Lecture 12 - Aggregate Demand and Aggregate Supply (Part II) Claude

Table of Contents

  1. Business Cycles as Deviations from Trend
  2. The Short-Run Aggregate Supply Curve
  3. Theories Explaining the Upward Slope of SRAS
  4. The SRAS Curve: Unified Summary Equation
  5. AD-AS Equilibrium: Short Run and Long Run
  6. Shifts in the SRAS Curve
  7. From AD-AS Framework to Business Cycles
  8. Bibliography

Business Cycles as Deviations from Trend

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set1(ADAS_P2)/Slide3.png

The chart above plots nominal GDP (in current US dollars) from 1960 through 2014 for a representative economy. The smooth red curve represents the long-run growth trend, whilst the jagged blue line captures actual GDP. The central insight is immediately visual: actual output does not travel along a smooth upward path but oscillates above and below trend, producing recognisable peaks and troughs. These oscillations are what economists define as the business cycle.

It is analytically important to resist the temptation to conflate the level of GDP with its deviation from trend. A country may enjoy rising nominal GDP every decade and still suffer serious recessions if actual output falls below potential for a sustained period. The particularly sharp dip visible around 2008–2009 reflects the Global Financial Crisis, during which actual output fell dramatically below its trend value.

Economic Intuition

Think of the trend as where the economy "should" be given its productive capacity — what it can produce at full employment and normal capacity utilisation. Business cycles are the story of why it temporarily over- or undershoots that level. The AD-AS framework is built precisely to explain those deviations.

Definition

Business cycle: Fluctuations in real economic activity (output, employment, income) around the long-run trend level of potential output, characterised by alternating phases of expansion (boom) and contraction (recession).

The Short-Run Aggregate Supply Curve

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set1(ADAS_P2)/Slide4.png

The diagram illustrates the fundamental property of the Short-Run Aggregate Supply (SRAS) curve: it slopes upward in price-level/output space. When the price level falls from to , the quantity of output that firms collectively supply falls from to . This positive relationship between the price level and the quantity of output supplied is the defining characteristic of the short run, and it stands in direct contrast to the vertical Long-Run Aggregate Supply (LRAS) curve, which asserts that output is independent of the price level in the long run.

The upward slope arises not from classical market-clearing logic but from the presence of market imperfections that prevent instantaneous adjustment. These imperfections take three main forms, each of which will be examined in turn. The critical commonality is that all three rely on a wedge between the expected price level () and the actual price level (). Once expectations catch up with reality, the imperfection dissolves and the economy reverts to its long-run supply.

Common Mistake

Students sometimes draw the SRAS curve as having the same interpretation as a microeconomic supply curve, responding to the "price" of a single good. The SRAS traces output responses to changes in the aggregate price level, and the upward slope arises from nominal rigidities or informational frictions, not from the law of supply in a competitive market.

Theoretical Interpretation

The SRAS curve implicitly assumes that some input prices (most importantly wages) or output prices are pre-set based on prior expectations. When the actual price level diverges from what was anticipated, real variables — real wages, real revenues, perceived relative prices — are distorted relative to planned values, inducing firms to alter production. This is the core of New Keynesian short-run supply theory.

Theories Explaining the Upward Slope of SRAS

All three theories the lecture presents share a common structure: they describe a mechanism by which an unexpected change in the price level generates a real response in output. The formal expression for this is:

Each theory offers a different institutional or informational account of why that gap translates into a change in supply.

Sticky-Wage Theory

The sticky-wage theory rests on the observation that nominal wages are not continuously renegotiated but are instead fixed by labour contracts over medium-term horizons. When workers and firms agree on a nominal wage at the start of a contract period, they implicitly base that wage on a forecast of the future price level. If the actual price level subsequently deviates from expectations, the real wage — which governs the firm's actual marginal cost of labour — departs from the level that was anticipated.

The mechanism can be stated precisely. The real wage is , where is the nominal wage (fixed by contract) and is the actual price level. Consider two scenarios:

  • When : the price level is lower than workers and firms anticipated when they set . Since is fixed, the real wage rises above the planned level. Higher real wages raise the marginal cost of labour, so firms find production more expensive than planned, cut output, and reduce employment.
  • When : the price level exceeds expectations, so the real wage falls below the planned level. Lower real wages reduce marginal costs, making production cheaper than firms expected, so they expand output and hire additional workers.

This asymmetric response to price surprises is exactly what the upward-sloping SRAS captures: higher actual prices relative to expectations are associated with higher output.

Economic Intuition

Imagine a firm negotiates a one-year pay deal expecting 3% inflation. If inflation turns out to be only 1%, the firm is paying its workers more in real terms than it anticipated. That unplanned cost increase squeezes profit margins and induces the firm to pull back on production. The wage is "stuck" because the contract cannot be immediately rewritten.

Exam Insight

When asked to explain why the SRAS slopes upward, always specify the channel: fixed nominal wages → real wages move inversely with unexpected price changes → marginal cost moves → output responds. Examiners reward the causal chain, not just the conclusion.

Sticky-Price Theory

The sticky-price theory applies a parallel logic to output prices rather than input prices. Many firms face menu costs — the real and administrative costs of changing posted prices (printing new menus, updating catalogues, renegotiating supplier contracts). Because these costs are non-trivial, firms pre-set prices based on expected future conditions and do not instantly revise them when actual conditions change.

In this framework, prices function as marginal revenues. Consider:

  • When : the overall price level is below what firms anticipated, meaning actual revenues are lower than planned. Firms with pre-set prices find their real revenues squeezed. Unable to immediately cut costs or raise prices, some firms respond by reducing output, contracting aggregate supply.
  • When : actual revenues exceed plans; firms with sticky prices earn unexpectedly high real revenues and respond by expanding output.

The sticky-price theory is particularly prominent in New Keynesian macroeconomics, where staggered price-setting by firms (Calvo pricing, Taylor contracts) is used to derive a New Keynesian Phillips Curve from first principles. Even if a firm would prefer to adjust its price, coordination failures and menu costs generate short-run price rigidity at the aggregate level.

Theoretical Interpretation

The microeconomic foundation here draws on imperfect competition: firms in monopolistically competitive markets face downward-sloping demand curves and set prices as a mark-up over marginal cost. If marginal costs change but prices are temporarily fixed, the mark-up is squeezed or inflated, altering the incentive to supply. This stands in contrast to the perfect competition assumed in classical models where prices adjust instantaneously.

Common Mistake

Do not conflate sticky wages and sticky prices. Sticky wages operate through the cost side (labour is an input whose price is fixed), whilst sticky prices operate through the revenue side (output prices are fixed, so revenues diverge from expectations). Both produce an upward-sloping SRAS, but via different channels.

Misperceptions Theory

The misperceptions theory (also called the imperfect information or Lucas island model approach) differs from the above two in that it requires no nominal rigidity whatsoever. Instead, it relies on an informational friction: individual producers observe the prices of the goods they sell but do not immediately observe the overall price level.

The mechanism is as follows. Suppose the aggregate price level falls below the expected level. An individual firm observing a fall in the price of its own product faces a signal extraction problem: is this fall a relative price decline (its good has become cheaper relative to others, signalling lower demand specifically for its product) or is it simply part of a general deflation? If the firm incorrectly attributes the aggregate price fall to a fall in its own relative price, it will perceive its real marginal revenue as having fallen, and rationally reduce production — even though in reality the general price level has fallen and no relative price change has occurred. Conversely, if the aggregate price level rises unexpectedly, firms may misinterpret this as an improvement in their relative price position and expand output.

This model, associated with Robert Lucas, has the striking implication that only unanticipated monetary policy can affect real output in the short run — anticipated changes will simply update expectations, leaving no wedge between actual and expected prices.

Theoretical Interpretation

The misperceptions theory is closely related to Lucas's (1972, 1973) rational expectations supply framework. Its policy implication is the famous "policy ineffectiveness proposition" in its strong form: if agents have rational expectations and only nominal surprises drive output, systematic monetary policy rules cannot systematically stabilise output. This contrasts sharply with the Keynesian sticky-wage and sticky-price frameworks, where even anticipated policy may have real effects.

Exam Insight

For a high-scoring answer, distinguish the informational basis of the misperceptions theory from the institutional basis of the sticky-wage and sticky-price theories. The former requires only imperfect information; the latter two require contractual or administrative frictions. Linking this to Lucas and the rational expectations revolution will demonstrate analytical depth.

The SRAS Curve: Unified Summary Equation

All three theories converge on a single algebraic representation of the SRAS curve:

where:

  • is the quantity of aggregate output supplied
  • is the natural rate of output, equivalent to the LRAS level of production (output at full employment and normal capacity)
  • is a parameter reflecting the responsiveness of output to unexpected price level changes; a larger implies a flatter SRAS curve
  • is the "price surprise" term — the gap between the realised and anticipated price level

This equation encapsulates the core logic of the short run: output deviates from its natural rate if and only if the actual price level differs from what was expected. In the long run, expectations adjust fully so that , the price surprise term vanishes, and by definition. This confirms the vertical LRAS.

Definition

Natural rate of output (): The level of real GDP produced when all inputs are employed at their normal utilisation rates, corresponding to the long-run equilibrium of the economy. It is the value of output to which the economy gravitates over time as wages, prices, and expectations fully adjust.

Theoretical Interpretation

The parameter determines the slope of the SRAS curve in space. If is very large, even a small price surprise generates a large output response, meaning the SRAS is relatively flat (highly elastic in output). If is small, the SRAS is steep, meaning price surprises have little effect on real output. In the limit, as , the SRAS becomes horizontal (the extreme Keynesian case); as , it approaches the vertical LRAS (the classical case).

Common Mistake

Do not confuse a movement along the SRAS with a shift of the SRAS. A change in with held fixed is a movement along the SRAS. A change in , , or any other shifter moves the entire curve.

Summary
  • The SRAS slopes upward because sticky wages, sticky prices, or misperceptions create a short-run link between price surprises and output.
  • All three theories are unified by the equation .
  • In the long run, by definition, so long-run output equals regardless of the price level.

AD-AS Equilibrium: Short Run and Long Run

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set1(ADAS_P2)/Slide12.png

The summary diagram brings together all three curves — the Aggregate Demand (AD) curve, the Short-Run Aggregate Supply (SRAS) curve, and the Long-Run Aggregate Supply (LRAS) curve — in a single framework. The long-run equilibrium is at point A, where the AD curve intersects the vertical LRAS at the natural rate of output. At this point, the actual price level equals the equilibrium price level, and crucially, , so the SRAS curve also passes through point A.

The diagram conveys a fundamental property of the AD-AS model: the long-run equilibrium is entirely determined by the supply side of the economy (the LRAS), whilst the price level is jointly determined by AD and LRAS. In long-run equilibrium, the economy produces at its potential regardless of where the AD curve lies; a shift in AD will only change the price level in the long run, not real output.

The SRAS passing through the same long-run equilibrium point is not a coincidence but a theoretical necessity: the long-run equilibrium is defined as the state in which there are no price surprises, and the SRAS equation confirms that when , output must equal . The three curves therefore always intersect at a single point in long-run equilibrium, and this property is what anchors the model's dynamics.

Economic Intuition

Think of the long-run equilibrium as the economy's "resting point." When disturbed by a demand or supply shock, the economy moves away from point A in the short run, but internal adjustment mechanisms (wage renegotiation, price revision, expectation updating) gradually pull it back. The SRAS shifts over time until all three curves once again intersect at the same point.

Exam Insight

In essay questions on macroeconomic stabilisation or the effects of demand shocks, always begin by drawing all three curves with the long-run equilibrium at point A. Then show the short-run deviation, explain the adjustment mechanism, and show the return to long-run equilibrium. This three-step structure — impact, adjustment, new long-run — will secure strong marks.

Shifts in the SRAS Curve

Understanding what moves the SRAS curve is essential for analysing macroeconomic shocks. The SRAS can shift for two broad categories of reason.

Shifts Inherited from the LRAS

Because the natural rate of output anchors the SRAS equation, any factor that changes the economy's productive capacity will shift both the LRAS and the SRAS together. These supply-side factors include:

  • Labour: changes in the size or quality of the workforce (immigration, education, demographics)
  • Capital: changes in the stock of physical or human capital through investment
  • Natural resources: discovery or depletion of productive resources
  • Technology: improvements in total factor productivity, process innovation

A rightward shift in the LRAS (higher ) shifts the SRAS rightward by an equivalent amount for any given expected price level, since the equation moves its intercept.

Shifts Arising from Changes in Expectations

The second and arguably more important source of SRAS shifts is a change in the expected price level . Since all three theories of the upward-sloping SRAS hinge on the expected-versus-actual price divergence, any revision to expectations will shift the entire curve.

If rises (inflation expectations increase), the SRAS shifts to the left. The intuition is direct: workers will negotiate higher nominal wages in anticipation of higher prices, raising production costs for firms. If actual prices do not rise by as much as expected, real wages are higher than planned, marginal costs exceed revenues, and firms supply less at every price level. Higher inflation expectations embedded in wage contracts shift the SRAS leftward, raising the price level and reducing output for a given AD curve.

This is precisely why central banks are so concerned with anchoring inflation expectations. If households and firms believe the central bank will keep inflation low and stable, stays anchored, the SRAS remains stable, and the economy avoids the stagflationary dynamics that arise when expectations become unmoored.

Theoretical Interpretation

The role of expectations in shifting the SRAS provides the microeconomic foundation for the expectations-augmented Phillips Curve, developed by Friedman (1968) and Phelps (1968). Their argument was that any attempt to exploit the short-run trade-off between inflation and unemployment by surprise demand expansion would eventually cause workers to revise their inflation expectations upward, shifting the SRAS leftward and returning the economy to the natural rate of unemployment at a permanently higher inflation rate. This insight demolished the notion of a stable long-run Phillips Curve and redirected macroeconomic policy towards credibility and expectation management.

Exam Insight

When answering questions about stagflation or supply-side shocks, emphasise that the SRAS shifts left when either falls or rises. The 1970s oil shocks are the canonical example: higher energy costs reduced and raised cost expectations simultaneously, producing a leftward SRAS shift that generated both higher inflation and lower output.

Summary

The SRAS shifts left (or up) when:

  • rises (higher inflation expectations)
  • falls (adverse supply shock: labour, capital, resources, technology)

The SRAS shifts right (or down) when:

  • falls (lower inflation expectations, credible disinflation)
  • rises (favourable supply shock: productivity growth, technology)

From AD-AS Framework to Business Cycles

The AD-AS model is the principal analytical tool for understanding macroeconomic fluctuations. Having derived all three curves and catalogued their shift factors, the framework can now be deployed to trace the economy's response to a variety of shocks.

A demand shock (such as a collapse in consumer confidence, a tightening of monetary policy, or a fiscal contraction) shifts the AD curve. In the short run, with the SRAS fixed, output falls below and the price level falls: the economy is in a recessionary gap. Over time, workers accept lower nominal wages (revising downward), the SRAS shifts right, and the economy returns to at an even lower price level.

A supply shock (such as a sharp rise in oil prices or a natural disaster) shifts the SRAS leftward. In the short run, output falls and the price level rises simultaneously — a phenomenon known as stagflation. The economy faces an inflationary gap in terms of prices but a recessionary gap in terms of output, presenting policymakers with an uncomfortable trade-off: stimulating AD to recover output exacerbates inflation, whilst contracting AD to fight inflation deepens the recession.

Economic Intuition

Business cycles are the economy's journey away from and back towards the long-run equilibrium point A on the AD-AS diagram. Every lecture in this course that discusses policy — monetary policy, fiscal policy, stabilisation — can ultimately be mapped to a question of how a particular intervention shifts AD or SRAS and whether it helps or hinders the return to .

Summary

Key takeaways for business cycle analysis using AD-AS:

  • Business cycles are temporary deviations of output from .
  • Demand shocks move output and prices in the same direction.
  • Supply shocks move output and prices in opposite directions (stagflation when adverse).
  • Self-correction occurs through wage and price adjustment, which shifts the SRAS over time.
  • Policy intervention can accelerate this adjustment but at potential costs (inflation, credibility).

Bibliography

Friedman, M. (1968) 'The role of monetary policy', American Economic Review, 58(1), pp. 1–17.
Lucas, R.E. (1972) 'Expectations and the neutrality of money', Journal of Economic Theory, 4(2), pp. 103–124.
Lucas, R.E. (1973) 'Some international evidence on output-inflation trade-offs', American Economic Review, 63(3), pp. 326–334.
Mankiw, N.G. (2020) Macroeconomics. 10th edn. New York: Worth Publishers.
Phelps, E.S. (1968) 'Money-wage dynamics and labor-market equilibrium', Journal of Political Economy, 76(4, Part 2), pp. 678–711.
Taylor, J.B. (1979) 'Staggered wage setting in a macro model', American Economic Review, 69(2), pp. 108–113.