Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 349 The Sticky-Wage Model To explain why the short-run aggregate supply curve is upward sloping, many economists stress the sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term contracts, so wages cannot adjust quickly when economic conditions change. Even in industries not covered by form contracts, implicit agreements between workers and firms may limit wage changes. Wages may also depend on social norms and notions of fairness that evolve slowly. For these reasons, many economists believe that nominal wages are sticky in the short run The sticky-wage model shows what a sticky nominal wage implies for ag- gregate supply To preview the model, consider what happens to the amount of tput produced when the price level rises: 1. When the nominal wage is stuck, a rise in the price level lowers the real wage, naking labor cheaper 2. The lower real wage induces firms to hire more labor 3. The additional labor hired produces more output This positive relationship between the price level and the amount of output means that the aggregate supply curve slopes upward during the time when the nominal wage cannot adjust To develop this story of aggregate supply more formally, assume that workers and firms bargain over and agree on the nominal wage before they know what the price level will be when their agreement takes effect. The bargaining par- ties--the workers and the firms--have in mind a target real wage. The target may be the real wage that equilibrates labor supply and demand. More likely, the tar- get real wage is higher than the equilibrium real wage: as discussed in Chapter 6, union power and efficiency-wage considerations tend to keep real wages above the level that brings supply and demand into balance The workers and firms set the nominal wage W based on the target real wage wo and on their expectation of the price level Pe. The nominal wage they set is Nominal Wage Target Real Wage X Expected Price Level After the nominal wage has been set and before labor has been hired firms learn the actual price level P. The real wage turns out to be W/P (P/P Real Wage Target Real Wage x Expected Price Level Actual Price level This equation shows that the real wage deviates from its target if the actual price level differs from the expected price level. When the actual price level is greater than expected, the real wage is less than its target; when the actual price level is less than expected the real wage is greater than its target. User JoENA: Job EFFo1429: 6264_ch13: Pg 349: 27756#/eps at 100smml Mon,Feb18,200212:56User JOEWA:Job EFF01429:6264_ch13:Pg 349:27756#/eps at 100% *27756* Mon, Feb 18, 2002 12:56 AM The Sticky-Wage Model To explain why the short-run aggregate supply curve is upward sloping, many economists stress the sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term contracts, so wages cannot adjust quickly when economic conditions change. Even in industries not covered by formal contracts, implicit agreements between workers and firms may limit wage changes. Wages may also depend on social norms and notions of fairness that evolve slowly. For these reasons, many economists believe that nominal wages are sticky in the short run. The sticky-wage model shows what a sticky nominal wage implies for ag￾gregate supply.To preview the model, consider what happens to the amount of output produced when the price level rises: 1. When the nominal wage is stuck, a rise in the price level lowers the real wage, making labor cheaper. 2. The lower real wage induces firms to hire more labor. 3. The additional labor hired produces more output. This positive relationship between the price level and the amount of output means that the aggregate supply curve slopes upward during the time when the nominal wage cannot adjust. To develop this story of aggregate supply more formally, assume that workers and firms bargain over and agree on the nominal wage before they know what the price level will be when their agreement takes effect. The bargaining par￾ties—the workers and the firms—have in mind a target real wage.The target may be the real wage that equilibrates labor supply and demand. More likely, the tar￾get real wage is higher than the equilibrium real wage: as discussed in Chapter 6, union power and efficiency-wage considerations tend to keep real wages above the level that brings supply and demand into balance. The workers and firms set the nominal wage W based on the target real wage q and on their expectation of the price level Pe .The nominal wage they set is W = q × Pe Nominal Wage = Target Real Wage × Expected Price Level. After the nominal wage has been set and before labor has been hired, firms learn the actual price level P.The real wage turns out to be W/P = q × (Pe /P) Real Wage = Target Real Wage × . This equation shows that the real wage deviates from its target if the actual price level differs from the expected price level.When the actual price level is greater than expected, the real wage is less than its target; when the actual price level is less than expected, the real wage is greater than its target. Expected Price Level  Actual Price Level CHAPTER 13 Aggregate Supply | 349