Suppose the price level falls. Because of fixed nominal wage contracts, firms become less profitable and they cut back on production. This is a demonstration of the

Question

a. sticky-wage theory of the short-run aggregate-supply curve.
b. sticky-price theory of the short-run aggregate-supply curve.
c. misperceptions theory of the short-run aggregate-supply curve.
d. classical dichotomy theory of the short-run aggregate-supply curve.

Answer 1

This scenario describes a situation where firms' profitability is affected by a decrease in the price level, leading them to cut back on production due to fixed nominal wage contracts. This is best explained by the a. sticky-wage theory of the short-run aggregate-supply curve.

The sticky-wage theory suggests that nominal wages are slow to adjust to changes in the price level, and as a result, when prices fall, the real wages increase, reducing firms' profits and their incentive to hire or produce at previous levels.