Question

Using the sticky wage theory or thr sticky price theory, why would a short run output deviate from potential output and how would the economy return to the long run rate of output?

Answer 1

Sticky wage theory or sticky price theory just talks about the slow movement of the prices or wages in relation to the changing equilibirum. Suppose there is a shock or policy intervention and the equilibirum or potential output shifts. The sticky theory will make the prices and wages to reflect slow, and hence in the short run, the output would thus deviate from the potential. As one moves to the long run, the stickiness of the price and wages reduce as the contracts in the long run changes and so on, and thus, the economy is returned to the long run rate of output.