AGGREGATE SUPPLY AND
GETTING TO FULL EMPLOYMENT: PART TWO
During the Great Depression, Herbert Hoover and other prominent leaders urged businesses not to cut wages, asserting that cutting wages would reduce spending. Was this good advise?
- It was the worst thing to advise. Lower wages would have shifted the AS curve out and to the right, increasing output and employment. It is true that lower wages (and lower other factor costs) will reduce nominal income and spending. But real spending will be increased as the lower prices make money holdings more valuable.
Suppose the economy is initially in a long-run full-employment equilibrium. The aggregate demand increases, shifting the AD curve to the right.
a. What will happen in the short run to employment? To real wages?
b. What will happen in the long run?
- a. Output will increase and prices will rise. Since money wages are constant in the short run, real wages will fall as prices go up. Employment will increase as employees find their real costs reduced. Workers will not like working for lower real wages, but they may be locked into a long-term contract.
- b. Workers will demand and get higher real wages. Employment will fall back to its full-employment level. Output will fall. Prices will rise even further than in the short run.
Over the last decade, more unions have been putting cost-of-living adjustment clauses into their contracts, so that their wages go up or down with the price level. How will this affect the time it takes for the economy to reach full employment if it is in a recession?
- Wages will adjust faster to changing prices, spending the economy’s return to recovery. For example, the recession in the early 1980s was shorter than would have had been predicted based upon prior wage-change patterns.
How will an economy’s recovery time be affected if workers become more militant, such that they will go on strike if the firm tries to negotiate lower wages?
- In a recession, this will slow the time it takes to reduce wages. Recovery will take longer.
State and local planners often claim that a plant being located in their area has a “multiplier” effect. The area’s residents will benefit, it is claimed, by the spending and employment the new plant adds to the community. Will this be true if the state’s resources are fully employed?
- No. At full employment, the resources used by the plant (including land and labor) must come from other uses. To get these resources, the plant (and its employees) must bud them away from others in the area by offering higher prices for them. The effect will be higher prices and a lower real income for those not directly benefited by the plant. The area as a whole will benefit only to the degree the plant on net adds resources to the area.
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