Sticky Model
Aggregate Supply Aggregate Demand Model - Effect of Increased Consumer Savings?
In the Aggregate Supply - Aggregate Demand short run sticky price model, why, precisely, does a rise in consumer savings (i.e. a reduction in consumer expenditure) lead GDP to fall below full employment output? What I want to understand here is why the classical analysis of a savings change does not go through in this framework. Assume that the money supply, government expenditure and inflation expectations are constant.
As consumers increase savings, they purchase fewer goods. This forces firms to decrease output or prices or both. In order to make up for lost revenues, firms must cut costs. As capital is fixed in the short-run, they will cut costs by firing workers. According to the classical framework, this implies the demand for labor will fall, causing the labor market to reach equilibrium at a point with a lower quantity of labor, lower wages, and no unemployment. However, if wages are sticky in the short-run, then the job cuts will not be accompanied by a fall in wages. You will then have a situation where at a given level of wages, the amount of labor supplied (i.e. the number of people seeking jobs) is greater than the demand for jobs (available positions). This 'surplus' of labor is unemployment.
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