The Short-Run AS curve

• In the previous topic, we had assumed that any increase

(or decrease) in aggregate demand is met by an increase
(decrease) in supply without any e↵ect on prices.
• We had implicitly assumed that the AS curve is flat, i.e.,
prices are completely fixed.
• In reality, prices do change in the short run, but any
adjustment is sluggish.

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• In the short run, an increase in the overall level of prices in
the economy tends to raise the supply of goods.
• Theories that help explain the upward slope of short-run
aggregate supply are called theories of nominal rigidity.
• The most widely accepted explanation of nominal rigidity
is the sticky price model.

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The sticky price theory

• Nominal prices are slow to adjust, or are “sticky” in the

short run.
• Firms want to set their price (p) according to

p = a + P + bY,

where P and Y are the average price level and aggregate

output respectively.
• At a point in time, a fraction 1 s of firms can set prices.
• The remaining firms set price according to expectations:

p = a + E[P ] + bE[Y ].

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• The average price level in the economy is

P = s(a + E[P ] + bE[Y ]) + (1 s)(a + P + bY ).

• Re-arranging yields
1 s
P =✓+ bY,
s
where ✓ depends on E[P ] and E[Y ].
• This is the short-run AS curve.

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Short-Run AS curve

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When does the short run AS curve shift?

Any supply shock shifts the short run AS curve.

Exogenous

• Oil prices could rise due to increase in risk of a conflict.

• A drought or flood could reduce crop yields.

Policy-induced

• Workers could unionize and negotiate wage increases.

• Environmental regulations could raise the cost of
compliance.

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Explaining business cycles
Equilibrium in the AD-AS model

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Long run equilibrium

• Long run equilibrium occurs at point A.

• The corresponding output is the natural rate of output.
• Any change in aggregate demand is absorbed by prices.

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Short run fluctuations

• In this model, short run fluctuation is any deviation from

the natural rate of output.
• Such deviations could arise due to
• Changes in aggregate demand or money market conditions
• Temporary changes in a country’s capacity to produce
output
• Any such deviation would be captured by a shift of either
the AD curve, or the AS curve, or both.

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A fall in AD

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• In the short run, a fall in aggregate demand causes a
decline in the economy’s output of goods and services.
• But over time, as wages adjust, the economy’s supply of
output rises.
• In the long run, a fall in aggregate demand reduces the
overall price level but does not a↵ect output.

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A fall in AS

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• In the short run, a fall in aggregate supply causes a decline
in the economy’s output of goods and services.
• At the same time, the price level rises.
• This combination of recession and inflation is known as
stagflation.

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Policymakers may respond in di↵erent ways:

• Do nothing and wait for wages and prices to adjust.

• Intervene in the economy using monetary and fiscal policy
that shifts the AD curve. E.g. reduce income tax.
• Intervene in the economy using fiscal policy that shifts the
AS curve. E.g. provide investment subsidies.

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Automatic stabilizers

Automatic stabilizers are changes in fiscal policy that stimulate

aggregate demand when the economy goes into a recession
without any intervention from policy makers.

Automatic stabilizers include

• Tax system
• Transfer payments

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Example: Proportional income tax

• Consider a simple aggregate demand equation:

Y = a + b(1 ¯
t)Y + I,

where t 2 (0, 1) is the income tax rate.

• Then the e↵ect of a change in I¯ on income is
Y 1
= .
I¯ 1 b(1 t)

• Observe that t > 0 results in a smaller e↵ect on income.

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