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 . 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 is based on the expected price level and a function of unemployment and labor market institutions or other influences .
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, , 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
: 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 on the production costs.
Combining these equations results in the aggregate supply curve:
The index represents the time period. The resulting price level depends positively on the expected price level and production (real social product).
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.
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.