The sticky-price theory of the short-run aggregate supply curve says that if the

Question

The sticky-price theory of the short-run aggregate supply curve says that if the price level rises by 5% and people were expecting it to rise by 2%, then firms have a. higher than desired prices, which leads to an increase in the aggregate quantity of goods and services supplied. b. higher than desired prices, which leads to a decrease in the aggregate quantity of goods and services supplied. c. lower than desired prices, which leads to an increase in the aggregate quantity of goods and services supplied. d. lower than desired prices, which leads to a decrease in the aggregate quantity of goods and services supplied.

Ans is number C.

c. lower than desired prices, which leads to an increase in the aggregate quantity of goods and services supplied

But when i did quiz it showed me wrong answer for number C.

Explanation / Answer

The sticky price theory is based on the idea that firms do not adjust to their prices instantly to the changes in the economy. It is a model that explains why the short term aggregate supply curve slopes upward. There are various reasons why firms do not ajdust their prices instantly to changes in the economy . Price of firms includes all its cost of production ( wages, rent , interests and profits) . Many prices ,like wages are set in a relatively long-term contracts. It is quite impossible for a firm to adjust according to changing economy . Wages of workers cant change everyday due to changes in economy , price of newspapers cant fluctuate due to change in price of ink or paper each day. Thus firms holds prices stable( or prices are sticky).

Now if according to sticky-price theory of the short-run aggregate supply curve says that if the price level rises by 5% and people were expecting it to rise by 2%, then firms have -

a. higher than desired prices, which leads to an increase in the aggregate quantity of goods and services supplied.

The answer to this lie in the fact that the price of firm has risen by 3% more than what was anticipated by the consumers. When a firm prepares to set its price , it takes into account the expected price level. When the expected price level is high , firm set its price high to compensate for the high price of inputs ( land, labour , capital and entreprenuer all become expensive due to high expectation of price) .When the price charged for output is high the firm is induced to produce more ( according to law of supply that states higher the price , higher the supply ). The total output rises ,thereby raising the production . Thus an increase in price level ( by 5% in this case ) adds to increase in the aggregate output.

( Answer to this question is option (a) and not ( c) ).

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