Chapter Five

Aggregate Supply

4.1 Introduction to Aggregate Supply

In chapter three, we have discussed aggregate demand and how they determine the national
income. The aggregate demand curve describes the amount of output that people are willing to
buy at different price levels. But, the levels of equilibrium output and price that will actually
emerge also depend on supply behavior. We now turn to the determination of supply behavior
and develop different approaches to the aggregate supply curve. Aggregate supply describes the
amount of output that producers are willing and able to supply to the goods market.
Subsequently, we will take a more general view of price determination and develop an
explanation of inflation – the rate of price change.

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 section, we examined
aggregate demand in some detail. The IS – LM model shows how changes in monetary and fiscal
policy shift the aggregate demand curve. We now turn our attention to aggregate supply and
develop theories that explain the position and slope of the aggregate supply curve.

The aggregate supply curve implicit in the Keynesian IS-LM model is based on the notion that
there are no supply constraints and that prices are pre-determined in the short-run. Thus,
whatever output level is demanded will be produced and the aggregate supply curve is a
horizontal line.

There is sufficient excess capacity so that an increase in demand leads to more production
without increasing production costs and prices. For this reason the early Keynesian economists
who were schooled by the experiences of the depression used IS-LM analysis exclusively
because they thought in terms of situations with a great deal of excess productive capacity. In
this framework, we can view the price level as being set by existing contractual arrangements
such as union contracts, sales agreements, and price lists. It is assumed that any level of output
can be supplied at this given level of prices.

At the opposite extreme to the Keynesian short-run horizontal supply curve lies the supply curve
of the classical (or the long-run equilibrium) view of the macroeconomic world. The classical
view implies a vertical supply curve. The classical view of macroeconomics is rooted in the idea
that the macro economy is the aggregate of an infinite number of perfectly competitive markets.

In this view each and every market for outputs and inputs reaches an equilibrium which
determines both the relative price and the quantity for that market. Hence, the level of output
supplied is simply the aggregate of all these outcomes for any overall price level. This is the case
because each and every market-equilibrium determines the relative price of the good in that

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market. As long as relative prices stay in equilibrium, the same level of aggregate output will be
supplied.

A change in the aggregate price level does not disturb the relative price relationships between all
pairs of goods. Thus, the aggregate supply curve is vertical at this equilibrium output level no
matter what the aggregate price level happens to be. The vertical classical aggregate supply
curve can be understood if we imagine that the aggregate price level doubles. If every price
doubles in terms of the money unit of account in the economy, the aggregate price level doubles
as well.

Moreover, no relative price between pairs of goods changes, and thus the equilibrium level of
output supplied remains unchanged. Therefore, the aggregate supply curve in the classical model
is vertical. The classical vertical aggregate supply curve and the Keynesian horizontal aggregate
supply curve represent two theoretical extremes, neither of which is a satisfactory representation
of behavior in the real world. The traditional Keynesian approach leaves us without a theory of
price determination. The classical approach introduces a theory of price determination, but at the
cost of eliminating an explanation of fluctuations in real output. By assuming that competitive
markets at all times generate equilibrium levels of output, the classical model does away with
fluctuations in output.

A more appropriate view of the total supply curve will be the middle road – a positively sloped
aggregate supply curve. Such an approach is relevant for adjustments that occur for longer
periods than the Keynesian short-run period (where quantity adjustments are dominant) and less
than the long run (the period for which the long-run equilibrium approach is dominant).

In general, 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. When the aggregate supply
curve is vertical, 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. In this case, shifts in aggregate demand do cause
fluctuations in output. So far we took a simplified view of price stickiness by drawing the short
run aggregate supply curve as a horizontal line, representing the extreme situation in which all
prices are fixed. Our task now is to refine this understanding of short run aggregate supply.

Unfortunately, one fact makes this task more difficult: economists disagree about how best to
explain aggregate supply. As a result, this section begins by presenting four prominent models of
the short-run aggregate supply curve. Among economists, each of these models has some
prominent adherents (as well as some prominent critics), and you can decide for yourself which
you find most plausible. Although these models differ in some significant details, they are also
related in an important way: 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.

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4.2 Four Models of Aggregate Supply

In this subsection we examine four prominent models of aggregate supply, roughly in the order
of their development. 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.

Although each of the four models takes us down a different theoretical route, each route ends up
in the same place. That final destination is a short-run aggregate supply equation of the form:

Each of the four models tells a different story about what lies behind this short-run aggregate
supply equation. In other words, each highlights a particular reason why unexpected movements
in the price level are associated with fluctuations in aggregate output.

4.2.1 The Sticky-Wage Model

According to the stick wage model, the short-run aggregate supply curve is upward sloping
(output is deviates from its potential level) because of the sluggish adjustment of nominal
wages. In many industries, nominal wages are set by long term contracts, so wages cannot adjust
quickly when economic conditions change. Even in industries not covered by formal contracts,
implicit agreements between workers and firms may limit wage changes. Wages may also
depend on social norms and notions of fairness that evolve slowly. For these reasons, many
economists believe that nominal wages are sticky in short run.

The sticky-wage model shows what a sticky nominal wage implies for aggregate supply. To
preview the model, consider what happens to the amount of output produced when the price level
rises:

 When the nominal wage is stuck, a rise in the price level lowers the real wage, making
labor cheaper.
 The lower real wage induces firms to hire more labor.

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  The additional labor hired produces more output.

This positive relationship between the price level and the amount of output means that the
aggregate supply curve slopes upward during the time when the nominal wage cannot adjust. To
develop this story of aggregate supply more formally, assume that workers and firms bargain
over and agree on the nominal wage before they know what the price level will be when their
agreement takes effect. The bargaining parties – the workers and the firms – have in mind a
target real wage. The target may be the real wage that equilibrates labor supply and demand.
More likely, the target real wage is higher than the equilibrium real wage: union power and
efficiency wage considerations tend to keep real wages above the level that brings supply and
demand into balance.

The workers and firms set the nominal wage W based on the target real wage ω and on their
expectation of the price level Pe. The nominal wage they set is:

W =ω×Pe
where W is nominal wage, ω is target real wage rate, and Pe is the expected price level.

After the nominal wage has been set and before labor has been hired, firms learn the actual price
level P. Thus, the real wage turns out to be:
W Pe
=ω×
P P

The real wage rate is the product of the target real wage rate and the expected to actual price
level ratio.

This equation shows that the real wage deviates from its target if the actual price level differs
from the expected price level.

 When the actual price level is greater than expected (Pe/P < 1), the real wage is less than
its target;
 When the actual price level is less than expected (Pe/P > 1), the real wage is greater than
its target.

The final assumption of the sticky-wage model is that employment is determined by the quantity
of labor that firms demand. In other words, the bargain between the workers and the 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. We describe the firms’ hiring decisions
by the labor demand function:

L = Ld (W/P).

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According to this labor demand function, the lower the real wage, the more labor firms hire. The
labor demand curve is shown in the below figure (panel a). Output is determined by the
production function:

Y = F(L),

which states that the more labor is hired, the more output is produced. This is shown in panel (b)
of the figure.

Panel (c) of the figure shows the resulting aggregate supply curve. Because 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. The aggregate supply curve can be written as:

Y = Y +a (P - Pe ) .

This equation says output deviates from its natural level when the price level deviates from the
expected price level.

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4.2.2 The Worker-Misperception Model

This model also explains the up-ward sloping short-run aggregate supply curve by focusing on
the labor market. Unlike the sticky-wage model, however, the worker-misperception model
assumes that wages can adjust freely and quickly to balance the supply of and demand for labor.

Its key assumption is that unexpected movements in the price level influence labor supply
because workers temporarily confuse real and nominal wages.

The two components of the worker-misperception model are labor supply and labor demand. As
before, the quantity of labor firm’s demand depends on the real wage:

Ld = Ld (W/P).

The labor supply is new:

Ls = Ls (W/Pe).

This equation states that the quantity of labor supplied depends on the real wage that workers
expect to earn. Workers know their nominal wage W, but they do not know the overall price
level P. When deciding how much to work, they consider the expected real wage, which equals
the nominal wage W divided by their expectations of the price level Pe.

We can also write the expected real wage as: W W P

= ×
Pe P Pe
The expected real wage is the product of the actual real wage W/P and the variable P/Pe. Notice
that P/Pe measures workers’ misperception of the price level: if P/Pe is greater than one, the
price level is greater than what workers expected, and if P/Pe is less than one, the price level is
less than that expected.

To see what determines labor supply, we can substitute this expression for W/Pe and write:

Ls = Ls [(W/P) X (P/Pe)].

The quantity of labor supplied depends on the real wage and on worker misperception of the
price level.

To see what this model says about aggregate supply, consider the equilibrium in the labor
market, shown in the figure below.

As is usual, the labor demand curve slopes downward, the labor supply curve slopes upward, and
the wage rate adjusts to equilibrate supply and demand. Note that the position of the labor supply
curve and thus the equilibrium in the labor market depend on worker misperception P/Pe.

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When P rises, economy’s reaction depends on whether workers anticipate the changes. If they
do, then Pe rises proportionately with P: workers’ perceptions are accurate; neither L s nor Ld
changes; W rises proportionally with prices; W/P & employment remain the same.

However, if the price rise catches workers by surprise, P e remains the same when P rises. The
rise in P/Pe shifts Ls to right, lowering W/P & raising the level of employment. Hence, workers
believe that P is lower & thus W/P is higher than actually is the case. This induces them to
supply more labor. Firms are assumed to be better informed than workers & to recognize the fall
in W/P: they hire more L & produce more Y.

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In general, the worker misperception model say the deviations of P from P e induce workers to
changes their Ls & this changes quantity of Y firms produce:

Y =Ȳ +α( P−Pe )

In the two models above (with an unchanging labor demand curve) an unexpected rise in P
lowers W/P & thus raises quantities of L hired & Y produced: W/P is countercyclical, it should
fluctuate in the opposite direction from employment and output.

Yet the real world data show only a weak correlation b/n W/P & Y, & the correlation is the
opposite of what Keynes predicted: if W/P is cyclical, it is slightly procyclical: i.e., the real wage
tend to rise when output rises.

Abnormally high labor costs cannot explain the low employment & Y observed in recessions.
Most economists conclude that the two models cannot fully explain AS. They advocate models
in which Ld shifts over the business cycle, may be due to firms having sticky prices & unable to
sell all they want at those prices.

4.2.3 The Imperfect-Information Model

This model assumes that markets clear, i.e., all wages & prices are free to adjust to balance
supply & demand. The Short run AS & Long run AS curves differ because of temporary
misperceptions about prices.

The imperfect information model assumes each supplier in the economy produces a single good
& consumes many goods. As the number of goods is large, suppliers cannot observe all prices at
all times. They monitor closely the prices of what they produce but less closely the prices of all
the goods they consume. Due to imperfect information, they some-times confuse changes in
overall P & in relative Prices. This confusion influences decisions about how much to supply &
leads to a positive relationship between P & Y in the short run.

Consider the decision facing a supplier – a wheat farmer, for instance. Because the farmer earns
income from selling wheat & uses this income to buy goods & services, the amount of wheat she
chooses to produce depends on relative P of wheat. If relative P of wheat is high, she is
motivated to work hard & produce more because the reward is great. If the relative price of
wheat is low, she prefers to enjoy more leisure and produce less wheat.

Unfortunately, when the farmer makes her production decision, she does not know the relative
price of wheat. As a wheat producer, she monitors the wheat market closely and always knows
the nominal price of wheat. But she does not know the prices of all the other goods in the
economy. She must, therefore, estimate the relative price of wheat using the nominal price of
wheat and her expectation of the overall price level.

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Consider how the farmer responds if all prices, including wheat price, increase. One possibility is
that she expected these changes in Prices: when she observes a rise in wheat P, her estimate of its
relative P is unchanged & she does not work any harder.

The other possibility is that the farmer did not expect P to rise: observing a rise in wheat P, she is
not sure whether other Prices have risen or only wheat P has risen. The rational inference is that
some of each has happened, i.e., the farmer infers that its relative price has risen somewhat, so
that she works harder & produces more.

Our wheat farmer is not unique: when P rises unexpectedly, all suppliers observe rises in the
prices of goods they produce. They all infer that the relative prices of the goods they produce
have risen: they work harder & produce more.

In sum, when P exceeds Pe, suppliers raise output: Y deviates from its natural rate when P
deviates from Pe: Y =Ȳ +α( P−Pe )

4.2.4 The Sticky-Price Model

This model emphasizes that firms do not instantly adjust the prices they charge in response to
changes in demand. Sometimes prices are set by long-term contracts between firms and
customers. Even without formal agreements, firms may hold prices steady in order not to annoy
their regular customers with frequent price changes. Some prices are sticky because of the way
markets are structured: once a firm has printed and distributed its catalog or price list, it is costly
to alter prices.

To see how sticky prices can help explain an upward-sloping aggregate supply curve, we first
consider the pricing decisions of individual firms and then add together the decisions of many
firms to explain the behavior of the economy as a whole. Notice that this model encourages us to
depart from the assumption of perfect competition. Perfectly competitive firms are price takers
rather than price setters. If we want to consider how firms set prices, it is natural to assume that
these firms have at least some monopoly control over the prices they charge.

Consider the pricing decision facing a typical firm. The firm’s desired price p depends on two
macroeconomic variables:

 The overall level of prices P. A higher price level implies that the firm’s costs are higher.
Hence, the higher the overall price level, the more the firm would like to charge for its
product.
 The level of aggregate income Y. A higher level of income raises the demand for the
firm’s product. Because marginal cost increases at higher levels of production, the greater
the demand, the higher the firm’s desired price.

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We write the firm’s desired price as:

p=P+a(Y −Y )
This equation says that the desired price p depends on the overall level of prices P and on the
level of aggregate output relative to the natural rate Y - Y . The parameter a (which is greater than
zero) measures how much the firm’s desired price responds to the level of aggregate output.

Now assume that there are two types of firms. Some have flexible prices: they always set their
prices according to this equation. Others have sticky prices: they announce their prices in
advance based on what they expect economic conditions to be.

Firms with sticky prices set prices according to: p=P e +a(Y e−Y e )
where, as before, a superscript “e’’ represents the expected value of a variable. For simplicity,
assume these firms expect output to be at its natural rate (the last term is zero); then these firms
set: p=P e

That is, firms with sticky prices set their prices based on what they expect other firms to charge.

We can use the pricing rules of the two groups of firms to derive the AS equation. To do this,
we find the overall price level in the economy, which is the weighted average of the prices set
by the 2 groups.

If s is fraction of firms with sticky prices & 1−s the fraction with flexible prices, then the overall
price level is: P=sP e+(1−s)[ P+a(Y −Y )]

The first term is price of sticky-price firms weighted by their fraction in the economy & the
second price of flexible-price firms weighted by their fraction.
e
Now subtract (1−s)P from both sides of this equation to obtain: sP=sP +(1−s)a(Y −Y )
e a
Divide both sides by s to solve for P: P=P +( 1−s )( s )( Y −Y )

The 2 terms are explained as follows:

 When firms expect a high price level, they expect high costs. Those firms that fix
prices in advance set their prices high. This causes the other firms to set high
prices. Hence, a high Pe leads to a high P.

 When Y is high, demand for goods is high. Firms with flexible prices set prices
high, leading to a high P. The effect of Y on P depends on s.

Hence, P depends on the expected price level & the level of output. Algebraic rearrangement
puts this pricing equation into a more familiar form: Y =Ȳ +α( P−Pe )

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Deviation of output from the natural rate is positively related to deviation of P from P e. Though
this model emphasizes goods market, consider what is happening in labor market.

If a firm’s price is stuck in short run, then a fall in AD reduces what the firm can sell. The firm
responds to the drop in sales by reducing its production & demand for labor. Unlike in the first
two models, the firm here does not move along a fixed L d curve. Instead, fluctuations in Y are
associated with shifts in the Ld curve. Because of shifts in Ld, employment, production & real
wage can all move in the same direction – real wage can be procyclical.

Although the four models of aggregate supply differ in their assumptions and emphases, their
implications for aggregate output are similar. All can be summarized by the equation:

Y =Ȳ +α( P−Pe )

This equation states that deviations of output from the natural rate are related to deviations of the
price level from the expected price level. If the price level is higher than the expected price level,
output exceeds its natural rate. If the price level is lower than the expected price level, output
falls short of its natural rate. The figure below graphs this equation. Notice that the short-run
aggregate supply curve is drawn for a given expectation Pe and that a change in Pe would shift
the curve.

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Now that we have a better understanding of aggregate supply, let’s put aggregate supply and
aggregate demand back together. The following figure uses our aggregate supply equation to
show how the economy responds to an unexpected increase in aggregate demand attributable,
say, to an unexpected monetary expansion. In the short run, the equilibrium moves from point A
to point B. The increase in aggregate demand raises the actual price level from P1 to P2. Because
people did not expect this increase in the price level, the expected price level remains at Pe 2 ,
and output rises from Y1 to Y2, which is above the natural rate Y . Thus, the unexpected
expansion in aggregate demand causes the economy to boom.

Yet the boom does not last forever. In the long run, the expected price level rises to catch up with
reality, causing the short-run aggregate supply curve to shift upward. As the expected price level
rises from P2e to P3e, the equilibrium of the economy moves from point B to point C. The actual
price level rises from P2 to P3, and output falls from Y2 to Y3. In other words, the economy
returns to the natural level of output in the long run, but at a much higher price level.

This analysis shows an important principle, which holds for each of the four models of aggregate
supply: long-run monetary neutrality and short-run monetary non-neutrality are perfectly
compatible. Short-run non-neutrality is represented here by the movement from point A to point

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B, and long-run monetary neutrality is represented by the movement from point A to point C. We
reconcile the short-run and long-run effects of money by emphasizing the adjustment of
expectations about the price level.

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