Ratchet Effect

This effect states that prices are "sticky" or inflexible in a downward direction.  Therefore, aggregate demand will not move downward very freely.

Causes for the Ratchet Effect:

• Wage Contracts - contracts prevent firms from decreasing wages, which are a major cost for a firm

• Morale and Productivity - employers are not willing to reduce wage rates because doing so reduces worker morale and labor productivity

• Training Investments - firms put an investment in workers when they train them.  If workers leave because of lower wages, firms do not get a return from that investment.

• Minimum Wage - firms cannot reduce wages below minimum wage

• Monopoly Power - many firms have sufficient monopoly power to resist price cuts for a time when demand declines.  

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