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 ( K , L )  (Y )

Aggregate supply and prices are not related in the long-run. Output is fixed at (Y ) . 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. Y 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)

A
P1
AD1
B
P2
AD2

Income, Output, 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 AD1 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

B A
P
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 Y1 to Y2 in Figure 5.2, price does not instantaneously
adjust. It remains fixed at P .

Figure 5.3: Adjustment towards Long-Run Equilibrium

P LRAS

A
SRAS
P B
P AD1
C
AD2
C
Y
Y2 Y1

Assume the economy initially works on point A, where AD1 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 AD1 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

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lower than the 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
Y
Assume that the economy was at point A, where AD1 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 Y2, 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 AD1 to AD2; and the economy goes back to

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the natural employment level. However, the cost of this policy is a permanently higher level of
prices despite ensuring natural employment at point C.

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:

5.2. Y  Y   ( P  P e ),   0.

Where Y is actual supply of output; Y 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  indicates how much
output responds to unexpected changes in the price level; 1/  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
based on the target real wage w and the expected price level P e . Thus, the contractual
wage is given by

5.3. W  wPe

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

Equation 5.4 indicates that when the actual price is greater than the expected price,
( P  P e ) actual real wages becomes lower than its target. On the contrary, if the actual

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 price is lower than expected ( P  P e ) , then the target real wage rate becomes higher
than the expected.

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

5.5. L  Ld (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

L L
L12 L2 L1 L2
P
Fig 5.5 (C): Aggregate Supply

Y  Y   (P  P e )
P2

P1
Y

Y1 Y2
Because the nominal wage W is stuck; an increase in the price level from P1 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.

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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 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.

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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, 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  Y )

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  Y ) . 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.

5.7. p  p e  a (Y e  Y e )

For simplicity, assume firms expect output to be at its natural rate, so that (Y e  Y e )  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:

5.9. P  sP e  (1  s )[ P  a (Y  Y )
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  Y )

Divide both sides of Equation 5.10 gives us,

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   s (1  s )a , Equation 5.11, can be re-written as:

5.12. P  p e  (1  )(Y  Y )

Further rearranging Equation 5.12 gives the general aggregate supply equation as indicated in
Equation 5.2; which is once again given by: Y  Y   ( P  p e ) .

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
P3 = P3e C

B AS1

P3 A
e e AD2
P1  P1  P 2

AD1
Y
Y Y

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This creates short-run fluctuation in output with a magnitude between Y and Y2. This
unexpected expansion in AD causes the economy to boom. This boom does not last forever. In
the long run, the expected price level rises to catch up with reality. This causes the short-run
AS curve to shift upward. As the expected price level rises from P2e to P3e 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 Y . 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.