CHAPTER 5: AGGREGATE SUPPLY CURVE

5.1. Introduction

Chapter 3 and Chapter 4 discuss about aggregate demand. Chapter 5 discusses how different
assumptions about price formations and time horizon will change the shape of aggregate supply
curve and how the changes in government policies will bring different equilibrium level of
income depending on the shapes of aggregate supply curves. Aggregate supply depicts the
aggregate supply of goods and services supplied in the economy with prices.

5.2. The Classical Long-run Average Supply Curve

The long-run supply curve is drawn based on the underlying assumptions of the Classical School
of thought. Given the available technology, the amount of output produced in the economy
depends on the fixed amount of capital and labour available in the economy. This is given by:

5.1. Y =F ( K̄ , L̄)=( Ȳ )

Aggregate supply and prices are not related in the long-run. Output is fixed at ( Ȳ ) . Prices are
fully flexible; their changes do not have any effect on output in the long run perspective. Thus,
an increase or decrease in money supply or any change in government spending may affect
aggregate demand curve; and change the equilibrium price level. These changes in AD and the
subsequent change in prices do not change the equilibrium level of income in the long run. The
aggregate supply curve is fixed. Ȳ is at full employment or natural level of output. The country’s
resources are either fully employed or unemployment is at its natural rate. Changing the
unemployment status-quo could only be possible in the short-run but maintaining this change
may not be sustainable in the long-run.

Figure 5.1: Long-Run Vertical Aggregate Supply Curve

Price level (P)

LRAS

A
P1
1 AD1
P2 B
AD2

Income, Output, Y

Y
For instance, if government reduces its money stock, AD declines and shifts the LM curve to left
in the IS-LM plane. Accordingly, AD curve shifts downwards from AD 1 to AD2, moving the

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equilibrium level of income from point A to B in Figure 5.1. Given vertical AS, the reduction in
AD affects only the price level; but does not have any effect on the fixed output level.

5.2. The Keynesian Short-run Horizontal AS Curve

In the short-run, at least some prices are sticky; they do not change with changes in aggregate
demand. Thus, AS curve is either upward sloping or horizontal. In the extreme, case all prices
are fixed in the short-run. In this case, we have horizontal SRAS curve. In this case, any fiscal or
monetary expansion leads to a change in equilibrium level of income without having any effect
on prices.

Figure 5.2: Short-Run Horizontal Aggregate Supply Curve

P

B A
P
AD1
AD2

Y
Y2 Y1
For instance, given horizontal SRAS, a reduction in money stock, leads into a lower equilibrium
level of income as AD declines as a result of a leftward shift of the LM curve in the IS-LM
plane. Thus, the equilibrium level of income from Y 1 to Y2 in Figure 5.2, price does not
instantaneously adjust. It remains fixed at P̄ .

Figure 5.3: Adjustment towards Long-Run Equilibrium

P LRAS

P B SRAS
AD1
C
AD2
C
Y
Y2 Y1

Assume the economy initially works on point A, where AD 1 is crossing the short-run AS curve
and long-run AS curve. A contractionary government policy, for instance, as a result of reduction
in money supply shifts the aggregate demand curve from AD 1 to AD2 with a new short-run
equilibrium at point B. Output is below its natural level given short-run sticky prices. As prices
fall, the economy gradually moves from recession at point B to point C. In this new equilibrium
point, output and employment are back to their natural levels, but prices are now lower than the

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case at point A. Any measure that affects AD will affect employment and output in the short-run;
but as firms adjust their prices the economy would restore to the natural level of employment.

In the short-run, output and employment fluctuates over their long-term natural level of
employment. Governments take policy actions to reverse back the economy into its natural level.
This policy action taken by government to reduce the severity of short-run economic fluctuations
is called stabilization policy. Stabilization policy dampens the business cycle by bringing back
output and employment to its long-run equilibrium level. If, for instance, by non-government
action AD shifts upwards; then in the short-run firms may tend to hire additional workers and
request those workers in the factories to work more hours than before. Using extra effort and
make greater use of machinery and equipment, firms may boost their production. This situation
leads the economy to operate beyond it natural level of employment or boom. However, this
situation is unsustainable. An increase in AD will not only pull up wages and prices in the long-
run but also as a reaction of which quantity demanded would decline. The economy gradually
approaches to its natural level of output. Observing that the economy is heat by short-run
aggregate demand shock, government may take stabilization policy. If government reduces the
money stock in the economy, AD will reduce; thus the natural level of employment may be
ensured even in the shorter period possible.

Similarly, AS shocks could arise as a result of drought, oil price hike, workers unions’
aggressiveness in terms of demanding for higher wages, etc. These are adverse supply shock. On
the other hand, a favorable supply shock may arise because of technological innovation, new
discoveries of natural resources, reduction of oil prices, etc.

Figure 5.4: Adjustment to a Short-run Aggregate Supply Shock

P LRAS

B C
P2 SRAS2
A
P1 SRAS1
AD2
AD1
Y
Y2
Y
Assume that the economy was at point A, where AD 1 curve crosses the short and long-run AS
curves. Assume that an adverse supply shock occurs; which shifts the short-run AS curve to
SRAS2 with the new equilibrium point at B. In this point, the income declines to Y 2, whereas
price goes up to p2. This is staginflation, which is a combination of increasing prices and falling
in output (increasing unemployment). In response to an adverse supply shock, central bank can
take expansionary fiscal or monetary policy and stimulate aggregate demand. Accordingly, the
aggregate demand curve shifts from upwards from AD 1 to AD2; and the economy goes back to
the natural employment level. However, the cost of this policy is a permanently higher level of
prices despite ensuring natural employment at point C.

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5.3. Keynesian Upward Sloping Short-Run Aggregate Supply

Unlike the classical extreme long-run vertical supply curve and also the horizontal aggregate
supply of the Keynesian case, aggregate supply can be upwardly slopped. Economists try to
highlight a particular reason for the unexpected movements in the price level that are associated
with AS. They use different ways but end up with concluding on one particular AS equation of
the form:

e
5.2. Y =Ȳ + α( P−P ), α >0 .

Where Y is actual supply of output;Ȳ is natural rate of output; P is actual price level and Pe is
expected price level. Equation 5.2 states that output deviates from its natural rate when the actual
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 AS curve.

5.3.1. The Sticky-Wage Model

Normally wages are set by long-term contracts; so nominal wages cannot be adjusted quickly
when some other economic conditions change. To show how this model works, we start with the
assumption that the price level rises. When the nominal wage is stuck, a rise in the output price
level lowers the real wage and making labor cheaper. This situation induces firms to hire more
labor and the additional workers hired could produce more output. Thus, aggregate supply curve
slops upward during the time when the nominal wage cannot adjust. To formally develop the
aggregate supply equation, let us make a couple of assumptions.

a) Assume workers and firms agree on the nominal wage and sign contracts before they
know what the output price will be when their agreement becomes effective. This wage
rate is higher than the equilibrium level real wage rate that keeps the labor market at
equilibrium. This is because of consideration of the demands of workers’ unions and
efficiency wage that we discussed in Chapter 1. The contractual nominal wage W is set
e
based on the target real wage w and the expected price level P . Thus, the contractual
wage is given by

e
5.3. W =wP

e
If the actual price deviates from the expected price ( P≠P ) , the real wage becomes
W Pe
=w
5.4. P P

Equation 5.4 indicates that when the actual price is greater than the expected price,
( P> Pe ) actual real wages becomes lower than its target. On the contrary, if the actual
e
price is lower than expected( P< P ) , then the target real wage rate becomes higher than
the expected.

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 b) Assume also that employment is determined by quantity of labour firms demand as per
the agreement.

d
5.5. L=L (W /P )

Equation 5.5 says firms’ demand for labor is (inversely) related to the real wage rate. Output is
determined by the production function and labour input. The more labor is demand and hired; the
more output is produced. The derivation of aggregate supply based on this model is given below.

Fig 5.5 (b): Production Function

Fig 5.5 (a): Labour Demand
W /P Y

W/P1 L  LD (W P) Y2
Y  F (L)
W/P2 Y1

L L
L121 L2 L1 L2
P
Fig 5.5 (C): Aggregate Supply

P2
Y  Y   (P  Pe )
P1
Y

Y1 Y2
Because the nominal wage W is stuck; an increase in the price level from P 1 to P2 reduced the
real wage level from W/P1 to W/P2. Lower real wage (W/P2) is associated with higher quantity of
labour demand and employed (L2) as shown on labour demand Panel (a). An increase in the
number of workers from L1 to L2 raises output from Y1 to Y2 in Panel (b). The interactions in
Panel (a) and Panel (b) lead to aggregate supply curve derivation in Panel (c). An increase in
price level increases the number of workers in Panel (a) and raises output in Panel (b). This
situation leads to a direct relationship between aggregate supply and price level. This whole
outcome is because of deviation of actual price from its expected level. Ultimately, this process
can be systematically captured by the aggregate supply equation expressed by Equation 5.2
above.

5.3.2. Cyclical Behavior of Real Wages

Real wage should be countercyclical. It should fluctuate in the opposite direction from
employment and output as Keynes himself indicated in his book entitled the General Theory.
When real wages increase employment and output tend to decline as already indicated. Instead of
changes in prices, real variable changes bring demand curve shifts. Economists argue that labor
demand curve is not constant; labor demand curve may shift whenever there is real business
cycle. For instance, technology shock, which alter labor productivity, can cause a shift in demand

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curve. As a result of that we may witnessed a different approach of deriving aggregate supply
curve; but ultimately we could have the same equation of aggregate supply as depicted in
Equation 5.2.

5.3.3. The Imperfect Information Model

This model assumes that all wages and prices freely adjust to balance supply and demand and
because of that markets clear. Deviations between short-run and long-run aggregate supply arise
because of some misperceptions about prices. The model assumes that each producer produces a
single product and consumes many goods. Thus, they cannot observe all prices at all times. They
monitor the prices of all the goods they produce; not the prices of goods they consume. 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 in
response to perceived relative prices. This is likely to lead to a positive relationship between
aggregate supply and price level in the short-run.

As an example, take a wheat producer who gets his income from the sales of his wheat. If the
relative price of wheat is high, the farmer will work hard and produce more to get high rewards.
If the relative price of wheat is low, he may reduce his production; instead he opts to spend part
of his time to maximize his leisure. In practice, the wheat producer only knows the price of
wheat and does not know his relative price. He simply tries to estimate the relative price of wheat
using the nominal price and his expectation of the overall price level.

Assume that all prices including the price of wheat increase. The reaction of the farmer could be
among the following alternatives.

(a) If he assumes that all other prices have increased as the increase of the price of wheat.
Relative price is unchanged and thus the wheat producer does not need to exert much
effort of hard work.
(b) If he assumes that as the price of wheat increases, the prices of at least some products
increase. Since the price increase is only for some items and the price of some items are
constant. The relative price of wheat is likely to increase as per the perception of the
farmer and thus motivates him to produce more;

All other producers are likely to have this rational expectation and thus ultimately lead to have an
aggregate supply curve of the economy as indicated in Equation 5.2.

5.3.4. The Sticky-Price Model

Firms do not instantly adjust prices. Sometimes prices are set by long-term contracts between
firms/producers and consumers/buyers. Even if demand has increased, sometimes firms may
hold prices as they used to be in order not to annoy customers with frequent price changes.
Firm’s desired price p depends on two macroeconomic variables (aggregate income (Y) and
aggregate price level (P). A higher price level implies that costs of firms are likely to be higher
and thus the more would the firm like to charge for his products. An increase in income in the
economy leads to an increase in the demand for the firm’s product. However, on the supply side,

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at higher level of production the marginal cost tends to increase and thus increases the cost of
production and the price of goods. Based on these presumptions the AS is given by:

5.6. p=P+a(Y −Ȳ )

Equation 5.6 shows that actual price charged by a typical firm p depends on the overall price
level (P) and the level of aggregate output relative to the natural rate ( Y −Ȳ ) . a> 0 and it
measures how much the firm’s desired price responds to the level of aggregate output.

Assume there are two types of producers: the ones who have flexible prices and others who have
sticky prices.

i. Firms with flexible prices charge price as Equation 5.6.

ii. Firms’ with sticky prices set their prices according to:

e e e
5.7. p= p +a(Y −Ȳ )

e e
For simplicity, assume firms expect output to be at its natural rate, so that (Y −Ȳ )=0 and thus
set price

5.8 p= p e

Firms with sticky prices set their prices based on what they expect other firms or producers will
charge.

A weighted average of the pricing rules of the two groups of firms could be used to derive the
aggregate supply equation. Let us denote s as the fraction firms with sticky prices and (1-s) is the
fraction of firms with flexible prices. The overall price could be given by:

P= ⏟e
sP ⏟
+(1−s )[ P+a(Y −Ȳ )
5.9. flexibleprice stickyprice

Subtract (1−s)P from both the left and the right side of Equation 5.9 to get
5.10. sP=sp e +(1−s )a(Y −Ȳ )

Divide both sides of Equation 5.10 gives us,

5.11.
P= p e +
(1−s )
s [
a(Y −Ȳ ) ]
Equation 5.11 gives the following implications:

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 (a) When firms expect a high price level, they expect high costs. Firms that fix prices in
advances set their prices high; which causes other firms to set high prices also. High
expected price leads to high actual price level.

(b) When output (income) is high, the demand for goods is high. Those firms with flexible
prices set their prices high, which leads to higher price level. The effect of output on the
price level depends on the proportion of firms with flexible income.

Generally, therefore, overall price depends on expected price and output or income level. If we
let α=s/(1−s)a , Equation 5.11, can be re-written as:

e
5.12. P= p +(1/α )(Y −Ȳ )

Further rearranging Equation 5.12 gives the general aggregate supply equation as indicated in
e
Equation 5.2; which is once again given by: Y =Ȳ + α( P− p ) .

The final conclusion is the same. The deviation of output level from its natural rate is positively
associated with the deviation of price from the expected price level. In this model, a firm’s price
is stuck in the short-run. A reduction in AD reduces the amount of that the firm wants to sell.
This forces firms to reduce production and labour demand. Unlike the case of sticky wage
model; fluctuations in output are associated with shifts in the labour demand curve. Thus, labour
demand, employment, production and the real wage can all move in the same direction in the
sticky price model.

5.4. Effects of AD Changes on Equilibrium Level of Income

Assume that the economy operates at long-run equilibrium point A. When AD increases because
of fiscal expansion or monetary expansion, the price level rises from P1 and P2 in Figure 5.6.

Figure 5.6: Short-run Fluctuations in AD and their Long-run Effects on Equilibrium Income

P
LRAS

AS2
P3e C

B AS1
A
AD2
P1  P1e  P2e
AD1
Y
Y Y

This creates short-run fluctuation in output with a magnitude between Ȳ and Y2. This
unexpected expansion in AD causes the economy to boom. This boom does not last forever. In

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the long run, the expected price level rises to catch up with reality. This causes the short-run AS
e e
curve to shift upward. As the expected price level rises from P2 to P3 and the equilibrium of the
economy moves from point B to point C. The actual price increases from P2 and output falls
from Y to Ȳ . The economy returns to the natural level of output in the long-run, but at a much
higher price level. This indicates that in the short-run monetary policy is not neutral. It has an
effect. However, this short-run effect has not been sustainable and thus leads to only price
changes without change in equilibrium level of income.

5.7. Conclusion

The shape of AS curve varies with the time horizon assumed for prices adjustment as
consequence of AD or AS fluctuations. In the long-run, prices are assumed to be perfectly
flexible. Any short-run fluctuation arising from a change in the AD will only lead to price
changes; without having any effect on output. Accordingly, the AS curve is vertically slopped. It
is named as the classical aggregate supply curve because of their underlying assumptions about
prices. In the short-run, there is short-run horizontal AS curve; assuming that prices are perfectly
sticky. Thus, any fiscal or monetary policy that causes AD to change brings changes in the
equilibrium level of income; without causing price changes of any sort. However, even in the
short-run, some prices could be sticky but some others are flexible. There are different methods
on how to derive upward slopping AS curves. However, all of them come-up on one conclusion:
output rises above the natural rate when the price level exceeds the expected price level. Output
falls below the natural rate when the price level is less than the expected price level. The
discussions on chapters three, four and five were based on the following general framework and
resultant outcome.