Suppose that in Wageland all workers sign annual wage contracts each year on January \(1 .\) No matter what happens to prices of final goods and services during the year, all workers earn the wage specified in their annual contract. This year, prices of final goods and services fall unexpectedly after the contracts are signed. Answer the following questions using a diagram and assume that the economy starts at potential output. a. In the short run, how will the quantity of aggregate output supplied respond to the fall in prices? b. What will happen when firms and workers renegotiate their wages?

Start by drawing an Aggregate Demand and Aggregate Supply diagram with Real GDP (Y) on the horizontal axis and the Price Level (P) on the vertical axis. Include the Short-Run Aggregate Supply (SRAS) curve and the Long-Run Aggregate Supply (LRAS) curve, which represents potential output. Also, draw the initial Aggregate Demand (AD) curve.

Identify the initial equilibrium point (E0) where the AD curve intersects the SRAS curve. This point represents the initial price level (P0) and level of real GDP (Y0), which coincides with the potential output since the economy starts at potential output.

Due to the unexpected fall in prices, the price level (P) drops. On the diagram, this is represented by a movement along the SRAS curve to a lower price level (P1) and a new equilibrium (E1). Since wages are fixed in annual contracts, the lower prices make labor relatively more expensive. As a result, firms will reduce production to save costs, leading to a decrease in aggregate output supplied in the short run.

When firms and workers renegotiate wages, they will likely agree to a lower wage level due to the fall in the prices of final goods and services. Lower wages make labor cheaper for firms, encouraging them to hire more workers and increase production. This will shift the SRAS curve to the right, leading to a new short-run equilibrium (E2) with a lower price level (P2) and a higher level of real GDP (Y1). #a# In the short run, the quantity of aggregate output supplied will decrease in response to the fall in prices. #b# When firms and workers renegotiate their wages, the wages will likely decrease, which will shift the SRAS curve to the right, resulting in an increase in the quantity of aggregate output supplied and a further decrease in the price level.