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Explain, using the AD-AS diagram, how wage rigidity may prevent real output to return its natural...

Explain, using the AD-AS diagram, how wage rigidity may prevent real output to return its natural level in the event of an aggregate demand shock in the short-run but real output will eventually reach its natural level as long as the price level is perfectly flexible.

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Initially the economy is in equilbrium at A where LRAS=SRAS=AD. However Aggregate demand shock shifts AD to ADo. Short run equilbrium is at B. Here actual output is less than potential output. Here we have unemployment of resources and labour. This should have decreased wages so that Aggregate supply shifts rightwards and full employment output is restored. But this doesn't happen die to wage rigidity

However in longrun wages will fall since in longrun wage contracts are revised. Note Keynesians streesed shortrun phenomena but this happens in longrun. Even otherwise since other resources are underemployed here there prices will fall which will shift AD rightwards. As a result of price flexibility short run Aggregate supply shifts to SRAS1. New equilbrium is at C where full employment output is restored

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