CHAPTER _FIVE

5. AGGREGATE SUPPLY
5.1 Introduction
The aggregate demand curve describes the amount of output that people are willing to
buy at different price levels. But, the levels of equilibrium output and price that will actually
emerge also depend on supply behavior. We now turn to the determination of supply behavior
and develop different approaches to the aggregate supply curve. Aggregate supply describes the
amount of output that producers are willing and able to supply to the goods market.

5.3 Four Models of Aggregate Supply

Now, we examine four prominent models of aggregate supply, roughly in the order of
their development. In all the models, some market imperfection 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:
e
Y =Y + α (P−P )

where Y is output, Y is the natural rate of output, P is the price level, Pe is the expected price
level, and α is a positive constant. 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
dY
much output responds to unexpected changes in the price level (that is , =α ).
dP

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.
5.3.1 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 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 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.
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.
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;
e
W =ω × P
whereW is nominal wage, ω is target real wage rate, and Pe the expected price level.
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:
 e
W P
=ω ×
P P
Expected price level
Real wage¿ Target real wage ×
Actual price level
The real wage rate is the product of the target real wage rate and the expected to actual
price level ratio.
This equation shows that the real wage deviates from its target if the actual price level differs
from the expected price level.
e
P
- When the actual price level is greater than expected ( <1), thereal wage is lesser r than its
P
target;
e
P
- when the actual price level is less than expected ( >1),thereal wage is greater than its target.
P

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:
d W
L=L ( )
P
According to this labor demand function, the lower the real wage, the more labor firms
hire.
Output is determined by the production function:
Y =F (L),
this states that the more labor is hired, the more output is produced.
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.
5.3.2 The Worker-Misperception Model
 This model also explains the up-ward sloping short-run aggregate supply curve by
focusing on the labor market. Unlike the sticky-wage model, however, the worker-misperception
model assumes that wages can adjust freely and quickly to balance the supply of and demand for
labor. Its key assumption is that unexpected movements in the price level influence labor supply
because workers temporarily confuse real and nominal wages.
The two components of the worker-misperception model are labor supply and labor
demand. As before the quantity of labor firms demand depends on the real wage:
d d W
L =L ( )
P
The labor supply is new:
s s W
L =L ( e
)
P
This equation states that the quantity of labor supplied depends on the real wage that
workers expect to earn. Workers know their nominal wage W, but they do not know the overall
price level P. When deciding how much to work, they consider the expected real wage, which
equals the nominal wage W divided by their expectations of the price level Pe .
We can also write the expected real wage as:
W W P
= × e
P
e
P P
The expected real wage is the product of the actual real wage W /P and the variable
e e e
P/ P . Noticethat P/ P measures workers’ misperception of the price level: if P/ P is greater than
one, the pricelevel is greater than what workers expected, and if P/ Pe is less than one, the price
level is lessthan that expected. To see what determines labor supply, we can substitute this
expression forW /P eand write:

Ls =Ls ([ WP ) × ( P /P )]
e

The quantity of labor supplied depends on the real wage and on worker misperception of
the price level.
As it is usual, the labor demand curve slopes downward, the labor supply curve slopes
upward, and the wage rate adjusts to equilibrate supply and demand. Note that the position of the
labor supply curve and thus the equilibrium in the labor market depend on worker misperception
e
P/ P .
 Whenever the price level P rises, the reaction of the economy depends on whether
workers anticipate the change. If they do, then Pe rises proportionately with P. In this case
workers’ perceptions are accurate, and neither labor supply nor labor demand changes. The
nominal wage rises by the same amount as prices, and the real wage and the level of employment
remain the same.
By contrast, if the price increase catches workers by surprise, then Pe remains the same
when P rises. The increase in P/ Pe shifts the labor supply curves to the right lowering the real
wage and raising the level of employment. In essence, workers believe that theprice level is
lower, and thus the real wage is higher, than actually is the case. This misperception induces
them to supply more labor. Firms are assumed to be better informed than workers do and to
recognize the fall in the real wage, so they hire more labor and produce more output.
To sum up, the worker-misperception model says that deviations of prices from expected
prices induce workers to alter their supply of labor and that this change in labor supply alters the
quantity of output firms produce. The model implies an aggregate supply of the form:
e
Y =Y + α(P−P )
Once again, as with the sticky-wage model but for different reasons, output deviates from
the natural rate when the price level deviates from the expected price level.
In any model with an unchanging labor demand curve, such as the two 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 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."
Yet the real world data show only a weak correlation between the real wage and output,
and it is the opposite of what Keynes predicted. That is, if the real wage is cyclical at all, it is
slightly procyclical: the real wage tends to rise when output rises. Abnormally high labor costs
cannot explain the low employment and output observed in recessions.
5.3.3 The Imperfect-Information Model
The third explanation for the upward slope of the short-run aggregate supply curve is
called the imperfect-information model. Unlike the sticky-wage model (and like the worker-
misperception model), this model assumes that markets clear – that is, all wages and prices are
free to adjust to balance supply and demand. In this model, as in the worker-misperception
model, the short-run and long-run aggregate supply curves differ because of temporary
misperceptions about prices.
The imperfect-information model assumes that 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. 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 – a wheat farmer, for instance. 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.
5.3.4 The Sticky-Price Model
Our fourth and final explanation for the upward-sloping short-run aggregate supply curve
is called the sticky-price model. This 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
catalog or price list, it is costly to alter prices.
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.
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
itsproduct.
  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 (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:
e e e
P=P +a (Y −Y )
where, as before, a superscript “e’’ represents the expected value of a variable. For simplicity,
assume that these firms expect output to be at its natural rate, so that the last term, a ( Y e−Y e ) , is
zero. Then these firms set the price:
e
P=P
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 find the overall price level in the economy, which is the weighted
average of the prices set by the two groups. If sis the fraction of firms with sticky prices and 1−s
the fraction with flexible prices, then the overall price level is:
P=sP +(1−s) [ P+ a(Y −Y ) ]
e

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) Pfrom both sides of this equation to obtain:
e
sP=sP +( 1−s)a(Y −Y )
Divide both sides by s to solve for the overall price level:
e a
P=P +(1−s) (Y −Y )
s
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.
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:
s
Y =Y + α ( P−P ) , where α =
e
(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 the 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 procyclical.
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 four of these market imperfections, and all may contribute
to the behavior of short-run aggregate supply.
Although the four models of aggregate supply differ in their assumptions and emphases,
their implications for aggregate output are similar. All can be summarized by the equation:
e
Y =Y + α(P−P )
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.

The figure below graphs this equation. 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.

e
Price, P Y =Y + α (P−P )
Long-run
e aggregate
P> P
supply Short-run
aggregate supply
e
P=P

e
P< P

Y Income, Output Y

Now, it is possible to analysis the relationship that exists between Aggregate demand and Aggregate
supply.