Aggregate Supply

There are four major models that explain why the short-run 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 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, labor becomes cheaper; when labor becomes cheaper, firms hire more labor; when firms hire more labor, output increases.

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 labor; when workers provide more labor, output increases.

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 labor supplied by producers increases. When the amount of labor supplied by producers increases, output increases.

Following are summaries of the two chains of events that characterize the relationship between the price level and output in the sticky-price model. First, when firms expect a high price level they set their relatively sticky prices high. Other firms follow suit and set their prices high as well. Thus, a high expected price level leads to a high actual price level. When the expected price level is high, producers produce more output. Second, when the level of output is high, the demand for goods and services is also high. When the demand for goods and services is high, the price charged for goods and services is also high. When the price charged for goods and services is high, firms set their relatively sticky prices high. When some firms set their relatively sticky prices high, other firms follow suit. Thus, the overall price level increases.