Q6. In the short run, the AS curve is often drawn as upward-sloping. What is the reason for this? What is the economic significance of this?
As we have seen in question 3, if there are imperfections in the functioning of the markets, as it is in the short run, there can be a positive relationship between price level and output. These rigidities can affect the labour market (sticky wages) or the good market (sticky prices). Four different models (describing different types of rigidity) are here explained, integrating the information given in the text.
i) Sticky-wage model: wages are sticky in the short term because of pay rigidities (previous signed contracts): an increase in P implies a decrease in real wage and in the cost of labour, thus increasing output (see figure 11.1 - the equilibrium moves from A to C).
ii) Worker-misperception model: because of money illusion, workers agree to work for a lower real wage (for example, they see an increase in nominal wages but they don't perceive an even higher increase in prices). A higher level of output is therefore attained.
iii) Imperfect-information model: this model is similar to the previous one but it does not assume that firms have perfect information either. Both workers and firms have adaptive expectations. If an increase in price level happens, they do not perceive this change in first instance and they take time to adjust to the new situation; in the meanwhile the AS is upward sloping.
iv) Sticky-price model. If prices are sticky in the short run, suppliers do not instantly adjust their prices in response to increases in demand (because of the hassle of changing prices frequently or because of previous agreements between producers and consumers). In this extreme case the AS is horizontal.
The significance of a positively sloping AS is twofold. First, any change in the AD has positive effects on income. If the AS is positively sloping, an outward shift of the AD (due for example to expansionary fiscal or monetary policy) has the effect of moving the equilibrium to the right: a modest increase in P is linked to a growth in total output and therefore employment (see figure 11.3 - increase from Y1 to Y2 and from P1 to P2).
Second, the possibility of increasing output shows that labour or other productive factors are not fully employed. Suppose the AD shifts outwards and, as a consequence of sticky-wages, workers end up working for a lower real wage. Output and employment, both increase as a result in the fall in wages. Therefore, pay moderation is the key to cut unemployment. This policy has the advantage of being effective also in the long run (because it moves the vertical AS to the right) while fiscal and monetary policies are effective only in the short term, the period in which the AS is upward sloping.