When wages are flexible, widespread unemployment and excess supply of labor result in fail of wages relative to labor productivity. The falling wages rates result in decline in per unit cost of production and shift the SRAS curve rightwards(downwards) from SRAS0 to SRAS1 as shown curve intersect the AD1 curve at E2. Corresponding to this equilibrium point E2, the output (GDP) level again increase to the full employment level income Yf.(potential GDP),but the price level further goes down to P2. Thus, flexible wage rates that fall along with rising unemployment result in downward shift of the SRAS curve to restore full employment or the potential GDP.
Flexible wages that fell during periods of unemployment would provide an automatic adjustment mechanism that would push the economy back towards full employment whenever output fell below potential.
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