Question

Workers and firms both expect that prices will be​ 2.5% higher next year than they are this year. As a​ result, A. the purchasing power of wages will rise if wages increase by​ 2.5%. B. aggregate demand will increase by​ 2.5% C. workers will be willing to take lower wages next​ year, but not lower than a 2.5 percent decrease. D. the​ short-run aggregate supply curve will shift to the left as wages increase.

Answer 1

Answer: The correct answer is option (B); Aggregate demand will increase by 2.5%

Explanation: The reason is due to what economists term as “Consumer behavior.” A consumer would normally be willing to purchase more of a commodity if the price becomes lower, and conversely he/she would be willing to purchase less if the price becomes higher (law of demand).

However, there is also what economists term “abnormal demand,” which is an opposite to the law of demand and in this case, consumers will be wiling to pay more for a commodity or service as the price begins to go up.

There are a number of factors responsible for an abnormal demand in the market and these include;

(1) Giffen goods: inferior goods such that as the price reduces, consumers buy less of such goods and shift their attention to a better quality commodity.

(2) Luxury goods: such goods that have some status symbol or prestige attached to them would have a higher demand even if the price goes up.

(3) Price illusions: Where consumers are under the impression that a higher price indicates better/higher quality, they would be willing to increase their demand even if the price goes up.

(4) Anticipation of price increase: When consumers sense there would be a future increase in price, they would increase their demand now to cushion the impact on their income when the increase eventually occurs.

Upon close observation the scenario described above is exactly what we have in point number 4. The workers and firms have information that prices would go up next year, which means their purchasing power would have reduced by then. The tendency therefore is for consumers to purchase now, hoping that when the price increment is effected, they would not be concerned about spending more to buy what they had bought for less earlier.