CHAPTER FOUR

AGGREGATE SUPPLY

4.1. INTRODUCTION

We have developed a framework for understanding the demand for goods and
services as a function of the aggregate price level (among other things). We now need
the other part, that is aggregate supply, and how it depends on the aggregate price
level. Aggregate supply is the total supply of all goods and services in an economy
and it is made up of two parts
1. Long-run aggregate supply (LAS)
2. Short-run aggregate supply (SAS)
It is the SAS that we will be concerned with, since almost all macroeconomists agree
that the Long-run aggregate supply curve is vertical and that business cycles are a
short-run phenomenon (but as you can guess aggregate supply in the short-run is
related to aggregate supply in the long-run). This relationship will become clearer
through the relations that we are going to discuss.

Though we reserved the details for this chapter and this section we have established
from the very beginning of this course that macroeconomists disagree on the shape of
the short-run aggregate supply curve. In the long-run, prices are flexible, and the
aggregate supply curve is vertical. This can be summarized by the following section.

2. AGGREGATE SUPPLY CURVE UNDER PERFECT INFORMATION AND

FLEXIBLE PRICES

The model we are about to develop encompasses how economists of most stripes and
hues believe the economy to operate in the long-run and some economists also believe
it operates in the short-run. Although not explicitly introduced in Chapter 13 of
Mankiw, what we are going to look at now is the base case from which other variants
should be compared.

Key Parts — the model with perfect information and flexible prices consists of three
key parts, which feature in all theories of AS:

1. The Labour Market

1.1 Supply of Labour — is the result of households choosing how much labour to
supply, how much leisure to consume, and how much consumption to undertake given
the general level of prices and the wage rate. It is upward sloping in the real wage.
1.2 Demand for Labour — is the result of firms choosing how much labour to
employ, given their capital stock (and other inputs), the price of their output, and the
wage rate. It is downward sloping in the real wage.
2. Production Technology
There is some technology available which describes the relationship between inputs
used (e.g. labour and capital) and output produced from those inputs. Normally it is
assumed to be of the constant returns to scale form.

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3. The Capital Stock
In the short-run the capital stock is fixed so that at a point in time there is a given
amount of capital which is used to produce output. The capital stock changes over
time due to net investment being positive (which can be negatively influenced by the
real interest rate). Note that the MPL is positively related to the amount of capital.

Assumptions about How Markets Work — this model includes the following
assumptions, and this is where the controversy occurs when using it to describe the
short-run (but not the long-run):
1. Perfect Information — this means that everyone knows all of the current
(and past if they are important) values of all prices in the economy. That is
they know the prices of all goods and services (final or inputs) that are
relevant to their optimisation problem.
2. Flexible Prices — inter-twined with clearing markets is the assumption
that prices of inputs and final goods are flexible, that they are free to rise if
excess demand occurs, or fall if excess supply occurs.
3. Clearing Markets — this means exactly what is says, that there is neither
excess supply nor excess demand and is a consequence of 1 and 2.
Vertical AS Curve
Putting these parts together gives us the AS curve as shown in the following diagram:

AS

Y = Potential output level

Vertical AS graph

Consider now why the AS curve is vertical:

Say that the price level increases:
1. The quantity of labour demanded will increase because the real
wage has fallen using the new price level and the old nominal wage
rate (i.e. The dollar price of a firm’s output has risen, but the dollar
cost of the inputs has not changed. This makes it profitable for firms
to hire extra units of labour.
2. The quantity of labour supplied will fall because the real wage has
fallen using the new price level and the old nominal wage rate (i.e.
the price of consumption goods has increased relative to the “price”
of leisure, so households will consume more leisure and therefore
supply less labour).
These effects result in an excess demand for labour and so the nominal wage increases
until the quantity of labour supplied equals the quantity of labour demanded. Nothing
“structural” (capital stock, production technology etc) has changed so the new real
wage will just equal the old real wage. Thus aggregate supply is independent of the
aggregate price level.

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• Comments
1. It is assumed that people and firms know what the prices actually are;
otherwise they would not change the amounts of labour they demand and
supply. This is where perfect information comes in.
2. Prices are assumed to be able to change, that is they are flexible, at any time
and by any amount to restore equilibrium. Hence why W ↑.
3. Markets clear; that is, in equilibrium there is no excess demand or supply of
any factor (or, it turns out, of any final good). This is an implication of 1
and 2.
4. Unemployment can occur, but it is only frictional unemployment which
arises out of the normal operation of an economy. This is where the
“natural rate of unemployment” is introduced. This is somewhat different
definition of “clearing markets” than we are normally used to, but
operationally it is of no consequence to our analysis.
5. If we take the theory of the SAS curve implied in this section to its logical
conclusion then shocks to AD can only ever affect the aggregate price level
and will never affect aggregate output. The only way in which output can
change is if something happens to the production side of the economy e.g.
technology improves, droughts occur etc. Many economists feel
uncomfortable with this. More importantly the evidence to date does not
conclusively support this implication e.g. the evidence available may be
consistent with things such as money supply changes having short-run
affects on output (it may also be consistent with other things).

A vertical SAS curve depends crucially on the assumptions of market clearing and
information availability. Various economists argue that the assumptions of perfect
information, or flexible prices, or both, do not hold in the short-run. What we will do
next is see what happens when we relax each of the two assumptions underpinning the
vertical AS curve. Each case provides a theoretical reason why the SAS curve may be
positively sloped without being vertical, and hence why aggregate output may be
affected by changes in the price level in the short-run.

The above supply curve (vertical-supply curve) which is based on flexibility of prices
and perfect information implies that shifts in the aggregate demand curve affect the
price level, but the output of the economy remains at its natural rate. But in contrast to
this 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. There are
three commonly argued reasons why all or some set of aggregate prices may be
“sticky” in the short-run: two are to do with the labour market and one is to do with
the prices of all goods and services, that is, the price level. By sticky, I mean that
prices in markets do not change instantaneously to changes in demand or supply but
only change slowly over time. In each case we can show that the SAS is positively
sloping.

In the following sections we will discuss three 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

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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. After examining the models, we examine an implication of the short-run
aggregate supply curve. We show that this curve implies a trade-off between two
measures of economic performance—inflation and unemployment. According to this
trade-off, to reduce the rate of inflation policymakers must temporarily raise
unemployment, and to reduce unemployment they must accept higher inflation.

3. Three Models of Aggregate Supply Curve

We will examine these three 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 three 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   (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 three 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.

3.1 STICKY NOMINAL WAGE MODEL

The first argument we will look at has to do with the operation of the labour market.
In particular, some economists have argued that there are factors that make the
nominal wage inflexible in the short-run. We will see what these factors are and the
implications this would have for the whole economy.

Contract versus Auction Markets

Recall from the section on the labour market that we found that the labour market was
not an auction market, but was instead a contract market. That is, suppliers of labour
services and buyers of labour services entered into contracts which set the values of
various employment related parameters. One important such parameter is the value of
the nominal wage. Typically the contract will also cover working conditions
concerning hours of work, redundancy, grievance procedures, etc.

Such contracts are not typically renegotiated instantaneously if the economy

experiences a “shock” (although in principle renegotiation clauses could be included

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in a contract) because it would be terribly expensive to do so. Thus contracts are only
renegotiated infrequently.

When the contract is negotiated firms and suppliers have to guess what will happen to
the price level for the period of the contract. Both groups will have some expectation
about:

1. The future price level.

2. Some target level of the real wage.
The contract is successfully negotiated when the two groups have common
expectations about the price level and a common target real wage rate. The common
target real wage will be the one that clears the labour market if the actual price level
equals the forecast price level.

Furthermore, many contracts are claimed to have the feature that workers agree to
supply the quantity of labour demanded by firms, either through things like overtime
or working fewer hours a week or being made redundant if necessary. This would
imply that given a contracted nominal wage, that the demand for labour determines
the actual quantity of labour traded over the lifetime of the contract, which changes as
the state of the economy changes.

Note: there is also some evidence that the nominal wage is particularly inflexible
downwards (found by an economist called Bewley). That is, firms do not like to
reduce nominal wages of workers. This is claimed to occur because of workers feeling
that these cuts reduce their status and are an insult to them, which lowers their morale,
and their productivity.

Graphing This Case

Using the basic framework we developed above we can see that we do not get a
vertical sloping aggregate supply curve, instead we get the following:

Price SRAS
level

Output/Income

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Consider now why the AS is upward sloping.
First, introduce a bit of notation:
W = the nominal wage.
P = the actual aggregate price level.
W
= the actual real wage.
P
Pe = the expected aggregate price level.
W = contracted nominal wage workers and firms agree to at the beginning of
the contract period.
Noting also that the quantity of labour traded at a point in time once the
contract is agreed to is given by the labour demand function, that is

L = Ld (Pe = P).
Over the course of the contract the actual price level is observed. There are three cases
to consider:

1. P = P0.
=> We are on the LAS curve, in fact where the SAS intersects the LAS. At
this price level, the real wage based on W clears the labour market.

2. P = P1 < P0.
W W
=> 
P1 P0
=> quantity of labour demanded labour decreases.
=> employment falls because firms layoff workers and/or workers cut back
the hours they work.
=> output decreases below Y0.
Notice that there is unemployment in this case of L0 − L1.

3. P = P2 > P0.
W W
=>  .
P2 P0
=> the quantity of labour demanded increases.
=> employment increases because workers agreed to supply whatever was
demanded at the nominal wageW, and the nominal wage has not changed.
=> output increases above Y0.

Comments

1. Bodies versus Hours: There is a bit of an asymmetry in the model which hints that
it might not be fully internally consistent or consistent with what we observe.
 When the real wage is higher than expected when negotiating the
contract, it must be that either existing workers work fewer hours
and/or that people are laid off.
 When the real wage turns out to be unexpectedly lower than was
thought in the negotiations, the increase in employment must be in
hours worked, not in people employed. i.e. it is overtime clause in the

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 negotiated contracts, since you can’t force people to work for the low
real wage!

So only adjustment in hours works one way, but it may be “bodies” another way.
Furthermore, most of the focus of booms, is about lower unemployment, not hours
worked per se, which seems inconsistent with this theory of the labour market.

2. Expectations Matter: The position of the SAS curve depends on the expectations
formed by firms and workers because underlying it are expectations of the price level
(and hence everything which could affect the future value of the price level) firms and
workers form in negotiating their labour market contracts. The LAS and SAS curves
are related as the point where Pe = P, or where expectations of the price level are
consistent with the actual price level, is where they intersect.

3.2. Sticky Price Model

The sticky price 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 catalogue or price list, it is costly to alter prices.

In the previous discussions we have thought of firms’ choosing how much output to
produce, taking as given the price at which they can sell their output. If we really want
to explain why prices may be sticky, we have to think about who actually sets prices
and on what basis. In reality, firms generally set the prices at which they want to sell
their output. To analyse this situation properly, we need models of imperfect
competition in which firms have some monopoly power.

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

 The overall price 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 )
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
(a > 0) 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

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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 )
For simplicity assume that these firms expect output to be at its natural rate, so the last
term, a (Y e  Y e ) , is zero. Then these firms set price as
p= P e .
That is, firms with sticky prices set their prices based on what they expect others firms
to charge.

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  sP e  (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

P  P  sP  sP e  P  a (Y  Y )  sP  sa (Y  Y )  P  sP
sP  sP e  a (Y  Y )  Sa (Y  Y )
sP  sP e  a (1  s )[Y  Y ]
Dividing both sides by s to solve for the overall price level:

a (1  s )
P  Pe  [Y  Y ]
s
The two terms in this equation are explained as follows:
 When the 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 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.
Hence, the overall price level depends on the expected price level and on the level of
output.

From the price equation above we can derive the aggregate supply equation using
some algebraic manipulation.

a (1  s )
Letting to be n, the price equation above can be written as
s
P  P e  n[Y  Y ] , and we can solve for Y- i.e

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 nY  nY  P  P e
1
YY  (P  P e )
n
1
Letting to be equals to 
n
Y  Y   (P  P e )
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.

Aggregate Demand and Aggregate Supply

P AS2

C
e
P3=P 3
AS1
P2 B
P1=P1e=p2e A
AD2
AD1

Y
Y1=Y3= Y

In the short run, the equilibrium moves from point A to 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 P e2, 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 SR aggregate supply curve to shift upward. As the
expected price level rises from Pe2 to Pe3, the equilibrium of the economy moves from
point B to point C. The actual price level rises from P 2 to P3, and output falls from Y2
to Y3 = Y . In other words, the economy returns to the natural level of output in the
long run, but at a much higher price level.

3.3 THE ISLAND ECONOMY MODEL (IMPERFECT-

INFORMATION/LUCAS’ MODEL)

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In this case prices and wages are assumed to be perfectly flexible, and markets clear,
but it is assumed that at the time firms and workers make decisions that neither groups
have perfect information about prices of goods or inputs. Hence, in this case the short-
run and long-run aggregate supply curves differ because of temporary misperceptions
about prices.

Rationale behind Imperfect Information

The basic argument is that there so many prices that no one is capable at a point in
time of knowing them all because it is prohibitively expensive to do so i.e.
information is costly and so people do not try and acquire all of the possible available
information. A way of thinking about this is to view the economy as composed of
many separate competitive markets, or “islands”, which periodically trade with each
other. The firms and workers on each island, or market, therefore know the actual
prices of their own goods but not of goods and services on many of the other islands
that make up the economy. This means that they have to form an expectation about
the price level, and ultimately about the relative prices of the goods they produce and
of the inputs they purchase. The result is that when they trade with other islands, or
markets, and observe changes in these prices the firms and households are not sure if
it is the price level that has changed or the relative prices of the goods they produce or
the inputs they purchase. They could make a mistake, and, if they do so, this means
changes in the price level could cause the amount of output produced and inputs
purchased to change, or, that the SAS is not vertical.

Graphing This Case

The SAS where workers and firms may have imperfect information about prices can
be graphed as follows:

Let us see what the graph is saying by considering an increase in the aggregate price
level (i.e. P ↓ from P0 to P1):

1. Firms
=> A firm sees that the price of its good decrease and thinks that it is a decrease in the
relative price of its output (note that the firms don’t know that P has decreased).
=> the firm wants to decrease production and thus decreases its demand for labour.
=> as part of demanding less labour the nominal wage it is offering decreases.

– 2. Workers

Workers at the firm see that their nominal wages have gone down and mistakenly
think that this is a decrease in their real wage. They may see some other prices of a
few of the goods they buy frequently decrease as well, but their prices may have
changed because of factors other than reflecting a decrease in the price level, so they
don’t know that P has decreased.
e.g. changes in consumer tastes, changes in production technology, changes in
the price of an input, etc. [you have to ask yourself here if you think prices of all
goods decrease immediately given some “economic shock” or if the effects of such a
shock take time to feed through to all prices.]

– 3. Overall

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The end result is that the demand for, and supply of, labour both decrease so that the
quantity of labour traded decreases from L0 to L1 and thus output decreases from Y0
to Y1.
We know also that the nominal wage has decreased, here from W0 to W1. We cannot
say for certain about what will happen to the real wage.
e.g. if Ls ↓> Ld ↓=> W/P ↑.
e.g. if Ls ↓< Ld ↓=> W/P ↓.
The movement in the real wage may thus depend on distributional considerations: e.g.
the average level of prices has increased, but prices of some goods may increase by
more than others and vice versa.
Different labour markets will be affected in different ways. The effect on the
aggregate labour market will depend on the sum of all of these effects.

Comments
• 1. The above story gives a plausible reason as to why output may be above or below
its long-run value.
• 2. A pertinent question to ask is for how long people would be ignorant of what is
actually happening.
– Measures of the money stock and the price level are available reasonably promptly.
– Measures of real output take along time to become available, and can be highly
inaccurate.
Really this story is about a “signal-extraction” problem and for a temporary shock to
have lasting effects requires that the signal be very noisy.

3.4. Summary and Implications (to be completed in class)

4. Inflation, Unemployment, and the Phillips curve

Two goals of economic policymakers are low inflation and low unemployment, but
often these goals conflict. Suppose, for instance, that policymakers were to use
monetary or fiscal policy to expand aggregate demand. This policy would move the
economy along the short-run aggregate supply curve to a point of higher output and a
higher price level. Higher output means lower unemployment, because firms need
more workers when they produce more. A higher price level, given the previous year’s
price level, means higher inflation. Thus, when policymakers move the economy up along the
short-run aggregate supply curve, they reduce the unemployment rate and raise the inflation
rate. Conversely, when they contract aggregate demand and move the economy down the
short-run aggregate supply curve, unemployment rises and inflation falls.

This trade-off between inflation and unemployment, called the Phillips curve, is our topic in
this section. As we have just seen (and will derive more formally in a moment), the Phillips
curve is a reflection of the short-run aggregate supply curve: as policymakers move the
economy along the short-run aggregate supply curve, unemployment and inflation move in
opposite directions. The Phillips curve is a useful way to express aggregate supply because
inflation and unemployment are such important measures of economic performance.

Deriving the Phillips Curve from the Aggregate Supply Curve

The Phillips curve in its modern form states that the inflation rate depends on three
forces:

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  Expected inflation
 The deviation of unemployment from the natural rate, called cyclical
unemployment
 Supply Shocks
This can be presented as:

   e   (u  u n )  
where β is a parameter measuring the response of inflation to cyclical unemployment.
Notice that there is a minus sign before the cyclical unemployment term: high
unemployment tends to reduce inflation. This equation summarizes the relationship
between inflation and unemployment. From where does this equation for the Phillips
curve come? Although it may not seem familiar, we can derive it from our equation
for aggregate supply. To see how, write the aggregate supply equation as

1
P  P e    (Y  Y )
 
With one addition, one subtraction, and one substitution, we can manipulate this
equation to yield a relationship between inflation and unemployment. Here are the
three steps. First, add to the right-hand side of the equation a supply shock υ to
represent exogenous events (such as a change in world oil prices) that alter the price
level and shift the short-run aggregate supply curve:

1
P  P e    (Y  Y )  
 
Next, to go from the price level to inflation rates, subtract last year’s price level P-1
from both sides of the equation to obtain:

1
( P  P1 )  ( P e  P1 )    (Y  Y )  
 

This gives us:

1
   e  ( )(Y  Y )  

To go from output to unemployment, recall from Chapter 1 that Okun’s law gives a
relationship between these two variables. One version of Okun’s law states that the
deviation of output from its natural rate is inversely related to the deviation of
unemployment from its natural rate; that is, when output is higher than the natural rate
of output, unemployment is lower than the natural rate of unemployment. We can
write this as

1
( )(Y  Y ) =   (u  u n )


Since the above terms can be substituted for one another, we can write our previous
equation as:

   e   (u  u n )  

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Thus, we can derive the Phillips curve equation from the aggregate supply equation.

All this algebra is meant to show one thing: the Phillips curve equation and the short-
run aggregate supply equation represent essentially the same macroeconomic ideas. In
particular, both equations show a link between real and nominal variables that causes
the classical dichotomy (the theoretical separation of real and nominal variables) to
break down in the short run. According to the short-run aggregate supply equation,
output is related to unexpected movements in the price level. According to the Phillips
curve equation, unemployment is related to unexpected movements in the inflation
rate. The aggregate supply curve is more convenient when we are studying output and
the price level, whereas the Phillips curve is more convenient when we are studying
unemployment and inflation. But we should not lose sight of the fact that the Phillips
curve and the aggregate supply curve are two sides of the same coin.

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