Chapter 9
Gesamtwirtschaftliches Angebot GA (Aggregate Supply: AS)

In the aggregate supply curve, a distinction is made between long- and short-term view. Both curves indicate the quantity of goods and services that companies produce and sell at a certain price level.

The long-term aggregate supply curve represents the long-term full employment equilibrium (steady state). Output does not depend on the price level, i.e. the curve runs vertically. The output quantity is determined by the production technology, labor and capital in the economy and is referred to as the natural level of output Y N. In the short run, the aggregate supply may deviate from the full employment equilibrium and then react price-sensitively. The slope of the curve is positive, i.e. aggregate supply increases when the price level increases. Conversely, the supply of goods and services decreases when prices decrease. The elasticity of supply represents price sensitivity, i.e. the steeper the curve, the weaker the quantity reaction to a given price change.

The positive slope of the supply curve is usually (cf. e.g. Mankiv, Grundzüge der Volkswirtschaftslehre) explained by one of the following approaches: (1) model of imperfect information, (2) wage rigidity, (3) nominal wage illusion or (4) price rigidity. These approaches describe different market imperfections in order to explain deviations of the supply quantity from the natural production level. A brief explanation of the ideas can be found at the bottom of the page.

In modern textbooks, a Neo-Keynesian approach, using price setting in monopolistic competition, is preferred (see e.g. Blanchard/Illing, Macroeconomics). Wage setting W is based on the expected price level and a function of unemployment u and labor market institutions or other influences z.

W = PeF(u,z)

For positive inflation expectations, nominal wages increase to counteract the anticipated decline in real wages. No money illusion is assumed. The term ‘money illusion´ refers to the sensation of being able to buy more when having more money in nominal terms. To simplify matters, the production technology is presented linear and determined only by the amount of work, Y = N, with N being the amount of actively employed people. Therefore, the production costs equal the wage. (Footnote: cost of capital, technical progress, different types of work, as the best known generalizations, would only unnecessarily overload this model).

The behavior of the labor supply (employees) depends on the unemployment rate

u = 1 Y t N

: The higher the unemployment, the lower the nominal wage demands of insiders (et vice versa). Employees believe that they can escape the threat of unemployment by keeping wages down (et vice versa). The accumulative variable summarizes things like social welfare, minimum wage, protection against dismissal, etc. These variables influence the fear of unemployment. If, for example, the reserve wage rises due to higher social welfare, the nominal wage demand increases for a given unemployment rate. Pricing: takes place through a constant profit markup μ on the production costs.

P = (1 + μ)W

Combining these equations results in the aggregate supply curve:

Pt = Pte(1 + μ)F(1 Y t N ,z)

The index t represents the time period. The resulting price level depends positively on the expected price level and production (real social product).

Shifting the AS-curve
Supply policy and supply shocks can shift the short-term AS-curve. Examples are changed price level expectations, oil price shock, deregulation and intensification of competition, or structural reforms (e.g., introduction of Hartz IV). The graph below, with the corresponding controllers, illustrates the reactions. By moving the crosses, the slope of the curves can be changed to see how the quantitative effects vary.

The long-term AS-curve, i.e. the natural production quantity, alters only due to changes in real or human capital (quantity, education), technical progress or changes in natural resources (expansion or depletion). This exogenous change is not included in the graph. The initial point is always the long-term equilibrium.

Model of imperfect information
The basic assumption of the model is market clearance at flexible prices and wages. The short and long term differ because of the assessments (misjudgements) of relative prices. Producers know the price development of their own goods exactly, but the development of the general price level only inaccurately. If the price level rises, they perceive this mainly through the price of their produced good. They conclude that the relative price of their good has risen, because, due to the lack of information, they can only estimate the price development of other goods. The (perceived) increase in the relative price of his good justifies an expansion of production. Since this applies to all producers, the aggregate supply reacts positively to price level increases.
Wage rigidity model
Rigid or inert nominal wages can result from collective labor agreements, social norms, adjustment costs, lags in business processes, etc. In the case of rigid nominal wages W an increase in the price level P leads to falling real wages W P and, consequently, to rising employment and a higher supply of goods Y S. In wage negotiations the expected price level often plays a decisive role. If the price level is later above the expected level, the real wage is lower than expected and employment is expanded, as described above. An (unexpected) price level increase leads to higher output and the supply curve has a positive slope.
Model of nominal wage illusion
The basic assumption of the model is that employees are not able to differentiate between nominal and real wages in the short term. They cherish the illusion that an increase in nominal wages means an increase in real wages. Similar to the rigid wage model, an increase in the price level leads to a decrease in the real wage and thus to more employment and higher aggregate supply. An increase in the nominal wage, to compensate for inflation, is not necessary because of the nominal wage illusion.

In reality, this pattern cannot be observed with such sharpness. However, if various effects, such as rising productivity and inflation, are mixed together, an underestimation can occur in some cases. In Germany, for example, real wages fell by around 3.6 % between 2003 and 2009 and the real unit labor costs even fell by 14% from 2003 to 2007. The problem with the models of wage rigidity and nominal wage illusion is that they predict an anti-cyclical behavior of real wages and production, but empirically they can only prove a weakly pro-cyclical relationship.

Price Rigidity Model
This New Keynesian theory of rigid (inert) prices is based on the assumption that prices are not immediately adjusted to changes in demand. Reasons may include long-term supply contracts, customer annoyance with frequent price changes, high menu costs (costs of changing prices such as printing and mailing new catalogs or price lists) or uncertainty about the sustainability of the change in demand. The inertia of prices is represented in the model by the fact that in each period only some of the companies can adjust their prices. If the price level rises, there will be an increased demand for products from those companies that have not yet adjusted their prices, as these are relatively cheaper. The increased demand leads to higher production and increases the aggregate supply.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743