Chapter five

Aggregate Supply

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5.1. Introduction
 Aggregate supply (AS) is the total supply of goods and
services that firms in an economy plan on selling
during a specific time period.
 AS behaves differently in the short run than in the long run
 In the long run, prices are flexible, and the AS curve is
vertical
 When the AS curve is vertical, shifts in the aggregate
demand curve affect the price level, but the output
remains at its natural rate
 In the short run, prices are sticky, and the AS curve is not
vertical
 In the short-run, shifts in aggregate demand do cause
fluctuations in output
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 ...‘ed
 The discussions so far using IS-LM and M-F model
was how income is determined by aggregate
demand in the short run (price is fixed) so that
supply curve is horizontal.
 But, the classicals claimed that AS curve is vertical
and the change in demand does not affect income
but it results increase in the price level
 In the next two sections the classical and
keynesian theories of the supply curve will be
discussed.

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5.2. The Classical approach to AS

 The classical AS curve is vertical indicating the fact that the same
amount of goods will be supplied whatever the price level.
 What is the rational behind?
 The classicals think that wages and prices are fully flexible: the labor
market will always be in equilibrium
 With full level of employment, firms produce the full employment output
(trend output).
 If AD increases, firms will attempt to produce more output by hiring more
workers. Since employment is already full, they will have to raise wages to
lure workers away from other firms. Wages are bid up and so firms will
attempt to raise prices to compensate. However, output will remain
unchanged.
 The point is that workers and firms both look at both wage and price
levels so that with full employment if wages rise, so will prices and
vice versa.
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 Classical....’ed

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 Classical....’ed
 Unemployment is not a problem for classical economists
because they assume that wages always adjust to the
full employment level
 Although the Classical AS assumes no unemployment
(that is, labor market is in equilibrium), there exists
some amount of frictional unemployment called natural
rate of unemployment. The natural rate of
unemployment is the rate of unemployment arising
from normal labor market frictions that exist when the
labor market is in equilibrium.
 The vertical supply shifts if more resources are available
for employment and if changes occur for productivity
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5.3. The Keynesian approach to AS

 Keynes and his followers argued

 Prices, including wages (the price of labor) are
inflexible, or “sticky”, downward
 An increase in aggregate demand, AD, will not
raise the price level
 A decrease in AD will not cause firms to lower the
price level

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 Keynes...’ed
 Keynesian Short-Run Aggregate Supply Curve
 The horizontal portion of the AS curve in which there is
excessive unemployment and unused capacity in the
economy

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 Keynes...’ed
 Keynes argued that in a depressed economy,
increased aggregate spending can increase
output without raising prices
 Data showing the U.S. recovery from the Great
Depression seem to bear this out
 In such circumstances, real GDP is demand driven
as the short-run AS curve was almost flat

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 Keynes...’ed
 The Keynesian model
 Equilibrium GDP is demand-determined
 The Keynesian short-run aggregate supply schedule
shows sources of price rigidities
 Union and long-term contracts explain inflexibility of
nominal wage rates
 The underlying assumption of the simplified
Keynesian model is that the relevant range of
the short-run aggregate supply schedule (SRAS)
is horizontal
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 Keynes...’ed

 The price level has drifted upward in recent

decades
 Prices are not totally sticky
 Modern Keynesian analysis recognizes some—but
not complete—price adjustment takes place in
the short run

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 Keynes...’ed
 Short-Run Aggregate Supply Curve
 Relationship between total planned economy
wide production and the price level in the short
run, all other things held constant
 If prices adjust incompletely in the short run, the curve
is positively sloped
• The next discussion will be to provide an
explanation why the short run AS curve is
positively sloped

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 Keynes...’ed
 The four models of short run aggregate supply: Sticky-
wage, Worker-Misperception, Imperfect-information
and the Sticky-wage
 In all the models, some market imperfection causes
the output of the economy to deviate from its
natural level
 As a result, the short-run AS curve is upward sloping,
rather than vertical, and shifts in the aggregate
demand curve cause the level of output to deviate
temporarily from its natural level
 These temporary deviations represent the booms
and busts of the business cycle

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 Keynes...’ed

 Each of the four models takes us to the same short-

run aggregate supply equation of the form…
Y =Y*+α (P−Pe)
where Y is output, Y* is the natural rate of output, P
is the price level and Pe is the expected price level.
 Therefore, output deviates from the natural rate
by the extent to which prices deviate from their
expected level, and 1/α is the slope of the
aggregate supply curve.

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5.3.1. The Sticky Price model
 The sticky price model emphasizes that firms do not instantly adjust
the prices they charge in response to changes in demand. Menu
prices are changed at a cost to the firms, including the possibility of
annoying their regular customers.
 This ability to set prices implies that firms are operating in imperfectly
competitive markets in which they have some market power.
 Suppose that a firm’s desired price is denoted by p. This price
depends upon two things. First, it depends upon the general price
level, P. Second, it depends upon the level of demand in the economy,
measured by the difference between current output and full
employment output.
 Now suppose that there are two types of firms in the economy. One
fraction denoted by (1-s) has flexible prices and adjusts to current
conditions. The other fraction, s, has sticky prices due to the cost of
price setting or other reasons.
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The sticky price model....
 The firms that set their price in advance and keep it in place for some
period of time (sticky portion) must set their price on the basis
of expectations of future demand conditions. Their best forecast is for
a level of demand at its long-run level, Y=Y*, such that shocks are
random, i.e. p = P*
 The actual price level in the economy is the average of these two sets of
prices:
 P = s P* + (1-s) (P + a(Y-Y*)) or (solving for P)
 P = P* + (a(1-s)/s) (Y-Y*)
 This equation tells us, first, that if output is at its natural rate, the actual
and expected price levels correspond. Second, if Y is greater than the
natural rate, the actual price level will exceed the expected price level,
so that the aggregate supply curve is upward sloping.
 Solving equation (2) for output results in the familiar equation for SRAS
where output is the natural rate plus alpha times the difference
between the actual price level and the expected price level.
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5.3.2. The Sticky Wage Model
 Focuses attention on wage-setting agreements made by
firms and workers.
 Nominal wages are set in advance and are not changed with
every event that alters their employers’ profits.
 The sticky-wage model starts with the presumption that
when a firm and its workers sit down to bargain over the
wage, they have in mind some target real wage upon which
they will ultimately agree. The level of employment at this
real wage is determined by demand (productivity) and
supply conditions assumed to be at full employment.
 When the price level rises, wages will be stuck at contract
levels, so that real wages fall, making labor cheaper.

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 Sticky wage model....
 The lower real wages induces firms to hire more
labor. This assumes that firms hire workers according to
their labor demand function, ie. their marginal physical
product.
 The additional labor hired produces more output.
 The positive relationship between the price level and
the amount of output means that the aggregate supply
curve is upward sloping.
 The only point on the aggregate supply curve in which
the real wage equals the targeted real wage occurs when
the actual price level equals the expected price level.

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5.3.3. The worker- misperception model

 Unlike the sticky-wage model, the worker-misperception model assumes

that workers are free to equate supply and demand in the labor market, but
that they temporarily confuse real and nominal wages.
 Workers know their nominal wage, W, but they do not know the
overall price level, P.
 Their expected real wage equal to W/Pe determines how much
they work, but if the actual price level rises and the expected price
level remains the same, then the supply of labor function will shift
to the right lowering the equilibrium real wage the employers pay.
 Lower real wages increases employment and output.
 Hence, higher prices that are not fully perceived by labor will
increase the supply of labor, increase employment, increase
output, and result in an upward sloping aggregate supply curve.
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5.3.4. Imperfect information Analysis

 This model, like the worker-misperception model, assumes that

the labor market clears, but unlike the worker-misperception
model it does not assume that firms have better information than
workers.
 Since individual suppliers work in separate markets they cannot
observe all prices at all times, even though they monitor closely
the prices in their individual markets.
 If there in an unexpected increase in the overall price level it may
be erroneous assumed that relative prices in their industry are
higher and workers and producers will work harder and produce
more for a given increase in the overall price level.
 The result is greater output and employment at a higher price
level than would have occurred if the producers and workers had
correctly recognized that their relative prices
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