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Using the four standard AS/AD diagrams, how would output and price change when reservation wages go...

Using the four standard AS/AD diagrams, how would output and price change when reservation wages go up?

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Answer #1

Increase in reservation wage will cause production cost to increase, therefore firms will decrease output. Aggregate supply will decrease, shifting SRAS curve leftward, increasing price level and decreasing real GDP, hence giving rise to Stagflation in short run.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. Increase in reservation wages shifts SRAS0 left to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP Y1 in short run.

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