Lecture 10

Aggregate Demand & Aggregate Supply

(Part 2)
(Ch:20; P.O.M.E)

ECO 104
Faculty: Asif Chowdhury

 The distinction between long run & short

run phases in an economy is defined by
the behavior of Aggregate Supply (AS).
As we have seen previously, the long run
AS doesnt respond to price changes,
however the short run AS is responsive to
price & there is a direct relationship
between price & quantity of goods &
services supplied. They move in the
same direction. Hence the short run AS is
upward sloping.

Why is AS curve upward

sloping:
Macroeconomist
have
formed
three
theories to explain why the AS curve is
upward sloping in the short run All these
three
theories
share
one
common
implication; whenever price deviates from
expected level ( the level that the people
expected the general price to be at),
quantity supply of output deviates from its
long run natural rate level. Higher than
expected price implies higher than natural
rate of output, lower than expected price
implies lower than natural rate of output.

The three theories explaining

why AS is upward sloping:
o The Sticky Wage Theory: Nominal wage being set based on
expected price level-actual price level may be higher or lowercost of production varying accordingly-employment & output
varying accordingly in the short run.
o The Sticky Price Theory: due to presence of Menu Cost not all
firms change price simultaneously towards the general price
level. Some firms can lag behind & depending on whether the
price level is higher or lower than the long run trend will
accordingly induce more quantity supplied, or less quantity
supplied of goods & services.
o The Misperception Theory: When general price level is rising/
falling supplier may be under the misperception that their
relative prices has risen/fallen, they will then adjust quantity
supply of output accordingly. It also applies in case of nominal
wage, when nominal wage is falling worker might not perceive
that the overall price level is also falling, hence react by
increasing/decreasing labor supply.

 Summing up the theories:

Quantity of Output Supplied: Natural Rate of
Output+ a( Actual Price Level-Expected Price
Level)
As mentioned previously, we are seeing a
deviation in output from its long run natural rate,
when actual price level is different from expected
level.
Its important to note that all the theories present
a temporary scenario, hence the short run, in the
long run wages, prices & misperceptions are all
adjusted according to the long run trend.

Factors that can shift the short

run AS curve:
All the factors that can shift the long run AS
can also shift the short run AS. E.g. capital,
labor are factors which shifts both the long
run & short run AS. However, in addition to
these factors, the expected price level is
the additional factor which can shift the
short run AS. The three theories which tries
to explain why the short run AS is upward
sloping, are all based on the expected price
level. So when expectation of people
regarding price level changes, the short
run AS shifts.

 Taking the case of Sticky Wage Theory

again; when expected price level is high,
nominal wage level also tends to be high,
cost of production rise, output level falls &
AS curve shifts to the left & vice versa.
During short run the expectations of price
level by people are fixed, in the long run
these expectations adjust & this in turn
causes the AS curve to shift & it shifts
towards the long run AS level.

Effects of shift in Aggregate

Demand (AD):
Output level falls-Employment level
falls-Price level falls- recession &
unemployment happens- due to
lower price, expected price level is
low, so short run AS curve shifts upthe economy moves back to its
natural rate of output at a lower
price level.

Effects of shift in Aggregate

Supply (AS):
Output level falls & price rises-leads to Stagflation.
o Stagflation: falling output (recession) & rising
prices ( Inflation)
Rising prices leads to rising nominal wage-this in
turn leads to wage-price spiral-however eventually
falling output & lower level of employment leads
to lower nominal wage level-again short run AS
curve shifts up to the long run level of output at a
lower price level.
The government can push up Aggregate Demand
to counter the effect of falling Aggregate Supply,
this will restore the economy to its natural rate &
avoid falling output & employment, but the price
will be at a permanently higher level.