To restore full employment, the money wage rate will ______. The price level .
A. fall and aggregate supply increases; falls
B. fall and aggregate demand increases; rises
C. rise and aggregate demand increases; rises
D. rise and aggregate supply increases; falls
The correct answer and explanation is:
The correct answer is B. fall and aggregate demand increases; rises.
To understand this, we need to look at the economic mechanisms that restore full employment when there is a gap between the actual output and the potential output of the economy.
- Wage Rate Falls: In an economy where there is unemployment, wages tend to fall. This happens because when there is a surplus of labor (unemployment), employers can hire workers at lower wages. The reduction in wages makes it cheaper for firms to produce goods and services, leading to an increase in aggregate supply.
- Aggregate Demand Increases: A decrease in wages reduces the cost of production for businesses, which might make goods and services cheaper. This can increase the purchasing power of consumers, leading to an increase in consumption and investment. As consumers and businesses spend more, aggregate demand rises.
- Price Level Rises: As aggregate demand increases, businesses may face higher demand for goods and services. To accommodate the higher demand, they may increase prices. This leads to an increase in the price level. However, this rise in prices is often a result of the increased economic activity driven by the higher aggregate demand, which supports the restoration of full employment.
In summary, when wages fall, businesses produce more, leading to an increase in aggregate demand. This process raises the price level because the increased demand pushes up prices as firms adjust to the higher economic activity.