Macroeconomics VII:

Aggregate Supply

Gavin Cameron
Lady Margaret Hall
Hilary Term 2004
 equilibrium in the labour market
bargained real wage
workforce
real wage

labour demand, Ld

L* employment
NAIRU
 equilibrium output
output (Y)

Y=A.F(K,L)
Y*

When employment is at its

equilibrium level, L*, and
with a fixed stock of capital,
K, and a fixed level of
technology, A, output will be
at its equilibrium, Y*

L* employment (L)
aggregate supply in the long-run
LRAS
prices

The classical dichotomy:

aggregate supply does not
depend upon the price level in
the long-run
or, to put it another way, at full-
employment, there is a maximum
level of physical output that the
economy can produce.

Y* output (Y)
shifts in aggregate supply
LRAS0 LRAS1
prices

Long-run aggregate
supply is determined
by:
productivity;
the capital stock;
supply and demand for
labour;
and input prices.

Y0* Y1* output (Y)

is long-run aggregate supply stable?
• Lots of evidence that the idea of equilibrium
unemployment and equilibrium output are useful concepts.
• We can estimate the NAIRU from statistical models.
• However, three complications:
• the NAIRU shifts over time and is hard to estimate precisely;
• even when unemployment is above the NAIRU, very rapid rises in
demand could still lead to increased inflation;
• if unemployment is high for a very long time, the NAIRU may rise
due to ‘hysteresis’.
expected prices
• Phillips (1958) found relation an empirical relationship
between unemployment and inflation in the UK – the
Phillips curve.
• Original interpretation:
• There is a trade-off between inflation and unemployment.
• Problem: after sustained inflation, the empirical
relationship broke down.
• New interpretation:
• There is a trade-off between unemployment and ‘surprise’ inflation
(i.e. current inflation judged relative to expected inflation).
aggregate supply in the short-run
In the short-run, aggregate supply is
not fixed: here are some possible
LRAS
shapes for the SRAS curve, some are
prices

SRAS3 more realistic than others!

SRAS2

SRAS1

Y* output (Y)
four models of aggregate supply
• In the four models that follow, the short-run aggregate
supply curve is not vertical because of some market
imperfection. As a result, output can deviate away from its
natural rate.
• Consider the following ‘surprise-supply’ function:
Y = Y * +α (P − Pe)
• where Y is output, Y* is the natural rate of output, P is the
price level and Pe is the expected price level.
• Therefore, output deviates from the natural rate by the
extent to which prices deviate from their expected level,
and 1/α is the slope of the aggregate supply curve.
the sticky-wage model
• ‘I hold that in modern conditions, wages in this country are, for various
reasons, so rigid over short periods that it is impracticable to adjust
them…’ J.M.Keynes
• In many industries, especially unionized ones, nominal wages are set by
long-term contracts. Social norms and implicit contracts may also be
important.
• When the nominal wage is fixed, an unexpected fall in prices raises the
real wage, making labour more expensive:
• higher real wages induce firms to reduce employment;
• reduced employment leads to reduced output;
• when contracts are renegotiated, workers accept lower nominal wages to
return their real wages to their original level, so employment rises.
 a fall in prices, with sticky-wages
labour supply, Ls
real wage

W/P0

W/P1

labour demand, Ld

L0 L1 employment
the worker-misperception model
• In the sticky-wage model, long-term contracts meant that the labour
market was slow to reach equilibrium.
• In the worker-misperception model, the labour market can reach
equilibrium, however, workers suffer from ‘money illusion’.
• This means that while firms know the price level with certainty,
workers temporarily mistake nominal changes in wages for real
changes.
• If prices rise unexpectedly, firms offer higher nominal wages but
workers mistake these higher nominal offers for higher real wages, and
so offer more labour.
• At every real wage, workers supply more labour because they think the
real wage is higher than it actually is.
• Eventually workers realise that real wages haven’t risen, so their
expectations correct themselves and labour supply returns to its
previous level.
 a rise in prices, with money-illusion
LS0 (Pe=P0)

LS1 (Pe<P1)
real wage

W/P0

W/P1

labour demand, Ld

L0 L1 employment
the imperfect information model
• Consider an economy consisting of many self-employed people, each
producing a single good, but consuming many goods.
• In this economy, a yeoman farmer can monitor the price of wheat and
so knows of any price change immediately. But she cannot monitor
other prices as easily, so she only notices price-changes after one time-
period has passed.
• How does the farmer react if wheat prices rise unexpectedly?
• One possibility is that all prices have risen, and so she shouldn’t work
any harder.
• Another possibility is that only the price of wheat has risen (and so its
relative price has risen), so she should work harder.
• In practice, any change could be a combination of an aggregate price
change and a relative price change. Therefore, the farmer has a ‘signal-
extraction’ problem and will tend to raise output when all prices rise,
mistaking this for a relative price rise.
the sticky-price model
• It may also be the case that firms cannot adjust their prices
immediately either, since they may have long-term
contracts or there may be costs to changing prices (‘menu
costs’).
• If aggregate demand falls and a firm’s price is ‘stuck’, it will
reduce its output, its demand for labour will shift inwards,
and output will fall.
• Notice that sticky-prices have an external effect since if
some firms do not adjust their prices in response to a
shock, there is less incentive for other firms to do so.
taxonomy of aggregate supply models
Market with imperfection
Labour Goods
Worker-Misperception Imperfect-Information
model: workers model: suppliers confuse
Yes confuse nominal wage changes in the price level
changes with real with relative price changes
changes
Markets clear?

Sticky-Wage model: Sticky-Price model: The prices

No nominal wages adjust of goods and services adjust
slowly slowly
short and long-run aggregate supply
LRAS SRAS2 (Pe=P2)
prices

SRAS1 (Pe=P1)
P2

P1

Y* output (Y)
summary
• In the long-run, aggregate supply is determined by real
factors, such as the level of employment and the
productivity of the workforce.
• In the short-run, there may be a trade-off between reduced
unemployment and rising inflation.
• Equally, rising unemployment will lead to downward
pressure on inflation.
• This trade-off may arise for a number of reasons, such as
sticky-wages, worker misperceptions, sticky-prices, and
imperfect information.