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Aggregate Supply Relation Revision.docx

The document outlines the Aggregate Supply (AS) relation, detailing the relationship between output and price levels, derived from wage and price-setting behaviors. It explains key equations, properties of the AS relation, and the effects of shifts in expected price levels on the AS curve. Key takeaways emphasize understanding wage and price-setting impacts on the economy and the differences between short-run and medium-run adjustments in price levels.

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zhanibekzhoni2006
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10 views

Aggregate Supply Relation Revision.docx

The document outlines the Aggregate Supply (AS) relation, detailing the relationship between output and price levels, derived from wage and price-setting behaviors. It explains key equations, properties of the AS relation, and the effects of shifts in expected price levels on the AS curve. Key takeaways emphasize understanding wage and price-setting impacts on the economy and the differences between short-run and medium-run adjustments in price levels.

Uploaded by

zhanibekzhoni2006
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Aggregate Supply Relation Revision

1. Overview of Aggregate Supply (AS) Relation


What it Captures:
The relationship between output (Y) and the price level (P).
Derived from wage and price-setting behaviors.
Key Equations (Chapter 6 Recap):
Wage determination: W=PeF(u,z)
Price determination: P=(1+m) W
wage setting and price setting determine the equilibrium (also called “natural”) rate of
unemployment.
Or
W/P=F(u,z): Wage determination implies a negative relation between the real wage, W/P, and
the unemployment rate, (u): The higher the unemployment rate, the lower the real wage chosen
by wage setters.
and W/P =1/ (1+m); Price-setting decisions determine the real wage paid by firms. An increase
in the markup leads firms to increase their prices given the wage they have to pay; equivalently,
it leads to a decrease in the real wage.

● The positions of the wage-setting and price-setting curves, and thus the equilibrium
unemployment rate, depend on both z and m
● Z shifts the Ws and m shifts the PS
2. Key Steps in Deriving the AS Relation
Start with Wage and Price Equations:
Replace W in the price equation with its expression from the wage equation:
P=Pe(1+m) F(u,z)P
The price level depends on the expected price level (Pe) and the unemployment rate (u).
Link Unemployment to Output:
The unemployment rate (u) is related to output (Y) by u=1−Y/L, where L is the labor force.
Substituting u into the price equation gives the AS relation:
P=Pe(1+m)F(1−Y/L,z)

3. Properties of the Aggregate Supply Relation


Property 1: Output and Price Level Relationship
Higher output (Y) leads to a higher price level (P).
Steps Involved:
Increase in Y→ more employment.
More employment → Lower unemployment rate (u).
Lower u → Higher wages (W).
Higher W → Higher prices (P).
Example:
A factory increases production → Hires more workers → Unemployment drops → Wages rise
→ Prices increase.

Property 2: Expected Price Level and Actual Price Level Relationship


If the expected price level Pe increases, the actual price level P increases by the same proportion.
Wage setters expect higher P → Demand higher wages (W).
Higher W→ Firms increase P.
Example:
Inflation expectations rise → Workers negotiate higher wages → Firms pass costs to consumers
→ Prices rise.
Property 3: Natural Output and the AS Curve
At the natural level of output Yn, P=Pe
Implications:
If Y>Yn ; P>Pe
If Y<Yn ; P<Pe.
Graphical View: The AS curve passes through the point where Y=Yn and P=Pe

4. Shifts in the Aggregate Supply Curve


Effect of Changes in Expected Price Level (Pe)
Increase in Pe: The AS curve shifts up because wages and prices rise.
Decrease in Pe: The AS curve shifts down as wages and prices fall.
Example: If workers expect inflation to rise next year, they negotiate higher wages now, shifting
the AS curve upward.
5. Key Takeaways
Understand how wage and price-setting behaviors affect the economy.
Recognize the short-run differences when P≠Pe and medium-run adjustments where P=Pe.
Use the AS curve to predict price level changes based on output and inflation expectations.
Example Scenario
Short Run: A sudden economic boom increases output Y;
Unemployment falls → Wages rise → Firms increase prices.
Result: Higher P, shifting along the AS curve.
Medium Run: Firms and workers adjust expectations (Pe) Wages and prices stabilize, aligning
P and Pe.

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