What role do nominal wages play in closing an inflationary gap?
1) They remain constant, having no effect on the inflationary gap.
2) They decrease, which shifts the SRAS curve to the right.
3) They increase, leading to a leftward shift of the SRAS curve as labor costs rise.
4) They are unaffected by changes in real GDP and the price level.
The correct answer and explanation is:
Correct Answer: 3) They increase, leading to a leftward shift of the SRAS curve as labor costs rise.
Nominal wages play a critical role in the adjustment process of an economy facing an inflationary gap. An inflationary gap occurs when actual output exceeds the economy’s potential output. This situation leads to increased demand for resources, including labor. As the labor market tightens, employers must offer higher nominal wages to attract and retain workers.
When nominal wages rise, production becomes more expensive for firms because labor is a major component of total costs. These increased costs lead firms to reduce output at any given price level. As a result, the short-run aggregate supply (SRAS) curve shifts to the left. This leftward shift causes real GDP to decline and the price level to rise further, eventually helping to close the inflationary gap by moving the economy back toward its full employment output level.
In the long run, higher nominal wages match the increase in the overall price level, preserving workers’ real wages. However, in the short run, the increase in nominal wages contributes to reduced aggregate supply because it takes time for prices to adjust across the economy. This wage adjustment mechanism is a self-correcting feature of the economy. It does not require government intervention but works through market forces as employers and workers react to labor market conditions.
Therefore, rising nominal wages reduce short-run aggregate supply, increasing costs and slowing the economy, which helps close the inflationary gap. This process reflects how labor markets respond to economic overheating and restore balance by realigning output with potential GDP. In summary, the increase in nominal wages contributes to closing the inflationary gap by making production costlier, thereby shifting SRAS to the left and reducing overall output.