Questions for Review

1. In this chapter we looked at three models of the short-run aggregate supply curve. All three models attempt to explain why, in the short run, output might deviate from its long-run “natural rate”—the level of output that is consistent with the full employment of labor and capital. All three models result in an aggregate supply function in which output deviates from its natural rate Y when the price level deviates from the expected price level: Y = Y + α(P – P). The first model is the sticky-wage model. The market failure is in the labor market, since nominal wages do not adjust immediately to changes in labor demand or supply—that is, the labor market does not clear instantaneously. Hence, an unexpected increase in the price level causes a fall in the real wage (W/P). The lower real wage induces firms to hire more labor, and this increases the amount of output they produce. The second model is the imperfect-information model. As in the worker-misperception model, this model assumes that there is imperfect information about prices. Here, though, it is not workers in the labor market who are fooled: it is suppliers of goods who confuse changes in the price level with changes in relative prices. If a producer observes the nominal price of the firm’s good rising, the producer attributes some of the rise to an increase in relative price, even if it is purely a general price increase. As a result, the producer increases production. The third model is the sticky-price model. The market imperfection in this model is that prices in the goods market do not adjust immediately to changes in demand conditions—the goods market does not clear instantaneously. If the demand for a firm’s goods falls, it responds by reducing output, not prices.