Is it possible to expand output above potential?

Yes. It may be the case, for example, that some people who were in the labor force but were frictionally or structurally unemployed find work because of the ease of getting jobs at the going nominal wage in such an environment. The result is an economy operating at point A in Figure Deriving the SRAS Curve at a higher price level and with output temporarily above potential.

Consider next the effect of a reduction in aggregate demand (to AD ₃), possibly due to a reduction in investment. As the price level starts to fall, output also falls. The economy finds itself at a price level–output combination at which real GDP is below potential, at point C. Again, price stickiness is to blame. The prices firms receive are falling with the reduction in demand. Without corresponding reductions in nominal wages, there will be an increase in the real wage. Firms will employ less labor and produce less output.

By examining what happens as aggregate demand shifts over a period when price adjustment is incomplete, we can trace out the SRAS curve by drawing a line through points A, B, and C. The SRAS curve is a graphical representation of the relationship between production and the price level in the short run. Among the factors held constant in drawing a SRAS curve are the capital stock, the stock of natural resources, the level of technology, and the prices of factors of production.

A change in the price level produces a change in the aggregate quantity of goods and services supplied and is illustrated by the movement along the SRAS curve. This occurs between points A, B, and C.

A change in the quantity of goods and services supplied at every price level in the short run is a change in SRAS. Changes in the factors held constant in drawing the SRAS curve shift the curve. (These factors may also shift the long-run AS supply curve.)

One type of event that would shift the SRAS curve is an increase in the price of a natural resource such as oil. An increase in the price of natural resources or any other factor of production, all other things unchanged, raises the cost of production and leads to a reduction in SRAS. In Panel (a) of Figure Changes in SRAS, SRAS ₁shifts leftward to SRAS ₂. A decrease in the price of a natural resource would lower the cost of production and, other things unchanged, would allow greater production from the economy’s stock of resources and would shift the SRAS curve to the right; such a shift is shown in Panel (b) by a shift from SRAS ₁ to SRAS ₃.

Figure Changes in SRAS

A reduction in SRAS shifts the curve from SRAS ₁ to SRAS ₂ in Panel (a). An increase shifts it to the right to SRAS ₃, as shown in Panel (b).

Reasons for Wage and Price Stickiness

Wage or price stickiness means that the economy may not always be operating at potential. Rather, the economy may operate either above or below potential output in the short run. Correspondingly, the overall unemployment rate will be below or above the natural level.

Many prices observed throughout the economy do adjust quickly to changes in market conditions so that equilibrium, once lost, is quickly regained. Prices for fresh food and shares of common stock are two such examples. Other prices, though, adjust more slowly. Nominal wages, the price of labor, adjust very slowly.

Wage Stickiness

Wage contracts fix nominal wages for the life of the contract. The length of wage contracts varies from one week or one month for temporary employees, to one year (teachers and professors often have such contracts), to three years (for most union workers).

One reason workers and firms may be willing to accept long-term nominal wage contracts is that negotiating a contract is a costly process. Both parties must keep themselves adequately informed about market conditions. Some contracts do attempt to take into account changing economic conditions, such as inflation, through cost-of-living adjustments, but even these relatively simple measures are not as widespread as one might think. Finally, minimum wage laws prevent wages from falling below a legal minimum, even if unemployment is rising. Unskilled workers are particularly vulnerable to shifts in aggregate demand.

Price Stickiness

Since wages are a major component of the overall cost of doing business, wage stickiness may lead to output price stickiness. With nominal wages stable, at least some firms can adopt a “wait and see” attitude before adjusting their prices. During this time, they can evaluate information about why sales are rising or falling and try to assess likely reactions by consumers or competing firms in the industry to any price changes they might make.

In the meantime, firms may prefer to adjust output and employment in response to changing market conditions, leaving product price alone. Quantity adjustments have costs, but firms may assume that the associated risks are smaller than those associated with price adjustments.

Another possible explanation for price stickiness is the notion that there are adjustment costs associated with changing prices. In some cases, firms must print new price lists and catalogs, and notify customers of price changes. Doing this too often could jeopardize customer relations.

Yet another explanation of price stickiness is that firms may have explicit long-term contracts to sell their products to other firms at specified prices. For example, electric utilities often buy their inputs of coal or oil under long-term contracts.

Taken together, these reasons for wage and price stickiness explain why aggregate price adjustment may be incomplete in the sense that the change in the price level is insufficient to maintain real GDP at its potential level. These reasons do not lead to the conclusion that no price adjustments occur. But the adjustments require some time. During this time, the economy may remain above or below its potential level of output.

Key concepts

· The short run in macroeconomics is a period in which wages and some other prices are sticky. The long run is a period in which full wage and price flexibility, and market adjustment, has been achieved, so that the economy is at the natural level of employment and potential output.

· The LRAS curve is a vertical line at the potential level of output. The intersection of the economy’s AD and LRAS curves determines its equilibrium real GDP and price level in the long run.

· The SRAS curve is an upward-sloping curve that shows the quantity of total output that will be produced at each price level in the short run. Wage and price stickiness account for the SRAS curve’s upward slope.

· Changes in prices of factors of production shift the SRAS curve. In addition, changes in the capital stock, the stock of natural resources, and the level of technology can also cause the SRAS curve to shift.

· In the short run, the equilibrium price level and the equilibrium level of total output are determined by the intersection of the AD and the SRAS curves. In the short run, output can be either below or above potential output