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 = щ * 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 = щ * 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