Introduction
The paper discusses the implication of upwardly flexible, but downwardly inflexible wages and how long it takes to recover from recessionary and inflationary gap. The second part of the paper focuses on how this rigidity of wages limits the balancing of the cyclic budget.
Question 1
In case of recessionary gap, the economy is operating under the full employment in the short-term. This is because of the fact that the wages are so high for the firms to employ more workers. Since wages are flexible upwards and sticky downwards, it would be difficult to lower the wages in order to attain the equilibrium at full employment level. Since prices are flexible upwards, the firm in economy may reduce the level of output and consequently reduce the supply. In the long run, as the supply reduces, the price of goods in the economy increases hence reducing the real wage. In this way the unemployment is eliminated and full employment equilibrium is achieved. Consequently, the increased employment boosts the production back to the neutral level.
The case of inflationary gap arises when the aggregate production at the equilibrium level is more than what it could be produced at full employment. In this case the aggregate demand is more than the production potential in the economy. Since the wages are sticky downwards, government can intervene by the use of fiscal or monetary policy to reduce the level of inflationary gap. In the monetary policy, the interest rate would be increased so as to reduce the consumers demand in the economy. Otherwise, the government may use fiscal policy by increasing the tax burden with an aim to reduce the real disposable incomes. These measures would help the firms to acquire more workers since in the long run the real wage is reduced.
Question 2
During recession, the government should experience deficit by running under borrowings while during booms the government is running under surplus and it is paying off the deficit. It is required that surplus should cancel out the deficits, which is referred to as balancing the budget over the business cycle.
However, to attain the balanced cyclic budget would be a little more difficult when the wages are flexible upwards and sticky downwards. This is because when the wages are sticky downwards, the economy experiences more recessions than booms. Consequently, the surplus will be not large enough to clear the deficits. When wages are equally sticky in both directions the surplus is large enough to clear off the deficit.
When the economy is operating under unemployment, the efforts to raise the employment would be difficult when the wages are sticky downwards compared to when there is flexibility of wage downwards. This is commonly experienced by the workers who are paid at their minimum wage, thus their wages are rigid to move downwards. Therefore, under condition of sticky downward wage, there would be difficulties in the economy to increase the level of employment. As a result, the aggregate level of production would be not enough to meet the aggregate level of demand in the economy. In other words, the economy would be operating in deficit rather than surplus. Ion such a way, it would be difficult for the economy to produce at surplus that is enough to offset the deficit.
In conclusion, the rigidity of wages to move downwards has a big impact on the balancing of the cyclic budget compared to the flexible wages. It is clear that, this rigidity challenges the economy in achieving the equilibrium employment level that would be required to generate sustainable output in economy.
