionary gap (think post-2008)
-Actual income is lower than potential income
-There is an excess supply of labour (there are a lot more people going around trying to find jobs in a recession than firms are willing to hire)
-This excess supply of labour means that companies can lower wages without having to worry about losing workers
-By lowering wages, producers effectively decrease their average costs
-As a result, the short run aggregate supply curve will shift to the right (remember, decreased costs allow firms to increase production at every output price level)
-IMPORTANT: This adjustment happens relatively slowly, because it takes longer to lower wages than to raise wages (firms have to fight with unions, and it takes a while to agree on a lower wage rate: people don't like to be paid less)
-So... given some time, recessionary gaps will correct themselves, and unemployment will fall back to normal levels. Also, this kind of an adjustment causes the price level to decrease
If the economy is in an inflationary gap (for an example, Alberta circa 2007)
-Actual income is greater than potential income
-There is an excess demand of labour (there are not enough workers to supply firms' increasing demands, which is why you have fifteen year olds working in restaurants and making $12/hour during economic boom-times... it's ridiculous!)
-This excess demand of labour means that firms have to pay higher wages to entice new workers to stay on, or alternately, to reward current workers for working overtime
-This means that average costs increase for firms
-This increase in costs shifts short run aggregate supply to the left (increased costs force firms to decrease production at every output price level)
-IMPORTANT: This is a fast change: wages rise relatively quickly in good times, so this natural return to economic equilibrium is relatively quick.
-So... in the long run, the price level increases, and production decreases, bringing us back to equilibrium... yah!
AS YOU CAN SEE, we have ADJUSTMENT ASYMMETRY:
-Booms cause wages to rise quickly
-Recessions cause wages to fall slowly
ALSO, you should probably know about the Phillips curve!
Basically, the phillips curve shows us that as employment increases, rate of wages become lower. In other words, in times were there is lots of unemployment (read: recessions), the wage rates will fall. Conversely in times when unemployment is high (booms), the wage rates will increase!
Basically, a good way to think about long run economic adjustment is to imagine that Y* (potential GDP) is like an anchor, and that short run aggregate supply is a chain. We have have demand shocks which shift the economy around for a little while, but because these demand shocks affect wage rates, which in turn, affects supplier costs, the short run aggregate supply will always eventually bring the economy back to it's potential level!
We can practice figuring out what happens with supply and demand shocks in the long run, but basically, all you need to know is what I've already told you.
-Inflationary gaps cause increases in prices in the long run
-Recessionary gaps cause decreases in prices in the long run
-Production will eventually shift back to its potential levels
-Also, for economies where wages are "stickier" (less flexible), recessions are likely to last longer, because the wage adjustment does not occur as quickly
-Recessionary and inflationary gaps WILL disappear on their own, but but discretionary fiscal policy can speed up the process a LOT!
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