Chapter Five

Aggregate supply

5.1 Introduction
Most economists analyze short-run fluctuations in national income and the price level using the model
of aggregate demand and aggregate supply. In the previous two chapters, we examined aggregate
demand in some detail. The IS–LM model-together with its open-economy cousin the Mundell–Fleming
model-shows how changes in monetary and fiscal policy and shocks to the money and goods markets
shift the aggregate demand curve. By itself, the aggregate demand curve does not tell us the price level
or the amount of output that will prevail in the economy; it merely gives a relationship between these
two variables. To accompany the AD curve, we need another relationship between price and output that
crosses the AD curve—an aggregate supply curve. The aggregate demand and aggregate supply curves
together pin down the economy’s price level and quantity of output. Thus, in this chapter, we turn our
attention to aggregate supply and develop theories that explain the position and slope of the aggregate
supply curve.

Aggregate supply is the total supply of goods and services produced within an economy at a given
overall price level in a given time period. It is represented by the aggregate-supply curve, which
describes the relationship between price levels and the quantity of output that firms are willing to
provide. Alternatively, aggregate supply curve describes the combinations of output and the price level
at which firms are willing, at the given price level, to supply the given quantity of output. Moreover,
aggregate supply measures the volume of goods and services produced each year. It represents the
ability of an economy to deliver goods and services to meet demand. Normally, there is a positive
relationship between aggregate supply and the price level. Rising prices are usually signals for
businesses to expand production to meet a higher level of aggregate demand.

Because the firms that supply goods and services have flexible prices in the long run but sticky prices in
the short run, the aggregate supply relationship depends on the time horizon. Here, we need to discuss
two different aggregate supply curves: the long run aggregate supply curve, LRAS (the classical supply
curve) and that of the short-run aggregate supply curve, SRAS (the Keynesian supply curve). Finally, an
attempt will be made to present four prominent models of short-run aggregate supply curve.

5.2 The Classical Approach to Aggregate Supply

Because the classical model describes how the economy behaves in the long run, we derive the long-run
(classical) aggregate supply curve from the classical model. The amount of output produced depends on
the fixed amounts of capital and labor and on the available technology. According to the classical model,
output does not depend on the price level. To show that output is fixed at this level, regardless of the
price level, we draw a vertical aggregate supply curve, as shown in the following figure. The classical
aggregate supply curve is vertical indicating that the same amount of goods will be supplied whatever
the price level, i.e. output does not depend on the price level. It is based on the assumption that there is
always full employment of labor (i.e., the labor market is assumed to be in equilibrium with full
employment of the labor force), and thus output is always at the corresponding level, Y (potential GDP).

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Figure 5.1: The Classical Aggregate Supply Curve

The intersection of the aggregate demand curve with this vertical aggregate supply curve determines the
price level. If high demand in economy wide and all the factors of production are already at work, there
isn’t any way to increase overall production, and all that happens is that all prices increase. If wages and
prices are fully flexible, then the labor market will always be in equilibrium with all firms will attempt
to produce more output by hiring more workers. For example, if AD increases, firms will attempt to
produce more output by hiring more workers. Since employment is already full, they will have to raise
wages to lure workers away from other firms. Wages are bid up and so firms will attempt to raise prices
to compensate. Output, however, will remain unchanged. The point is that workers and firms both look
at both wage and price levels so that with full employment if wages rise, so will prices and vice versa.
Let us see graphically the change in aggregate demand and its impact on the aggregate supply of the
classical model. For example, if the national bank reduces money supply, the AD curve shifts
downward, as shown in the following figure. The economy moves from the old intersection of aggregate
supply and aggregate demand, point A, to the new intersection, point B. The shift in aggregate demand
affects only prices. The vertical aggregate supply curve satisfies the classical dichotomy, because it
implies that the level of output is independent of the money supply. This long run level of output Y is
called the full-employment or natural level of output. It is the level of output at which the economy’s
resources are fully employed or, more realistically, at which unemployment is at its natural rate. Thus, if
the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not output.

Figure 5.2: the Classical Aggregate Supply Curve and Change in Aggregate Demand

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Note: Although the Classical AS assumes no unemployment (that is, labor market is in equilibrium),
there exists some amount of frictional unemployment called natural rate of unemployment. The natural
rate of unemployment is the rate of unemployment arising from normal labor market frictions that exist
when the labor market is in equilibrium.

In general, over long periods of time, prices are flexible, the AS curve is vertical, and changes in
aggregate demand do affect only the price level but not output. Thus, GDP (output level) does not
depend on the price level.

5.3 The Keynesian Approach to aggregate supply

The classical model and the vertical aggregate supply curve apply only in the long run. In the short run,
some prices are sticky and, therefore, do not adjust to changes in demand. Because of this price
stickiness, the short-run aggregate supply curve is not vertical. The short-run AS curve is the Keynesian
aggregate supply curve. In the extreme Keynesian case, aggregate supply curve is horizontal; indicating
that firms will supply whatever amount of goods is demanded at the existing price level. Suppose that all
firms have issued price catalogs and that it is too costly for them to issue new ones. Thus, all prices are
stuck at predetermined levels. At these prices, firms are willing to sell as much as their customers are
willing to buy, and they hire just enough labor to produce the amount demanded. Because the price level
is fixed, we represent this situation in the following figure with a horizontal aggregate supply curve.

Figure 5.3: The Keynesian aggregate supply curve

The idea underlying the Keynesian AS curve is that because there is unemployment, firms can obtain as
much labor as they want at the current wage. Their average costs of production, therefore, are assumed
not to change as their output levels change. They are accordingly willing to supply as much as
demanded at the existing price level. Because there is some unemployment in the economy, firm can
hire as much labor as they want at the current wage. Without increase in input costs as output expands,
firms can supply any amount of output at the going price. The wage does not fall even though there is
excess demand, since the Keynesian model assumes that wages are sticky downward. Price is also
assumed to be sticky.
The short-run equilibrium of the economy is the intersection of the aggregate demand curve and this
horizontal short-run aggregate supply curve. this case, changes in AD either through fiscal policy or
monetary policy do affect the level of output in the economy but not price level. For example, if the
national bank suddenly reduces the money supply, the aggregate demand curve shifts inward, asin figure
below.
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Figure 5.4: The Keynesian aggregate supply curve and change in aggregate demand

The economy moves from the old intersection of aggregate demand and aggregate supply, point A, to
the new intersection, point B. The movement from point A to point B represents a decline in output at a
fixed price level. Thus, a fall in aggregate demand reduces output in the short run because prices do not
adjust instantly. After the sudden fall in aggregate demand, firms are stuck with prices that are too high.
With demand low and prices high, firms sell less of their product, so they reduce production and lay off
workers. The economy experiences a recession.

In general, over short periods of time, prices are sticky, the AS curve is flat, and changes in aggregate
demand do affect the economy’s output of goods and services. Thus, in the Keynesian AS curve, the
price level does not depend on GDP.

Be cautioned that reality is a bit more complicated than illustrated here. Although many prices are sticky
in the short run, some prices are able to respond quickly to changing circumstances. In an economy with
some sticky prices and some flexible prices, the short run AS curve is upward sloping rather than
horizontal. The above figure just illustrates the extreme case in which all prices are stuck. Because this
case is simpler, it is a useful starting point for thinking about short-run aggregate supply.

The Models of Short-run Aggregate Supply

When we introduced the aggregate supply curve earlier, we established that 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 level. 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. 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 to
better reflect the real world in which some prices are sticky and others are not. Unfortunately, one fact
makes this task more difficult: economists disagree about how best to explain aggregate supply. As a
result, in this sub-section, we present four prominent models of the short-run aggregate supply curve.
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
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a common conclusion that the short-run aggregate supply curve is upward sloping. 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:

Y =Y +α ( P−Pe ) , α >0.
Where Y is output, Y is the natural rate of output, P is the price level, and Pe is the expected price level.
This equation states that output deviates from its natural rate when the price level deviates from the
expected price level. The parameter α indicates how much output responds to unexpected changes in the
price level; 1/ α is the slope of the aggregate supply curve.
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.

1. The Sticky-Wage Model

To explain why the short-run aggregate supply curve is upward sloping, many economists stress 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 the 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:
1) When the nominal wage is stuck, a rise in the price level lowers the real wage, making
labor cheaper.
2) The lower real wage induces firms to hire more labor.
3) 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:
1. 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. In other words, contracts over nominal wage are
signed between the employer and employee in advance. Therefore, nominal wages are fixed, W.
2. 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.
3. 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 X Pe
Nominal Wage = Target Real Wage X Expected Price Level.

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4. After the nominal wage has been set and before labor has been hired, firms learn the actual price
level P. The real wage turns out to be:
W/P = ω X Pe/P
Expected Pr ice Level
Real Wage = Target Real Wage X Actual Pr ice Level
This equation shows that the real wage deviates from its target if the actual price level differs from
the expected price level. When actual price equals the expected price, unemployment and output are
at their natural rates. When the actual price level is greater than expected, the real wage is less than
its target, so firms hire more workers and output rises above its natural rate. When the actual price
level is less than expected, the real wage is greater than its target, so firms hire fewer workers and
output falls below its natural rate.

5. 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), which states that the lower the real wage, the more labor firms hire. The labor demand
curve is shown in panel (a) of the figure below.
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
e
Y =Y +α ( P−P ) .
Output deviates from its natural level when the price level deviates from the expected price level.
The sticky-wage model can now be analyzed by using the following graphs:

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 2. The Imperfect-Information Model
The second explanation for the upward slope of the short-run aggregate supply curve is called the
imperfect-information model. The model assumes that:
1. Markets clear – that is, all wages and prices are free to adjust to balance supply and demand.
2. The short-run and long-run aggregate supply curves differ because of temporary misperceptions
about prices. Both workers and firms are ill informed about the price level.
3. Each supplier in the economy produces a single good and consumes many goods. Because the
number of goods is so 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. Each
supplier knows the nominal price of the good she/he produces, but does not know the overall
price level. The supply of each good depends on its relative price: the nominal price of the good
divided by the overall price level. The supplier doesn’t know price level at the time she makes her
production decision, so uses the expected price level, 𝑃𝑒. Because of imperfect information, they
sometimes confuse changes in the overall level of prices with changes in relative prices. This
confusion influences decisions about how much to supply, and it leads to a positive relationship
between the price level and output in the short run.
Consider the decision facing a single supplier—for instance, a wheat farmer. Because the farmer earns
income from selling wheat and uses this income to buy goods and services, the amount of wheat she
chooses to produce depends on the price of wheat relative to the prices of other goods and services in the
economy. If the relative price of wheat is high, the farmer is motivated to work hard and produce more
wheat, 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.

Consider how the farmer responds if all prices in the economy, including the price of wheat, increase.
One possibility is that she expected this change in prices. When she observes an increase in the price of
wheat, her estimate of its relative price is unchanged. She does not work any harder. The other
possibility is that the farmer did not expect the price level to increase (or to increase by this much).When
she observes the increase in the price of wheat, she is not sure whether other prices have risen (in which
case wheat’s relative price is unchanged) or whether only the price of wheat has risen (in which case its
relative price is higher).The rational inference is that some of each has happened. In other words, the
farmer infers from the increase in the nominal price of wheat that its relative price has risen somewhat.
She works harder and produces more. Our wheat farmer is not unique. When the price level rises
unexpectedly, all suppliers in the economy observe increases in the prices of the goods they produce.
They all infer, rationally but mistakenly, that the relative prices of the goods they produce have risen.
They work harder and produce more.

To sum up, the imperfect-information model says that when actual prices exceed expected prices,
suppliers raise their output. The model implies an aggregate supply curve that is now familiar:
Y=Y +α ( P−Pe ) .
Output deviates from the natural rate when the price level deviates from the expected price level.

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The imperfect-information story described here is the version developed originally by Nobel Prize–
winning economist Robert Lucas in the 1970s. Recent work on imperfect-information models of
aggregate supply has taken a somewhat different approach. Rather than emphasizing confusion about
relative prices and the absolute price level, as Lucas did, this new work stresses the limited ability of
individuals to incorporate information about the economy into their decisions. In this case, the friction
that causes the short-run aggregate supply curve to be upward sloping is not the limited availability of
information but is, instead, the limited ability of people to absorb and process information that is widely
available. This information-processing constraint causes price-setters to respond slowly to
macroeconomic news. The resulting equation for short-run aggregate supply is similar to other models
even though the microeconomic foundations are somewhat different.

3. The Sticky-Price Model

Our third and the most widely accepted explanation for the upward-sloping short-run aggregate supply
curve is called the sticky-price model. The model emphasizes on the goods market and considers 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. Sometimes sticky prices can be a reflection of sticky
wages: firms base their prices on the costs of production, and wages may depend on social norms and
notions of fairness that evolve only slowly over time.
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. Firms set their own prices (e.g. as in monopolistic competition).

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.
We write the firm’s desired price as:
p =P + a(Y − Y ), where a > 0.
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 = Pe + a(Ye − Y e),where, as before, a superscript “e’’ represents the expected value of a variable.
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For simplicity, assume that firms with sticky prices expect output to be at its natural rate so that the last
term, a(Ye − Y e), is zero. Then, these firms set the price:
p = Pe.
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 aggregate supply equation. To do
this, we first find the overall price level in the economy, which is the weighted average of the prices set
by the two groups. If s is the fraction of firms with sticky prices and 1−s the fraction with flexible prices,
then the overall price level is:
P = sPe + (1 −s) [P +a(Y − Y )].
The first term is the price of the sticky-price firms weighted by their fraction in the economy, and the
second term is the price of the flexible-price firms weighted by their fraction. Now subtract (1 −s)P from
both sides of this equation to obtain:
sP = sPe + (1 −s)[ a(Y − Y )].
Divide both sides by s to solve for the overall price level.

The two terms in this equation 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. These high prices cause the other firms to set high prices also.
Hence, a high expected price level Pe leads to a high actual price level P.
 When output is high, the demand for goods is high. Those firms with flexible prices set their
prices high, which leads to a high price level. The effect of output on the price level depends on
the proportion of firms with flexible prices. The greater the fraction of flexible price firms, the
smaller is s and the bigger is the effect of ΔY on P.
Hence, the overall price level depends on the expected price level and on the level of output.
Algebraic rearrangement puts this aggregate pricing equation into a more familiar form AS equation by
solving for Y:
Y=Y +α ( P−Pe ) , where α = s /[(1 −s)a].
Like the other models, the sticky-price model says that the deviation of output from the natural rate is
positively associated with the deviation of the price level from the expected price level.

Although the sticky-price model emphasizes the goods market, consider briefly what is happening in the
labor market. If a firm’s price is stuck in the short run, then a reduction in aggregate demand reduces the
amount that the firm is able to sell. The firm responds to the drop in sales by reducing its production and
its demand for labor. Note that, in contrast to the sticky-wage and worker-misperception models, the
firm here does not move along a fixed labor demand curve. Instead, fluctuations in output are associated
with shifts in the labor demand curve. Because of these shifts in labor demand, employment, production,
and the real wage can all move in the same direction. Thus, the real wage can be pro-cyclical.

4. The Worker -misperception Model

In any model with an unchanging labor demand curve, such as the models we just discussed,
employment rises when the real wage falls. In these models, an unexpected rise in the price level lowers
the real wage and thereby raises the quantity of labor hired and the amount of output produced. Thus, the
real wage should be countercyclical: it should fluctuate in the opposite direction from employment and
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output. Keynes himself wrote in The General Theory that “an increase in employment can only occur to
the accompaniment of a decline in the rate of real wages.’’
Like sticky-wage model, the worker misperception model focuses on the labor market. It assumes:
1. Wages are not sticky, but they are free to equilibrate supply and demand in the labor market.
2. Workers temporary confuse real and nominal wages due to information asymmetric regarding the
price level. In other words, firms are better informed than workers about the overall price level, P-
its key assumption.
3. The components of the model are labor demand (Ld) and labor supply (Ls) where Ld is a function
of the real wage (W/P), while L s is a function of the real wage that workers expect (W/P e).
Workers know nominal wage (W), but they do not know the overall price, P. Hence, when they
decide on how much to work, they consider the expected real wage to be:
W/P=(W/P)*P/Pe
Hence, labor supply (Ls)= Ls(W/P*P/Pe). This implies labor supply is determined by the real
wage and worker’s misperceptions, P/Pe.
The implication for aggregate supply: Consider an increase in the price level, P and its impact on the
labor market. When P rises there are two possible reactions in the model:
A. If workers anticipated the change, then P e rises proportionately with P and hence there is no
change in Ld and Ls.
B. But, if workers are not aware of the price change, P e remains the same. Then, at every real wage,
workers are willing to supply more labor. They believe that their real wage is higher than it
actually is. The increase in P/Pe shifts the labor supply curve outward, which lowers real wage
and raise the level of employment. In essence, the increase in nominal wage caused by the rise in
price level leads workers to think that their real wage is higher; this induces them to supply more
labor. But in actuality, the nominal wage rise by less than the price level. Here, firms are
assumed to be better informed than workers and to recognize the fall in the real wage, so they
hire more labor and produce more output.
In general, this model says that deviation of prices from expected prices induce workers to alter their
supply of labor. The worker-misperception model implies an aggregate supply curve of the same as the
sticky model. That is, Y= Y + α (P – Pe). Since the price level deviates from the expected price level,
output deviates from its natural rate.

Summary and Implications

We have seen four models of aggregate supply and the market imperfection that each uses to explain
why the short-run aggregate supply curve is upward sloping. Keep in mind that these models are not
incompatible with one another. We need not accept one model and reject the others. The world may
contain all of these market imperfections, and all may contribute to the behavior of short-run aggregate
supply. Although these 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=Y +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. Figure below graphs this equation.

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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.
Now that we have a better understanding of aggregate supply, let’s put aggregate supply and aggregate
demand back together. Figure below 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 P2eand output rises from Y1 to Y2, which is above the natural rate.
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 P2to 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 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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