Table of Contents

Aggregate supply models.................................................................................3

Introduction to aggregate supply models..................................................3
Sticky-Wage Model.............................................................................................3
Worker-Misperception Model...........................................................................4
Imperfect-Information Model............................................................................5
Sticky-Price Model..............................................................................................6
Why is the aggregate demand (AD) curve downward sloping?..............7
Work out..............................................................................................................10
Reference...............................................................................................................15
 Aggregate supply models

Introduction to aggregate supply models

The aggregate supply curve shows the relationship between the price level and output.
While the long run aggregate supply curve is vertical, the short run aggregate supply
curve is upward sloping. There are four major models that explain why the short-term
aggregate supply curve slopes upward. The first is the sticky-wage model. The second
is the worker-misperception model. The third is the imperfect-information model. The
fourth is the sticky- price model. The following headings explain each of these models in
depth. As we move on to explore each of these four models, keep in mind that an
upward sloping short run aggregate supply curve means that as the price level rises,
output increases. This is the point of each of the following models.

Sticky-Wage Model

The sticky-wage model of the upward sloping short run aggregate supply curve is based
on the labor market. In many industries, short run wages are set by contracts. That is,
workers are paid based on relatively permanent pay schedules that are decided upon
by management or unions or both. When the economy changes, the wage the workers
receive cannot adjust immediately.
Stickiness is an important concept in macroeconomics, particularly so
in Keynesian, macroeconomics and New Keynesian economics. Without stickiness,
wages would always adjust in more or less real-time with the market and bring about
relatively constant economic equilibrium. With a disruption in the market would come
proportionate wage reductions without much job loss. Instead, due to stickiness, in the
event of a disruption, wages are more likely to remain where they are and, instead,
firms are more likely to trim employment. This tendency of stickiness may explain why
markets are slow to reach equilibrium, if ever.

Stickiness is a theoretical market condition wherein some nominal price resists change.
While it often apply to wages, stickiness may also often be used in reference to prices
within a market, which is also often called price stickiness.
According to sticky wage theory, when stickiness enters the market a change in one
direction will be favored over a change in the other. Since wages are held to be sticky-
down, wage movements will trend in an upward direction more often than downward,
leading to an average trend of upward movement in wages. This tendency is often
referred to as “creep” (price creep when in reference to prices) or as the ratchet effect.
Some economists have also theorized that stickiness can, in effect, be contagious,
spilling from an affected area of the market into other unaffected areas. Economists
have also warned, however, that such stickiness is only an illusion, since real
income will be reduced in terms of buying power as a result of inflation over time. This
is known as wage-push inflation.

Given that wages are sticky, the chain of events leading from an increase in the price
level to an increase in output is fairly straightforward. When the price level rises, the
nominal wage remains fixed because this is solely based on the dollar amount of the
wage. The real wage, on the other hand, falls because this is based on the purchasing
power of the wage. A higher price level means that a given wage is able to purchase
fewer goods and services.
When the real wage that firms pay employees falls, labor becomes cheaper. However,
since the amount of output produced for each unit of labor is still the same, firms choose
to hire more workers and increase revenues and profits. When firms hire more labor,
output increases. Thus, when the price level rises, output increases because of sticky
wages.
Let's summarize the chain of events that leads from an increase in the price level to an
increase in output in the sticky-wage model. When the price level rises, real wages fall.
When real wages fall, labor becomes cheaper. When labor becomes cheaper, firms hire
more labor. When firms hire more labor, output increases.

Worker-Misperception Model

 The worker-misperception model of the upward sloping short- run aggregate

supply curve is again based on the labor market. This time, unlike in the sticky-
wage model, wages are free to move as the economy changes. The amount of
work that an employee is willing to supply is based on the expected real wage.
That is, workers know how many dollars they are being paid, the nominal wage,
but workers can only guess at how much goods and services they can purchase
with this wage, the real wage. In general, the higher the real wage, the more
work that workers are willing to supply.

Now let's say that the price level increases. Because we assume that firms have more
information than workers do, firms will give workers a raise so that their nominal wage
increases with the price level. But since the workers do not realize that the price level
increased, they will believe that their real wage increased, not just their nominal wage.
At a higher real wage, workers are induced to work more. When workers work more,
output increases. Thus, when the price level increases, output also increases because
of worker-misperception.
 When nominal wages increase, workers--due to misperceptions--believe that real
wages also increase. When workers believe that real wages increase, workers
provide more labor. When workers provide more labor, output increases.

Unlike the sticky-wage model, the worker-misperception model assumes that workers
are fee to equate supply and demand in labor market, but they temporarily confuse real
and nominal wages. Workers know their nominal wage (W) but they do not know the
overall price level (P).

Imperfect-Information Model

The imperfect-information model of the upward sloping short- run aggregate supply
curve is again based on the labor market. In this model, unlike either the sticky-wage
model or the worker-misperception model, neither the worker nor the firm has complete
information. That is, neither is better informed than the other is about the real wage, the
nominal wage, or the price level.
In this model, producers are considered to be really only aware of the price of the goods
and services that they produce. That is, producers are unable to recognize overall
increases in the price level because they are focused on their products only. Instead,
producers only recognize changes in the prices of the goods and services that they
produce. Given that producers are unable to recognize changes in the overall price
level, they are likely to confuse changes in the goods and services they produce
(relative changes in the price level) with changes in the overall price level (absolute
changes in the price level).
It is important to understand the implications of both relative changes in the price level
and absolute changes in the price level. When a relative change in the price level
occurs, producers of some goods and services are better off because the price of their
output increases to a greater extent than the overall price level. Both the real wage and
the nominal wage earned by these producers increase. When an absolute change in the
price level occurs, all producers are affected equally and the nominal wage increases
while the real wage remains constant.
Recall that producers are willing to provide more labor when the wage is high. That is,
they will work harder when they are getting paid more for their work. Also recall that
producers cannot differentiate between relative changes in the price level and absolute
changes in the price level. Thus, when a producer sees a change in the price level, she
will likely believe that it is a relative change in the price level, even if it is an absolute
change in the price level. Because of this, the producer will work more and produce
more output when the price level rises. Thus, an increase in the price level causes
output to rise.
Let's summarize the chain of events that leads from an increase in the price level to an
increase in output in the imperfect-information model. When the overall price level rises,
producers mistake it for a relative increase in the price level. When the relative price
level rises, the real wage earned by producers rises. When the real wage earned by
producers rises, the amount of labor supplied by producers increases. When the
amount of labor supplied by producers increases, output increases.

Sticky-Price Model

The sticky-price model of the upward sloping short-run aggregate supply curve is based
on the idea that firms do not adjust their price instantly to changes in the economy.
There are numerous reasons for this.
 First, many prices, like wages, are set in relatively long-term contracts. Imagine if
your wage at McDonalds changed every day as the economy changed.
 Second, firms hold prices stable to keep from annoying regular customers. It
would really be a pain if the price of a newspaper changes from 24 cents to 25
cents to 23 cents as the price of paper and ink changed.
 Third, firms hold prices stable because of menu costs. Menu costs are those
costs that are associated with printed catalogues and menus. It would be very
expensive to constantly change catalogues and menus in response to economic
changes.

But how does the fact the prices are sticky in the short run lead to an upward sloping
relationship between the price level and output? When firms prepare to set their prices,
they take into account the expected price level. When the expected price level is high,
firms set their prices high to compensate for the high price of inputs. When the price
charged for output is high firms produce more output, as the incentive for production is
also high. Thus, an increase in the price level leads rather directly to an increase in
output in the sticky-price model.
There is another way to conceptualize the relationship between the price level and
output in the sticky-price model. When the level of output is high, the demand for
goods and services is also high. Thus, when firms set their sticky- prices, they set
them high to account for the high demand. When firms set their prices high, the overall
price level increases. Thus, a high level of output leads to a high level of demand, which
leads to a high price level.
Let's summarize the two chains of events that characterize the relationship between the
price level and output in the sticky-price model.
 First, when firms expect a high price level they set their relatively sticky prices
high. Other firms follow suit and set their prices high as well. Thus, a high
expected price level leads to a high actual price level. When the expected price
level is high, producers produce more output.
 Second, when the level of output is high, the demand for goods and services is
also high. When the demand for goods and services is high, the price charged
for goods and services is also high. When the price charged for goods and
services is high, firms set their relatively sticky prices high. When some firms set
their relatively sticky prices high, other firms follow suit. Thus, the overall price
level increases.

Conclusions from the Four Models

While each of these four models of the upward sloping short run aggregate supply curve
is useful, it is the combination of all four that provides the most realistic picture of
aggregate supply. The conclusion drawn from these models is that, in the short run, the
aggregate supply curve is upward sloping. Again, this relationship is represented by
Y = Ynatural + a(P – Pexpected),
where Y is output, Ynatural is the natural rate of output that exists when all productive
factors are used at their normal rates, a is a constant greater than zero, P is the price
level, and Pexpected is the expected price level.

Why is the aggregate demand (AD) curve downward sloping?

The aggregate demand curve (AD) is the total demand in the economy for goods at
different price levels. AD = C + I + G + X – M
If there is a fall in the price level, there is a movement along the AD curve because with
goods cheaper – effectively, consumers have more spending power.
The following are the main reasons for the downward sloping of the aggregate
demand curve. Or as further explained there are three essential theories why
economists believe that there is a downward sloping aggregate demand curve.

1. The Price Level and Consumption: The Wealth

Effect

 increased spending power. At a lower price level, consumers are likely to have
higher disposable income and therefore spend more. (Note this assumes that
wages are constant and not falling with prices)
The Wealth Effect take into account the money that you hold in your savings. The
nominal value of this money is the same, but its real value is not. When Everything else
in the economy is the same,

• Employment has not changed.

• Profits have not changed.
• People’s optimism has not changed.
The single thing that is different is the prices of everything in the economy drops. When
prices fall, people can buy more goods and services with the same amount of money.
Thus, a decrease in the price level makes consumers feel wealthier, which in turn
encourages them to spend more money. The increase in consumer spending leads to a
larger quantity of goods and services demanded.
Similarly, if for any reason people woke up the next morning, and the price of everything
was to double. Everything will be expensive. People will have to buy less of everything.
Moreover, demand fewer goods and service.

2. The Price Level and Investment: The Interest-

Rate Effect

 Lower interest rates. At a lower price level, interest rates usually fall, and this
causes higher aggregate demand.

The price level is one factor of the quantity of money demanded. The cheaper the price
level, the fewer money households need to hold to buy the goods and services they
want.
When the price level falls, therefore, households try to reduce their holdings of money
by lending some of it out.
For instance, a household might use its excess money to buy interest-bearing bonds.
Alternatively, it might deposit its excess cash in an interest-bearing savings account,
and the bank would use these funds to make more loans.
In either case, as households try to convert some of their money into interest-bearing
assets, they drive down interest rates.
Lower interest rates, in turn, encourage borrowing by firms that want to invest in new
plants and equipment and by households who wish to invest in new housing.
Thus, a lower price level reduces the interest rate, encourages greater spending on
investment goods, and thereby increases the number of products and services
demanded.

3. The Price Level and Net Exports: The Exchange-

Rate Effect

 Increase in demand for exports. If there is a lower price level in the UK, UK
goods will become relatively more competitive, leading to higher exports.
Exports are a component of AD, and therefore AD will be higher.
Any situation that changes net exports for a given price level also shifts aggregate
demand. For example, when Europe experiences a recession, it buys fewer goods from
the United States.
Fewer sales reduce U.S. net exports and shifts the aggregate-demand curve for the
U.S. economy to the left.
When Europe recovers from its recession, it starts repurchasing U.S. goods, shifting the
aggregate-demand curve to the right.
Net exports sometimes change because of movements in the exchange rate.

Work out

1. In the Keynesian cross model, assume that the consumption function is given by
C=200+0.75(Y-T), planned investment is 100; government purchases and taxes are
both 100.
a. derive the IS-function
Y=C+I+G
Y = 200 + 0.75 (Yd) + 100 + 100
Y = 400 + 0.75 (Yd)
Y = 400 + 0.75Yd
b. What is the equilibrium level of income?
 At equilibrium level of income,
AS = AD
Y=C+I+G
Y = 200 + 0.75 (Y – T) + 100 + 100
Y = 400 + 0.75 (Y – 100)
Y = 400 + 0.75Y – 75
Y – 0.75Y = 400 – 75
0.25Y = 325
Y = 1300
C. If government purchases increase to 125, what is the new equilibrium income?
New government purchase= 125
Y=C+I+G
Y = 200 + 0.75 (Y – T) + 100 + 125
Y = 425 + 0.75 (Y – 100)
Y = 425 + 0.75Y – 75
Y – 0.75Y = 425 – 75
0.25Y = 350
Y = 1400
 Therefore the increase in government purchases causes the equilibrium income
to increase from 1300 to 1400.

d. what level of government purchases is needed to achieve an income of 1600?

Y=C+I+G
1600 = 200 + 0.75 (Y – T) + 100 + G
1600 = 200 + 0.75 (1600 – 100) + 100 + G
1600 = 300 + 0.75 (1500) + G
1600 = 300 + 1125 + G
G = 1600 – 1425
G = 175
 Therefore 175 level of government purchase is needed to achieve an income of
1600.

2. consider the consumption function C= 200+0.75(Y-T), investment function I= 200-25r,

m
government purchase and tax= 100, ( ¿ d=Y −100 r ,money supply(M) = 1000 and the
p
price level is P= 2
a. derive IS function and LM function
IS function
Y=C+I+G
Y = 200 + 0.75 (Y – T) + 200 – 25r + 100
Y = 500 + 0.75 (Y – 100) – 25r
Y = 500 + 0.75Y – 75 – 25r
Y – 0.75Y = 500 – 75 – 25r
0.25Y = 425 – 25r
Y = 1700 – 100r
LM function
m m
( ¿ d =( ¿ s ,
p p
m mss 1000 m
( ¿s = = = 500 = ( ¿ d
p p 2 p
m m
( ¿ d = 500, ( ¿ d = Y −100 r
p p
Y −100 r = 500
Y= 500 + 100r
b. what is the equilibrium level of income and interest rate in the IS-LM model?
IS function = 1700 – 100r
LM function = 500 + 100r
1700 – 100r = 500 + 100r
-100r – 100r = 500 – 1700
-200r = -1200
r = 6%
Y = 500 + 100r
Y = 500 + 100(6)
Y = 500 + 600
Y = 1100
When the national income is 1100 the interest rate is 6%
c. suppose that the government purchase are raised from 100 to 150. What are the new
equilibrium interest rate and level of income?
When the government purchase raises from 100 to 150 the is function will become
Y = 200 + 0.75 (Y – T) + 200 – 25r + 150
Y = 550 + 0.75 (Y – 100) – 25r
Y = 550 + 0.75Y – 75 – 25r
Y – 0.75Y = 550 – 75 – 25r
0.25Y = 475 – 25r
Y = 1900 – 100r
 IS = LM
1900 – 100r = 500 + 100r
-100r – 100r = 500 – 1900
-200r = -1400
r = 7%
Y = 500 + 100r
Y = 500 + 100(7)
Y = 500 + 700
Y = 1200
 Therefore the increase in government purchases causes the equilibrium interest
rate to rise from 6% to 7%, while output increases from 1100 to 1200.

d. suppose instead that the money supply is raised from 1000 to 1200. What are the
new equilibrium interest rate and level of income.
m m
( ¿ d =( ¿ s ,
p p
m mss 1200 m
( ¿s = = = 600 = ( ¿ d
p p 2 p
m m
( ¿ d = 600, ( ¿ d = Y −100 r
p p
Y −100 r = 600
Y = 600 + 100r
 IS = LM
1700 – 100r = 600 + 100r
-100r – 100r = 600 – 1700
-200r = -1100
r = 5.5%
Y = 600 + 100r
Y = 600 + 100(5.5)
Y = 600 + 550
Y = 1150
 Therefore the increase in money supply causes the equilibrium interest rate to
decrease from 6% to 5.5%, while output increases from 1100 to 1150.
 Reference

 Pocket sense (2018, October 17). https://pocketsense.com/calculate-

equilibrum-level-income-1147.html

 Economics help (2017, September 11).

https://www.economicshelp.org/blog/11437/economics/why-is-the-aggregate-
demand-ad-curve-downward-sloping/

 Spark notes
https://www.sparknotes.com/economica/macro/aggregatesupply/section2/