Deriving Aggregate Supply
Introduction to Aggregate Supply
In the previous SparkNote we learned
that aggregate demand is the total demand for goods
and services in an economy. But the aggregate demand
curve alone does not tell us the equilibrium price level
or the equilibrium level of output. In order to obtain
this information, we need to add the aggregate supply
curve to the diagram containing the aggregate demand
curve. Then, and only then, do the equilibrium values of
the economy in the AS-AD model appear.
The aggregate supply curve shows the relationship between
the price level and the quantity of goods and services
supplied in an economy. The equation for the upward
sloping aggregate supply curve, in the short run, is Y =
Ynatural +
a(P - Pexpected). In this equation, Y is output,
Ynatural is the natural rate of output that
exists when all productive factors are used at their
normal rates, a is a constant greater than zero,
P is the price level, and Pexpected is the
expected price level. This equation holds only in the
short run because in the long run the aggregate supply
curve is a vertical line, as output is dictated by the
factors of production alone.
But what does the equation for the aggregate supply curve
mean? Basically, this equation means that output deviates
from the natural rate of output when the price level
deviates from the expected price level. The constant,
a, shows how much output changes due to unexpected
deviation in the price level. It is also important to
notice that the slope of the aggregate supply curve is
(1/a).
Figure 1.1: Graph of the aggregate supply curves
depicts the short-run aggregate supply curve and the long-
run aggregate supply curve. Notice that the axes are the
same as for the aggregate demand curve. The vertical axis
is the price level. The horizontal axis is output or
income. Also notice that the short-run aggregate supply
curve is downward sloping with slope equal to (1/a) while
the long-run aggregate supply curve is vertical with no
slope.
Aggregate Supply in the Short Run
The equation for aggregate supply presented above holds
only in the short run. Recall that the aggregate supply
curve shows the relationship between the price level and
the quantity of goods and services supplied. Also recall
that the aggregate supply curve states that output
deviates from the natural rate of output when the price
level deviates from the expected price level. All of
these elements of aggregate supply point to an upward
sloping short-term aggregate supply curve and a vertical
long-term aggregate supply curve.
But how do we know that aggregate supply is upward sloping
in the short run and vertical in the long run? First,
recall from microeconomics that output is a function of
capital and labor--the inputs to production.
Thus, in the long run, the levels of capital and labor in
an economy fix the level of output. The only way to
increase output in the long run is to increase the levels
of capital and labor. This is called increasing the
capital stock--the result of investment--and
increasing the labor force--the result of more people
working. Therefore, in the long run, the aggregate
supply curve is affected only by the levels of capital and
labor and not by the price level. Thus, the long run
aggregate supply is vertical with respect to the price
level.
The reason that the short-term aggregate supply curve is
upward sloping is a bit more complex. There are four
basic explanatory models, which will be explained in
detail in the next section.
These models are the sticky-wage model, the worker-
misperception model, the imperfect-information model, and
the sticky-price model. In their own ways, each of these
models explains why output deviates from the natural rate
of output when the price level deviates from the expected
price level.
