Questions: Short-Run Equilibrium with Sticky Prices

Question 1

Government spending increases sharply. A classical model with perfectly flexible prices predicts prices rise immediately and real output stays at potential. What does the sticky-price model predict instead?

• A. Real output falls because higher spending crowds out private investment
• B. Prices rise immediately because firms always reprice when demand changes
• C. Real output rises significantly while prices barely change, because firms meet higher demand at their preset prices rather than raising them
• D. The predictions are identical — sticky and flexible price models agree in the short run

Answer: (C)

With sticky prices, firms have already set prices (menu costs, contracts, etc.) and simply supply whatever quantity is demanded at those prices — output is demand-determined. A rightward shift in aggregate demand moves the economy along the flat short-run AS curve: output rises, price level barely changes. In the classical model, immediate price flexibility would push the economy back to potential output with a higher price level and no real output gain. The sticky-price model is precisely why fiscal and monetary policy can affect real GDP in the short run.

Question 2

In the AS-AD diagram with a flat short-run aggregate supply curve, what happens when aggregate demand shifts rightward?

• A. The price level rises sharply and output returns immediately to potential
• B. Both price level and output rise in equal proportion
• C. Output rises significantly while the price level is largely unchanged
• D. Output falls as firms reduce supply to protect profit margins

Answer: (C)

A flat SRAS means firms are price-takers in the short run — they set prices and supply whatever demand arrives. The new equilibrium after a rightward AD shift is found where the shifted AD curve crosses the flat SRAS: higher output, same price level. This is the graphical expression of quantity adjustment dominating price adjustment in the short run. Only over time does SRAS shift upward as wages and other sticky prices eventually adjust.

Question 3

Sticky wages are a key reason demand contractions cause recessions: firms cannot quickly reduce wages to maintain production at lower prices, so they instead reduce output and employment.

• T. True
• F. False

Answer: True

Wages are among the stickiest prices in the economy due to contracts, efficiency wage considerations, and fairness norms. When demand falls, a firm facing a rigid wage bill cannot cut costs proportionally to lower prices and maintain output. Instead, it reduces employment and production. This propagates the demand shortfall through the labor market — unemployment rises, consumer spending falls further, deepening the recession. Wage stickiness is the primary transmission mechanism linking sticky prices to employment fluctuations.

Question 4

The 'short run' in sticky-price macroeconomics refers to a fixed calendar period — typically one to four quarters — after which prices are assumed to be fully flexible.

• T. True
• F. False

Answer: False

The short run is NOT a calendar period — it is the window during which prices remain predetermined at their preset levels. This duration varies enormously by sector: financial asset prices adjust in milliseconds, airline seat prices in hours, retail goods perhaps in weeks, wage contracts in months to years. The economy as a whole exhibits short-run stickiness because enough prices — especially wages — adjust slowly. This is why 'short run' cannot be pinned to a calendar: it depends on which prices are binding in a given context.

Question 5

Why can fiscal and monetary policy affect real output in the short run but not in the long run, according to the sticky-price model? What happens as prices eventually adjust?

Model answer: In the short run, prices are preset, so firms supply whatever is demanded at those prices — output is demand-determined. A positive demand shock (more government spending or easier monetary policy) raises real output. In the long run, prices — especially wages — adjust upward to reflect the higher demand, shifting SRAS upward until the economy returns to potential output. The long-run effect is purely a higher price level with no change in real output. The short run is the transitional window during which price rigidity keeps firms from immediately absorbing demand changes into prices.

The long-run neutrality of money and fiscal policy follows directly from price flexibility: once all prices adjust, relative prices are unchanged and real allocations return to their efficient levels. The short run's policy power comes entirely from the delay in that adjustment. This is why central banks focus on inflation expectations — if prices adjust faster (because people expect inflation and reprice immediately), the short-run window shrinks and policy loses traction.