Aggregate Supply Curve

DR. PRAMOD KUMAR NAIK

 Three models of AS curve
1. The sticky wage model

2. The imperfect information model

3. Sticky price model Solving for P

All the tree model concludes the following functional form
𝑌 − 𝑌ത = 𝛼 𝑃 − 𝑃𝑒
𝑌 = 𝑌ത + 𝛼 𝑃 − 𝑃𝑒 α>0 1
𝑃 = 𝑃𝑒 + 𝑌 − 𝑌ത
Y= output; 𝑌ത = Natural level of output 𝛼
1
P = Price level; 𝑃𝑒 = expected price level
: slope of AS curve
𝛼

𝑌 − 𝑌ത = 𝛼 𝑃 − 𝑃𝑒
AS curve is upward
Output deviates from its natural level when the price level deviates from the sloping
expected price level

α = how much output responds to unexpected changes in price

 The sticky wage model
❑Nominal wages are sticky in the short run (at least downside rigidity) and the firm and the workers negotiate and fix a
nominal wage before they know what the price level would be.

❑ 𝑊 = 𝜔 × 𝑃𝑒

Nominal wage = Target real wage × Expected price level

❑After the nominal wage has been set and before labor has been hired, firms learn the actual price level P

The Real wage thus

𝑊 𝑃𝑒
⇒ =𝜔×
𝑃 𝑃

[This equation implies that the real wage deviates from its target if the actual price level differs from its expectation]

• Unemployment and output are at their natural rates,

• when
• Real wage is less than its target, so firms hire more workers and output rises above its natural rate
• Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate
 Sticky Wage model of AS curve
• When the nominal wage W is stuck at
a. Labor demand
ഥ
𝑊, Real Income,
b. Production Function

• A rise in P means real wage declines wage Output

W/P0
ഥ → 𝑊 ↓
• If P↑, given 𝑊 Y1 Y=F(L)
𝑃 W/P1 4. … raises output
• The lower real wage means labor is 2. …Decreases the DL
Y0

cheaper now → Firm wants to hire real wage for a

given nominal wage
more worker → employment ↑ → The L0 L1 Labor L0 L1 Labor

additional labor hired produce more 3. …which raises

employment
output → Y ↑
c. Aggregate Supply
• So an increase in price level increases Price level

the output or income Y P1

𝑌 = 𝑌ത + 𝛼 𝑃 − 𝑃𝑒
6. The AS curve
• The AS curve slopes upward summarizes these
P0
NOTE: changes
1. An Increase in P
Assumed that Employment is determined by
the qtty of labour that the firm demands Y0 Y1 Income,
5. … raises output Output
The cyclical behavior of the real
wage
➢This model implies that the real wage should be countercyclical

➢It should move in the opposite direction as output over the course of the business cycle
➢In booms, when Prices increase the real wage should fall
➢In a recession when Prices decrease the real wage should rise

➢This prediction does not come true in the real world (empirical evidence!)
 Empirical Evidence
Percentage
change in real4 1972
• The sticky wage model
wage
3 cannot explain the AS.
1998
1965
2
1960 1997 • Economists advocate that
1999 when prices are too high,
1
firms sell less of their
1996 2000
0 1970 1984 output and reduce their
1993
1982
1991 1992 demand for labor.
-1
1990
-2 1975

-3 1979
1974

-4
1980
-5
-3 -2 -1 0 1 2 3 4 5 6 7 8
Percentage change in real GDP
The Imperfect- Information Model
Assumptions:
o All wages and prices are perfectly flexible
o All markets are clear
o Each supplier produces one good, consume many goods
o Each supplier knows the nominal price of the good he/she produces but does not know the overall price
level.
 The Imperfect- Information Model
• Each individual supplier observes their own price closely but must guess at the overall price level and form an
EXPECTATION (because the overall price is unknown)

• If all prices of the economy (unobserved) increase including the supplier’s own price (observed) and the We can now write
supplier expected it, then 𝑌 = 𝑌ത + 𝛼 𝑃 − 𝑃𝑒
• 𝑃 = 𝑃 𝑒 and output remains unchanged
𝑒
𝑌 − 𝑌ത = 𝛼 𝑃 − 𝑃𝑒
• The perception is that the relative price (𝑃/𝑃 ) for the supplier has not changed
1
• However, suppose P increases and Pe does not,
𝑃 = 𝑃𝑒 + 𝑌 − 𝑌ത
𝛼
• In other words

• If all prices in the economy (unobserved) increased including the supplier’s own price (observed) and the
supplier did not expect it, then

• The supplier perceives mistakenly that the relative price of their own product has increased (P > Pe)

• The supplier then produce more output, Y will increase

• So when P > Pe → Y↑

• AS Curve Upward Slopes

The Sticky Price model
It has a micro foundation

It is based on the pricing behavior of the firm

This model emphasizes that firms do not instantly adjust the prices they charge in response to changes in
demand.

Reasons for Price stickiness

1. Prices are set by the long-term contract between firms and customers

2. Firms do not want to annoy their regular customers

3. Menu costs
The Sticky Price model
Assumption:
Firms have some market power over the prices they charge (price setter) similar to monopolistic competition

The pricing decision facing a typical firm.

The firm’s desired price p (small p) depends on two macroeconomic variables:

1. The overall level of Price P (which is the weighted avg. of all individual price)

As P↑ → Cost of inputs ↑ → firms are like to charge more p.

2. The level of aggregate income Y

Y ↑ → dd for firms’ product ↑

because marginal product increases at a higher level of production the the greater the demand the higher the firms desired price.

𝑝 = 𝑓(𝑃, 𝑌)
The Sticky Price model
Firm’s desired price:

𝑝 = 𝑃 + 𝑎 𝑌 − 𝑌ത (1)

Firm’s desired price depends on the overall price level and on the aggregate output relative to the
natural level

If p and P are the log of the firm’s price and the overall prices respectively, then, eq(1) states that

The desired relative price depends on the deviation of output from its natural level
The Sticky Price model
Let’s assume that there are two types of firms:

Type 1: firms have flexible prices

They always set their price according to eq(1), i.e. 𝑝 = 𝑃 + 𝑎 𝑌 − 𝑌ത

Type 2: firms have sticky price

They announce their price in advance based on what they expect the economic condition to be

Thus they set the price as

𝑝 = 𝑃𝑒 + 𝑎 𝑌 𝑒 − 𝑌 𝑒 (2)

For simplicity assume that

These firms expect the output to be at its natural level

So that 𝑎 𝑌 𝑒 − 𝑌 𝑒 = 0 , so 𝑝 = 𝑃𝑒

Meaning firms with sticky price set their prices based on what they expect other firms to charge
 The Sticky Price model
We can now us the pricing rule to derive the AS curve

We find the overall price level in the economy which is the

weighted average of the price set by these two groups

If 𝑠 = 𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑓𝑖𝑟𝑚𝑠 𝑤𝑖𝑡ℎ 𝑠𝑡𝑖𝑐𝑘𝑦 𝑝𝑟𝑖𝑐𝑒

1 − 𝑠 = 𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑓𝑖𝑟𝑚𝑠 𝑤𝑖𝑡ℎ 𝑓𝑙𝑒𝑥𝑖𝑏𝑙𝑒 𝑝𝑟𝑖𝑐𝑒

Then the overall price level is

𝑃 = 𝑠𝑃𝑒 + (1 − 𝑠) 𝑃 + 𝑎 𝑌 − 𝑌ത (3)

Price of the sticky price

firm weighted by their Price of the flexible firms
fraction in the economy weighted by their fraction
The Sticky Price model
𝑃 = 𝑠𝑃𝑒 + (1 − 𝑠) 𝑃 + 𝑎 𝑌 − 𝑌ത
When firms expect a high price level,
They expect high costs
Now subtract 1 − 𝑠 𝑃 both the side
Those firms that set fixed prices in advance
𝑃 − 1 − 𝑠 𝑃 = 𝑠𝑃𝑒 + 1 − 𝑠 𝑃 + 𝑎 𝑌 − 𝑌ത − 1−𝑠 𝑃
set their price high
𝑠𝑃 = 𝑠𝑃𝑒 + 1 − 𝑠 𝑃 + 1 − 𝑠 𝑎 𝑌 − 𝑌ത − 1−𝑠 𝑃 These high prices cause the other firms to
set high prices also
= 𝑠𝑃𝑒 + 1 − 𝑠 𝑎 𝑌 − 𝑌ത Hence, 𝑃𝑒 ↑ →P ↑
Dividing both side by s

1−𝑠 𝑎 𝑌−𝑌ത
𝑃 = 𝑃𝑒 +
𝑠
1−𝑠 𝑎
𝑃 = 𝑃𝑒 + 𝑌 − 𝑌ത (4)
𝑠

Hence the overall price level depends on expected price level and on
the level of output
 The Sticky Price model
When the output is high then the demand for goods is high.
Those firm with flexible price set their price high.
So Price level P increases
The effect of output on the price level depends on the proportion of firms with flexible prices
1−𝑠 𝑎
We can rewrite the eq(4) 𝑃 = 𝑃𝑒 + 𝑎 𝑌 − 𝑌ത as
𝑠

𝑌 = 𝑌ത + 𝛼 𝑃 − 𝑃𝑒
𝑠
where 𝛼 = 1−𝑠 𝑎

Conclusion: the deviation of output from its natural level is positively associated with the deviation of the price
level from the expected price level.
AS curve slopes upward
Summary and Implication
• If the price level is higher than
LRAS
P the expected price level, output
SRAS exceeds its natural level
𝑌 = 𝑌ത + 𝛼 𝑃 − 𝑃𝑒
• If the price level is lower than the
P>Pe
expected price level, output falls
short of its natural level
P=Pe

P<Pe

Y
𝑌ത
 Putting AD and AS togather
This diagram shows how the economy responds to an unexpected increase in AD attributable to an unexpected monetary
expansion
LRAS
P
SRAS2 • The economy begins in a long-run equilibrium at
SRAS1 point A.
Long-run increase • When aggregate demand increases unexpectedly, the
in Price Level price level rises from P1 to P2.
P3=Pe3 C
• Because people did not expect this increase in the
price level the expected price level remains at Pe2 but
P2 B
output increases from Y1 to Y2 temporarily.
A • The unexpected expansion in AD causes the economy
P1=Pe1= Pe2
to Boom.
• The economy moves along the short-run aggregate
Short-run increase
in Price Level AD2 supply curve from point A to point B.
• In the long run, (to catch up the reality) the expected
AD1 price level rises to Pe3, causing the short-run
aggregate supply curve to shift upward.
Y1=Y3=𝑌ത Y2 Y • The economy returns to a new long-run equilibrium,
point C, where output is back at its natural level.
Short-run Fluctuation
in output The economy return to the natural level of output in the
long run but at a much higher price level.