Chapter Four

Aggregate Supply
 4.1. Introduction
• Most economists analyze short-run fluctuations in aggregate
income and the price level using the model of aggregate
demand and aggregate supply.

• In the previous chapter, we examined aggregate demand in some

detail using IS-LM framework.

• In this chapter, we develop theories that explain the position and

slope of the aggregate supply curve.

• Aggregate supply is the relationship between the total quantity

of goods and services supplied and the price level.

• The aggregate supply relationship depends on the time horizon.

• This is because prices are flexible in the long run but sticky prices
in the short run.

• In other words, aggregate supply behaves differently in the short-

run than in the long-run.

• In the long-run, prices are flexible, and the aggregate supply curve
is vertical and hence shifts in the aggregate demand curve affect
the price level but the output of the economy remains at its
natural rate.

• By contrast, in the short-run, prices are sticky and the aggregate

supply curve is not vertical and shifts in aggregate demand do
cause fluctuations in output.
4.2. Aggregate supply curve under Flexible prices(LRAS)
Assumptions
• Perfect Information — everyone knows all of the current (and
past if they are important) values of prices of all goods and
services(final or inputs) in the economy hat are relevant to
their optimisation problem.

• Flexible Prices —prices of inputs and final goods are flexible,

that they are free to rise if excess demand occurs, or fall if
excess supply occurs.

• Clearing Markets —there is neither excess supply nor excess

demand and is a consequence of 1 and 2.
key parts
1. The Labour Market
• Supply of Labour — is the result of households choosing how much
labour to supply, how much leisure to consume, and how much
consumption to undertake given the general level of prices and the
wage rate.
• It is upward sloping in the real wage.

• Demand for Labour — is the result of firms choosing how much

labour to employ, given their capital stock (and other inputs), the
price of their output, and the wage rate.
• It is downward sloping in the real wage.

2. Production Technology describes the relationship between inputs

used (e.g. labour and capital) and output produced from those inputs.
• Normally it is assumed to be of the constant returns to scale form.
3. The Capital Stock
• In the short-run the capital stock is fixed so that at a point in time
there is a given amount of capital which is used to produce
output.
• The capital stock changes over time due to net investment being
positive (which can be negatively influenced by the real interest
rate).
 Putting these parts together gives us the AS curve as shown in the
following diagram:
• Vertical-supply curve which is based on flexibility of prices and
perfect information implies that shifts in the aggregate demand
curve affect the price level, but the output of the economy remains
at its natural rate.

• i.e. output does not depend on the price level. It is determined by

the amount of capital, labour ad available technology, which in the
short run are fixed.

• The only way in which output can change is if something happens

to the production side of the economy e.g. technology improves,
droughts occur etc.

• Unemployment can occur, but it is only frictional unemployment

which arises out of the normal operation of an economy-“natural
rate of unemployment”
• Say that the price level increases:
1. The quantity of labour demanded will increase because the real
wage has fallen and the dollar price of a firm’s output has risen, but
the dollar cost of the inputs has not changed. This makes it
profitable for firms to hire extra units of labour.

1. The quantity of labour supplied will fall because the real wage has
fallen and the price of consumption goods has increased relative to
the “price” of leisure, so households will consume more leisure and
therefore supply less labour.

• These effects result in an excess demand for labour and so the

nominal wage increases until the quantity of labour supplied equals
the quantity of labour demanded.

• Nothing “structural” (capital stock, production technology etc) has

changed so the new real wage will just equal the old real wage.
• Thus aggregate supply is independent of the aggregate price level.
• So factors shifting AD( M, T, G, etc) will not affect AS(Output), but
only changing prices.

• Almost all macroeconomists agree that the LAS curve is vertical,

since prices are fully flexible.

• But they disagree on the shape of the SAS curve, because various
economists argue that the assumptions of perfect information, or
flexible prices, or both, do not hold in the short-run.
 4.3. Four Models of Aggregate Supply
• A vertical SAS curve depends crucially on the assumptions of
market clearing and information availability.
• What we will do next is see what happens when we relax each of
the two assumptions underpinning the vertical AS curve.
• Each case provides a theoretical reason why the SAS curve may be
positively sloped without being vertical, and hence why aggregate
output may be affected by changes in the price level in the short-
run.
• The above vertical-supply implies that shifts in the AD curve affect
the price level, but the output of the economy remains at its
natural rate.
• But in contrast to this in the short run, prices are sticky, and the AS
curve is not vertical.
• In this case, shifts in aggregate demand do cause fluctuations in
output.
• By sticky, we mean that prices in markets do not change
instantaneously to changes in demand or supply but only change
slowly over time. In each case we can show that the SAS is positively
sloping.

• In the following sections we will discuss three prominent models of

the short-run aggregate supply curve.

• Although these models differ in some significant details, they share a

common theme about what makes the short-run and long-run
aggregate supply curves differ and a common conclusion that the
short-run aggregate supply curve is upward sloping.

• We show that this curve implies a trade-off between inflation and

unemployment. i.e. to reduce the rate of inflation policymakers
must temporarily raise unemployment, and to reduce
unemployment they must accept higher inflation.
• In all the models, some market imperfection (that is, some type of
friction) causes the output of the economy to deviate from the
classical benchmark.
• As a result, the short-run aggregate supply curve is upward sloping,
rather than vertical, and shifts in the aggregate demand curve
cause the level of output to deviate temporarily from the natural
rate.
• These temporary deviations represent the booms and busts of the
business cycle.
• Short-run aggregate supply equation

states that output deviates from its natural rate when the price level
deviates from the expected price level.

• In general, each of the models highlights a particular reason why

unexpected movements in the price level are associated with
fluctuations in aggregate output.
 4.3.1 Sticky Nominal Wage Model
• focuses on the wage setting process in the labour market.
• This process has impact on the shape of the aggregate supply
curve.
• Accordingly, wage is set based on long term contracts.
• So wage is sticky in the short run, that is nominal wage is inflexible
in the short-run.
• Labour market was not an auction market, but was instead a
contract market.
• That is, suppliers of labour services and buyers of labour services
entered into contracts which set the values of various employment
related parameters.
• One important such parameter is the value of the nominal wage.
• Such contracts are not typically renegotiated instantaneously if the
economy experiences a “shock” because it would be terribly
expensive to do so.
• Thus contracts are only renegotiated infrequently.
• Even in industries not covered by formal contracts, implicit
agreements between workers and firms may limit wage
changes.
• When the contract is negotiated firms and suppliers have to guess
what will happen to the price level for the period of the contract.
Both groups will have some expectation about:
1. The future price level.
2. Some target level of the real wage.
• The contract is successfully negotiated when the two groups have
common expectations about the price level and a common target
real wage rate.
• .The common target real wage will be the one that clears the
labour market if the actual price level equals the forecast price
level.
• There is also some evidence that the nominal wage is particularly
inflexible downwards due to union power and efficiency-wage
considerations
• That is, firms do not like to reduce nominal wages of workers.
• This is claimed to occur because of workers feeling that these cuts
reduce their status and are an insult to them, which lowers their
morale, and their productivity.

• The workers and firms set the nominal wage ‘W’ based on the
target real wage ‘ω’ and on their expectation of the price level ‘ ’.
So, the nominal wage they set is:

• After the nominal wage has been set and before labor has been
hired, firms learn the actual price level P. Because of this the real
wage turns out to be
 Where W/P = is real wage ; w = is
target real wage ; Pe = is expected price level ad P= is actual price
level.
• This equation shows that the real wage deviates from its target if
the actual price level differs from the expected price level.

• The final assumption of the sticky-wage model is that employment

is determined by the quantity of labor that firms demand.
• The bargain between workers and firms does not determine the
level of employment in advance; instead, the workers agree to
provide as much labor as the firms wish to buy at the
predetermined wage.
• Thus, the firms' hiring decisions is described by the labor demand
function
• This demand function states that the lower the real wage, the
more labor firms hire. Because of this, the labor demand curve is
downward sloping

• And again output is determined by the production function

which states that the more labor is hired, the more output is
produced.

 Suppose actual price after the production started is observed .

There are three cases to consider
i) If actual price after production started is found to be equal to the
expected price pe i.e. P = Pe, the economy is at full employment and
output is at full capacity.
• If price is not changing output doesn’t change. ) (Y=Y)
=> We are on the LAS curve, in fact where the SAS intersects
the LAS.
At this price level, the real wage based on W clears the labour
market.

ii) If the actual price is lower than the expected price , the actual real
wage rate will be higher than the agreed real wage rate.
This implies that.
=> quantity of labour demanded decreases.
=> employment falls because firms layoff workers and/or workers
cut back the hours they work and there is unemployment
=> This reduces output and aggregate supply (Y)output decreases
below Y0.
iii) If the actual is greater than the expected price , the real wage will
be lower than the agreed one =>

=> the quantity of labour demanded increases.

=> employment increases because workers agreed to supply
whatever was demanded at the nominal wage W, and the nominal
wage has not changed.
=> output increases.

 Assume that the situation in the labour market is represented by

(iii) i.e. the actual price is greater than the expected price P > Pe
and real wage has been lowered.
• This implies that labour becomes cheaper, labour demand
increases and this increases output.
.
• The resulting aggregate supply curve is shown in Figure-22c.
• Since the nominal wage is sticky, an unexpected change in the
price level moves the real wage away from the target real wage
and this change in the real wage influences the amounts of labor
hired and output produced.

• Therefore, the aggregate supply curve can be written as

• As the aggregate supply equation shows, output deviates from its

natural level when the price level deviates from the expected price
level.

• The basic message of this model is that given wages are

fixed/sticky; a rise in price level would lead to a lower real wage
rate and hence higher labour demand which again increases
output.