Aggregate Supply is a relation between aggregate price level P and the aggregate output Y

producers are willing to supply (at that price) when the labour market is in equilibrium.

AS Curve is derived from the labour market equilibrium which is based on following assumptions:
Assumption 1:Supply of labour force (employed + unemployed) equals L . Unemployment rate is denoted by u

N U
N
N U L 1u 1
L L
L
Assumption 2:Aggregate Production Function

Y N 1 u L

It means that one unit of labour employed produces one unit of aggregate output. This production
function implicitly assumes
Constant MPL

APL 1

CRS

Assumption 3: Firms set prices as mark-up over wages.

Price-setting relation

P 1 mW

m 0 called mark-up includes all other

costs plus supernormal profits

m is an indicator of market power of firms
Coz of mark-up pricing, real wage

W
in
P

1
1
1 m
Real wage depend negatively on m
W
In the graph relating
to u , the priceP
labour market is always

setting relation is shown by a horizontal line

cutting the real-wage axis at

1
1 m

Assumption 4: Nominal wage W (set by bargaining between labourers and firms) depends
1. Positively on Expected future price level P e
2. Negatively on present unemployment rate u
3. Positively on a composite variable z

W Pe F u,z

Wage-setting relation

F is some function for which Fu' 0 and Fz' 0

z includes food subsidies, unemployment benefits or workers preference for leisure etc.

Real-wage set are F u,z

Pe
P

W
set is therefore
P
F u, z if P e P

e
F u, z if P P

F u, z if Pe P

In the graph relating

W
to u , the wageP

setting relation is a downward sloping curve

The position of wage-setting curve is fixed by

Pe &z

1. If wage-setters correctly estimate future price P then real wages set equals F u,z
2. If wage-setters overestimate P then real wages set are more than F u,z for any u

3. If wage-setters underestimate P then real wages set are less than F u,z for any u

Labour-Market Equilibrium: Since real-wage in equilibrium must

be

1
(owing to the price1 m

setting relation), the wage-setting

relation only can decide the level of
equilibrium unemployment.
Equilibrium unemployment when

Pe P is called the natural (or

potential or full-employment) rate of
unemployment un

Nn 1 un L is called the natural

level of employment and Yn Nn 1 un L is called the natural level of output

un depends positively on m and z

un

Pe Pthenu *un N * N n AS Yn

If Pe Pthenu *un N *N n AS Yn
e

P Pthenu *un N * N n AS Yn

u * depends positively on m,z&Pe and negatively on P

Pe givenP

P givenPe

u*

Short-Run Aggregate Supply Curve: Eliminating W &u from the price-setting, wage-setting and production relations, we get
Y
P Pe 1 m F 1 ,z
L

Short-run Aggregate Supply Equation

AS is the locus of P, L 1 u * P and especially passes through P e ,Yn

AS Curve is positively sloped coz (given Pe m, z& L ) ,

Y uF P
Fu'
0 since Fu' 0
The slope of AS is
L
e
Given P , PPe ASYn
Given P e , a line segment from Yn to the

AS curve has length Pe

The position of the AS curve depends upon

Pe m,z&L (mainly P e ). See Equation.

Change
Increase

Shift in AS
Upwards

"

"

m
L

"
"

"
Downwards

Parameter

Reasoning
P or z W set at given u (or Y ) via shift in
wage-setting relation P at a given Y (coz
W / P are fixed by price-setting relation)
m P at a given W by price-setting relation
P at a given u (or Y ) since W is fixed by u
e

1. Derive the equation of the aggregate supply curve from the wage setting and the price setting
relations. Explain clearly how this curve is affected by a decline in each of the following:
a. Oil price
b. Unemployment benefits
c. Expected price level
7.5
Ans. Oil Price is the part of non-labour costs which is included in m W . Given W , an increase
in oil price means an increase in m .
2. What are wage-setting and price-setting relations? How is the equilibrium rate of unemployment
determined in the labour market?
5
3. In price-setting relation, what is the value of mark-up and real-wage when perfect competition
exists?
2.5
Ans. Under perfect competition firms have no market power. It implies that m 0 . Thus price
of a unit of good is only equal to cost of production. If the production function is given by

Y N then cost of production of 1 unit of output is W . Thus real wage

W
1 .
P