The aggregate supply curve (ASC)

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B) Second hypothesis

3. The long term adjustment

3.6 The aggregate supply curve (ASC)

The next step is to transform the augmented wage Philips curve. The augmented wage Philips curve shows the relationship between the inflation rate and the rate of output on which the expected rate of inflation is based. There are assumptions for the aggregate supply curve which are as follows:

The first assumption is that firms maintain constant markup prices over wages. The rate of increase of prices or the rate of inflation as ¹

1

(P P ) P₋ ⁻

∏ = − means that inflation is equal to the rate of wage.

Alternatively,

g

w

∏ =

^(3.19)

Substituting the rate of wage increase (3.18) into (3.19) yields the dynamic aggregate supply curve

(

*

)

e

λ Y Y

∏ = ∏ + −

_(3.20)

The above equation shows one of the two building blocks of a model of inflation prices. This is the expected augmented aggregate supply curve.

Advanced Macroeconomics

97

Aggregate supply, wages, prices and employment

3.6.1 The short run aggregate supply curve

The short run aggregate supply curve examines the relationship between inflation, output and the expected inflation rate, that is, ∏_{, Y and}

∏

^e_.

Given the expected inflation rate, the aggregated supply curve shows the inflation rate rising with the level of output, that is, the higher the level of output, the higher is the rate of inflation.

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Figure 3.6 The short run aggregate supply curve and income

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Advanced Macroeconomics

98

Aggregate supply, wages, prices and employment Figure 3.6 shows that the higher the expected inflation rate, the higher the short run aggregate supply curve (SAS). Thus, at SAS’, the expected inflation rate is 10 percent. For any expected inflation rate, there is a corresponding short run aggregate supply curve. It is parallel to SAS and SAS’, with the vertical distance between any two short run supply curves equal to the difference in

∏

^e between them.

In the above figure, the

∏

^e is constant on a SAS curve. It is five percent on the short run aggregate supply and 10 percent on the SAS’. Each short run ASC is shown to be quite flat, reflecting the fact that in the short run, it takes a large change in output to generate a certain change in inflation. The short run aggregate supply curve shifts with the expected rate of inflation. The inflation rate corresponds to any given level of output. Therefore, there are changes over time as the

∏

^e changes. The higher the expected

∏

^e, the higher the inflation. The π rate corresponds to a given level of output.

3.6.2 The long run aggregate supply curve

If the inflation rate remains constant for any long term period, firms and workers will expect the inflation rate to continue to rise. The expected inflation rate will become equal to the actual rate. The assumption that ∏ = ∏^e distinguishes the long run from the short run aggregate supply curve. The long run aggregate supply curve describes the relationship between inflation and output when actual and expected inflation is equal. Assume

∏ ₌

∏

^e

The equation can be further explained as

(

*

)

e

λ Y Y

∏ = ∏ + −

It shows that Y = Y*

The meaning of the vertical long run aggregate supply curve is that in the long run, the level of output is independent of the inflation rate. In figure 3.7, the points on the short run aggregate supply curve show the expected inflation which is equal to actual inflation. The long run curve is thus a vertical line.

The long run aggregate supply is Y* at any level of output. The short run aggregate supply curve shows point A where 5 percent inflation is observed. When the inflation rate rises from 5 to 10 percent, the SAS curve shifts upwards from SAS to SAS’.

Advanced Macroeconomics

99

Aggregate supply, wages, prices and employment

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Figure 3.7 The short run aggregate supply curve and inflation