Aggregate Supply (AS) NOTES
Definition of Aggregate supply (AS)
The aggregate supply curve describes; for each given price level, the
quantity of output firms are willing to supply. in the shot run the AS
curve is horizontal (the Keynesian aggregate supply curve); in the run
the AS is vertical (the classical supply curve).
6.2 The Classical Supply Curve
The classical supply curve is vertical indicating that the same amount
of goods will be supplied whatever the price level. It is based on the
assumption that the labour market is in equilibrium with full employment
of the labour force. We call the level of output corresponding to full
employment of the labour force potential GDP,Y*. It grows over time as
the economy accumulates resources and as technology improves, so the
position of the classical aggregate supply curve moves to the right over
time
6.3 The Keynesian Aggregate Supply Curve
It is horizontal; indicating that firm‘s will supply whatever amount of
goods is demanded at the existing price level. The idea underlying the
Keynesian aggregate supply curve is that because there is unemployment
firm‘s can obtain as much labour as they want at the current wage. Their
average costs of production therefore are assumed not to change as their output level
changes.
They are accordingly willing to supply as much as is demanded at the
existing price level. This is an existence situation in which all prices
are fixed. Our task now is to refine this understanding of short – run
aggregate supply. Unfortunately, one fact makes this task more
difficult; economists disagree about how best to explain aggregate supply.
As a result this section begins by presenting the four prominent models
of the short-run aggregate supply curve. Although these models differ in
some significant details, they are also related in an important way:
they share a common theme about what makes the short-run and long-un
aggregate supply curve differ and a common conclusion that the short-run
aggregate supply curve is upward sloping.
6.4 Models of Aggregate Supply in the Short Run
In all the models, some market imperfection cause 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 tasks us down a different theoretical route,
each route ends up in the same place. That final destination is a short
-run aggregate supply curve equation of the form.
Y =Y* +a(P-Pe ) , a>0
Where Y is out put, 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 K indicates how much of output
responds to unexpected changes in the price level. 1/ a id the slope of
the aggregate supply curve.
The aggregate supply curve shows the relationship between the price
level output. While the long run aggregate supply curve is vertical, the
short run aggregate supply curve is upward sloping. There are four major
models that explain why the short-term aggregate supply curve slopes
upward. The first is the sticky-wage model. The second is the worker
misperception model. The third is the imperfect – information model. The
fourth is the sticky-price model. The following headings explain each of
these models in depth. As we move on to explore each of these four
models, keep in mind that an upward sloping short run aggregate supply
curve means that as the price level rises, output increases. This is the
point of each of the following models.
6.5 Sticky -Wage Model
The sticky-wage model of the upward sloping run aggregate supply curve
is based on the labour market. In many industries, short run wages are
set by contracts. that is, workers are paid based on relatively
permanent pay schedules that are decided upon by management or unions or
both. When the economy changes, the wage the workers receive cannot
adjust immediately. Given tat wages are sticky; the chain of events
leading from an increase in the price level to an increase in output is
fairly straightforward. The price level rises, the normal wage remains
fixed because this is solely based on the dollar amount of the wage. The
real wage, on the other hand, falls because this is based on the
purchasing power of the wage. A higher price level means that a given
wage is able to purchase fewer goods and services.
When the real wage that firms pay employees falls, labour becomes
cheaper. however, since the amount of output produced for each unit of
labour is still the same, firms choose to hire more workers and increase
revenues and profits. When firms choose to hire labour, output
increases. Thus, when the price level rises, output increases because of
sticky wages. Let‘s summarize the chain of events that leads from an
increase in the price level to an increase in output in the sticky-wage
model. When the price level rises, real wages fall. When real wages
fall, labour becomes cheaper. When labour becomes cheaper, firms hire
more labour. When firms hire more labour, output increases.
6.6 Worker Misperception Model
The worker – misperception model of the upward sloping short-run
aggregate supply curve is again based on the labour market. This time,
unlike in the sticky -wage model, wages are free to move as the economy
changes. The amount of work that an employee is willing to supply is
based on the expected real wage. That is, workers know how many dollars
they are being paid, the nominal wage, but workers can only guess at how
much goods and services they can purchase with this wage, the real wage.
In general, the higher the real wage the more work the workers are
willing to supply.
Now let‘s say that the price level increases because we assume that
firms have more information than workers do, firms will give workers a raise so that their
nominal wage increases with the price level. But since the workers do
not realize that the price level increased, they will believe that their
real wage increased, not just their nominal wage. At a higher real wage,
workers are induced to work more. When workers work more, output
increases. Thus, when the price level increases output also increases
because of worker – misperception.
Let‘s summarize the chain of events that leads from an increase in the
price level to an increase in output in the worker-misperception model.
When the price level rises, firms increase nominal wages. When nominal
wages increase, workers-due to misperceptions- believe that real wages
also increase. When workers believe that real wages increase, workers
provide more labour. When workers provide more labour, output increases.
6.7 Imperfect-Information Model
The imperfect-information model of the upward sloping short-run
aggregate supply curve is again based on the labor market. In this
model, unlike either the sticky- wage model or the worker-misperception
model, neither the worker nor the firm has complete information. That is
neither is better informed than the other is about the real wage, the
nominal wage, or the price level. In this model, producers are
considered to be really only aware of the price of the goods and
services that they produce. That is, producers are unable to recognize
overall increases in the price level because they focused on their
products only. Instead, producers only recognize changes in the prices
of the goods and services that they produce. Given that producers are
unable to recognize changes in the overall price level, they are likely
to confuse changes in the overall price level (absolute changes in the
price level).
It is important to understand the implications of both relative changes
in the price level and absolute changes in the price level. When a
relative change in the price level occurs, producers of some goods and
services are better off because the price of their output increases to a
greater extent than the overall price level.
Both the real wage and nominal wage earned by these producers increase. When an absolute
change in the price level occurs, all producers are affected equally and
the nominal wage increases while the real wage remains constant. Recall
that producers are willing to provide more labor when the wage is high.
That is, they will work harder when they are getting paid more for their
work. Also recall that producers cannot differentiate between relative
changes in the price level and absolute changes in the price level.
Thus, when a producer sees a change in the price level, she will likely
believe that it is a relative change in the price level, even if it is
an absolute change in the price level. Because of this, the producer
will work more and produce more output when the price level rises. Thus,
an increase in the price level causes output to rise.
Let‘s summarize the chain of events that leads from an increase in the
price level to an increase in output in the imperfect – information
model. When the overall price level rises, producers mistake it for a
relative increase in the price level. When the relative price level
rises, the real wage earned by producers rises. When the real wage
earned by producers rises the amount of labour supplied by producers
increases. When the amount of labour supplied by producers increases,
output increases.
6.8 Sticky -Price Model
The sticky-price model of the upward sloping short-run aggregate supply
curve is based on the idea that firms do not adjust their price instantly to changes in the economy. There are numerous reasons for this. First, many prices, like wages, are set in relatively long-term contracts. Imagine if your wage at work place changed every day as the economy changed. Firms hold prices sable from distracting their regular customers Firms hold their prices stable of middleman costs When firms prepare to set their prices .they take into account the expected price level .when the expected price level is higher, firms set prices higher to compensate for the higher price of
inputs. When the price charged for input is higher firms produce more
output as the incentive for production is also higher. Therefore, an
increase in the price level leads rather directly to an increase in
output in the sticky price model
Another way to conceptualize the relationship between the price level
and output in the sticky price model .when the level of output is high
the demand fro goods and services is also high. therefore when firms set
their sticky price they set them high to account for high demand .When
firms set their prices high ,the overall price level increases and a
high level of output leads to a high level of demand which leads to a
high price level
