Shifting the Curve

Before examining the details of flexible prices, consider the typical long-run aggregate supply curve, labeled LRAS, presented in this graph. The vertical slope of this curve captures the independent relation between the price level and aggregate real production. What is most important about this independent relation is that long-run aggregate real production is ALWAYS full-employment real production AT EVERY PRICE LEVEL.

Click the [Lower Price Level] button to illustrate that the resulting real production does not change, but also remains at full-employment production. The lower price level corresponds to the same real production. Click the [Higher Price Level] button to illustrate that the resulting real production does not change, but remains at full-employment production. The higher price level corresponds to the same real production. Movements along this LRAS curve result because all prices are flexible.

Flexible Prices

Suppose, for example, that The Wacky Willy Company, which manufactures Wacky Willy Stuffed Amigos (those cute and cuddly armadillos, scorpions, and rattlesnakes), faces falling demand reflected by buyers willing and able to pay a lower price. With a lower price and less revenue, The Wacky Willy Company needs to cut production cost. In the short run, it is likely to do so by reducing production and resource employment rather than resource prices. In the long run, however, wages eventually fall, enabling Wacky Willy employment and production to return to their original full-employment levels.

The reason is that equilibrium in the labor market is determined by the real wage, the ratio of the nominal wage to the price level. Those on the demand-side of the labor market, including The Wacky Willy Company, hire employees based on the real wage paid. Those on the supply-side of the labor market, including employees of The Wacky Willy Company, offer their labor services in response to the real wage received. Equilibrium in the labor market, which is another way of saying full employment, is then generated by a specific real wage.

A Lower Price Level

In other words, while workers are willing to work more because the purchasing power of their wage payment is greater, this boost in the real wage means employers are inclined to hire fewer workers. The result is a labor market surplus, or cyclical unemployment. In the long run, this unemployment surplus is eliminated when the nominal wage declines. In fact, the nominal wage eventually declines by the same proportion as the decline in the price level. If the price level declines by 10 percent, the nominal wage also declines by 10 percent. This ensures that the real wage returns to its original, full-employment, equilibrium level.

Because the real wage is at the full-employment equilibrium level BEFORE the price level decline and the real wage is the same after the price level decline as before, the labor market is once again at the full-employment equilibrium level. The aggregate real production supplied AFTER the price level decline is exactly the same as BEFORE the price level decline. In other words, the decline in the price level has absolutely no affect on the aggregate real production.

A Higher Price Level

The end result is a labor market shortage, or overemployment, that enables aggregate real production to exceed full-employment production. This persists only as long as the real wage is less than the full employment level. In the long run, this overemployment shortage is eliminated when the nominal wage increases. In fact, the nominal wage increases by the same proportion as the increase in the price level. If the price level increases by 10 percent, the nominal wage also increases by 10 percent. This ensures that the real wage returns to its original, full-employment, equilibrium level.