Economics 101: Unemployment, Wages, and Aggregate Demand

Unemployment and Recession

  • Unemployment is a significant personal and social cost during a recession.

  • A key question arises: Why don't employers simply cut wages instead of firing workers?

  • Sticky Wages

    • Definition: Sticky wages are wages that do not adjust downwards easily, which can prolong the recovery process during a recession.

Phenomenon of Sticky Wages

  • Reasons for Sticky Wages

    • Employers are reluctant to lower wages due to potential negative impacts on worker morale.

    • Example of Sticky Wages:

    • Reflects poorly on productivity. E.g., angry professors at a university become demotivated when faced with reduced nominal wages.

  • Behavior of Workers Regarding Wages

    • Workers often show greater displeasure towards nominal wage cuts than equivalent real wage reductions.

    • Money Illusions

    • Definition: Money illusion occurs when individuals' perceptions of pay changes don’t align with actual adjustments when adjusted for inflation.

    • Example:

      • A professor receiving a 3% nominal raise in the presence of a 4-5% inflation rate still experiences a reduction in real wages but may not react negatively to this decrease.

  • Importance of Firm Morale

    • Maintaining nominal wages helps preserve overall morale and productivity among current employees. Firing workers may seem like a better option to protect the remaining employees' morale.

Economic Implications of Sticky Wages

  • Inflation's Role in Recessions

    • A moderate level of inflation can aid in reducing real wages without cutting nominal wages, keeping employee morale intact.

    • Example: If inflation rises by 4% while nominal wages increase by only 2%, real wages have effectively decreased by 2%, thus aiding firms to manage wages better during economic downturns.

  • Truman Bewley's Survey

    • Survey of managers revealed most preferred to fire employees rather than cutting wages due to fear of low morale impacting productivity.

    • Sticky wages are notably more resistant for employed individuals than for those who are unemployed.

  • Adjustment Time:

    • Slow adjustment in wages leads to prolonged unemployment and economic recovery periods during recessions.

Aggregate Demand and Supply in Economics

Short-Run Aggregate Supply and Demand Changes

  • The focus is on short-run aggregate demand (AD) shocks and their role in business fluctuations.

  • Real vs. Nominal Wages

    • Definition of Nominal Wages: The stated wage on a paycheck, not accounting for inflation.

    • Definition of Real Wages: Wages adjusted for inflation, reflecting actual purchasing power.

  • Dynamic Quantity Theory of Money

    • Equation: Growth in money supply + growth in velocity = inflation + real growth.

    • When spending increases, nominal and real wages may initially increase, but prices adapt and real wages eventually decrease.

Reaction to Changes in Aggregate Demand

  • Negative Shocks to AD Curve:

    • An unexpected decline in AD results in lower inflation rates and potential negative growth rates.

    • Businesses cut expenditures and hiring, exacerbating unemployment.

  • Long-Run Equilibrium Adjustments

    • High temporary unemployment can result until the economy adjusts to a new equilibrium.

Aggregate Demand Influences

  • Influence of Government Spending

    • Increased government spending can lead to a temporary boost in AD, which won't sustain in the long run if not aligned with growth rates.

    • Short-term spending increases can lead to inflation, but adjustments in government spending affect long-term economic health.

Analyzing the Great Depression

Causes of the Great Depression

  • Aggregate Demand Shocks

    • The Great Depression was marked by severe negative aggregate demand shocks, which caused widespread unemployment and economic decline.

  • Key Events:

    • Stock market crash in 1929 led to reductions in consumer spending and investment.

    • Pessimism led to a significant drop in investments by businesses, dropping by as much as 75%.

  • The Federal Reserve's Role:

    • The Fed allowed the money supply to decline sharply (nearly 30%), exacerbating the economic crisis.

    • Deflation increased the real burden of debt, further reducing spending and investment.

Real Shocks and Policy Implications

  • Real shocks,

    • Such as bank failures, led to reductions in investment due to firms facing uncertainty. This led to both supply and demand-side shocks, worsening economic conditions.

  • Human Displacement:

    • The Dust Bowl caused mass migrations and reduced productivity in the agriculture sector.

  • Government Policies: Negative Effects

    • Tariffs like the Smoot-Hawley Tariff reduced competition and increased prices, stifling recovery by worsening economic conditions.

Conclusion: Economic Adjustments During Crises

  • Slow Recession Recovery

    • Economic adjustments take time due to sticky wages and negative consumer sentiment, leading to a prolonged recession period.

  • Key Lessons:

    • Rapid changes in monetary policy, consumption behaviors, and government interventions can significantly shape economic recovery trajectories.