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Can you explain this in simple terms? First, suppose the economy is hit by a negative productivity shock, such as a sudden surge in oil
Can you explain this in simple terms? First, suppose the economy is hit by a negative productivity shock, such as a sudden surge in oil prices. The shock would dampen the marginal productivities of and reduce the demand for all variable factor inputs, including labor. On the other hand, the shock, if large and persistent, may also shrink people's wealth, inducing them to lengthen their work hours via the wealth effect. At any initial wage level, such changes would end up generating an excess supply of labor (i.e., unemployment) while lowering employment (under the short-side rule). But that is not the end of the story. Coupled with the adverse productivity change, the fall in labor employment would reduce aggregate supply (AS) of goods without directly affecting demand (AD). The result is a rise in the general price level (P) and a fall in real output (y). Given the fixed nominal wage, the real wage would dropthat is, w = W0/(P)thus narrowing the gap between labor supply and labor demand and offsetting (at least partially) the initial effects of the shock on (un)employment. In other words, unemployment may not be too serious in this case and may even vanish if the price level soars sufficiently to bring the real wage down to its market- clearing level. Moreover, the countercyclicality of the price levelnegative correlation between P and yis counterfactual. For these reasons, Keynesians (unlike the classical economists) do not put much emphasis on supply shocks as drivers
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