Business Cycle Theory
The Sticky-Wage Model
In this model, economists pursue the sluggish adjustment of nominal wages path to explain why it is that the short-run aggregate supply curve is upward sloping. For sticky nominal wages, an increase in the price level lowers the real wage therefore making labor cheaper for firms. Cheaper labor means that firms will hire more labor, and the increased labor will in turn produce more output. The time period where the nominal wage cannot adjust to the changes in price level and output signifies the positive sloping aggregate supply curve.
The nominal wage is set by the workers and the firms based on the target real wage, which may or may not be the labor supply & demand equilibrium, and on price level expectation.
W = ù * Pe
Nominal Wage = Target Real Wage * Expected Price Level
After the nominal wage has been set but before any hiring, firms learn the actual price level (P). From this the real wage is derived
W/P = ù * Pe/P
Real Wage = Target Real Wage * Expected Price Level/Actual Price Level
From the equation,
real wage = target real wage when expected price level = actual price level
real wage > target real wage when expected price level < actual price level
real wage < target real wage when expected price level > actual price level
The bargaining between workers and firms determine the nominal wage rate but not the actual level of employment. This is determined by the firms' hiring decisions and the labor demand function
L = Ld(W/P)
Output is determined by the production function, Y = F(L). The aggregate supply curve, under the sticky-wage model, summarizes the two functions and the relationship between the price level and output. Any unexpected changes in the price level cause a deviation...
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