See Also Aggregate Demand Curve
Classical theory relies on market adjustments to changes in individual supplies and demands to keep an economy close to full employment. Thus, it predicts a vertical long-run Aggregate Supply curve. Keynesian theory deals with a depressed economy---so many resources are idle that Aggregate Supply is horizontal. An intermediate position is that Aggregate Supply is positively sloped.
In the short run, the Aggregate Supply curve reflects a positive relationship between the price level and the real quantity of National Output.
This short-run positive relationship occurs primarily because production costs (e.g., wages) are "sticky" relative to output prices when demand changes. Increases to Aggregate Demand cause movements up along the Aggregate Supply curve in which prices rise more quickly than wages, so higher profit per unit induces more output. Declines in Aggregate Demand reverse these movements along the Aggregate Supply curve---prices fall more quickly than costs, so profits decline and firms reduce production.
Along the Aggregate Supply curve shown in Figure 3, if output is below Q0 and much capacity is idle, then output can increase in the short run without significant hikes in the price level. But when the classical prediction of full employment is approached, even small increases in output above Qf necessitate large increases in the price level. Between output levels Q0 and Qf, moderate growth in output results in relatively smaller price hikes.
Figure 3 The Aggregate Supply Curve
As is true for typical market supply curves, the Aggregate Supply curve is positively sloped. Thus, increases in Aggregate Demand along a stable Aggregate Supply curve normally entail increases in the price level and national output.
National Output and the Work Force
Increases in the total demand for labor generate pressure for more employment and output and for hikes in wages and prices as well. Conversely, declines in the economy-wide demand for labor create pressure for lower employment, output, wages, and prices. There are, however, differences between short-run and long-run adjustments. Understanding Aggregate Supply requires an appreciation of these differences.
Labor Markets: The Short Run
Keynesian models emphasize short-run adjustments. Suppose Aggregate Demand grew slightly during a severe depression like that of the 1930s. Keynes believed that high unemployment permits firms to fill all vacant positions at the going wage, so the relevant part of the aggregate labor-supply curve is assumed to be flat, while extensive idle capital limits diminishing returns as a problem. Thus, if the demand for labor grows during a depression, employment and output rise, but wages and prices may not. Consequently, Keynesian analysis assumes a horizontal Aggregate Supply curve (see the Keynesian depression range in Figure 3). Remember that from Keynes' point of view, Say's Law was backwards and should have read "Demand creates its own supply."
Keynes' assumptions about depressed labor markets are drawn from the 1930s experience of a prolonged depression. Labor's supply curve normally has a positive slope because drawing more workers into the labor force requires higher wages; rising wages also enable unemployed workers to more rapidly find jobs they perceive as suitable. As firms pay higher wages to attract additional employees, wages rise for all workers. This results in a moderately positive slope in the Aggregate Supply curve in its intermediate range in Figure 3.
Workers know that higher prices lower their real wages, but there is a lag between a given inflationary decline in real wages and labor's recognition of this loss. Workers may temporarily be "fooled" by hikes in money wages that are less than inflation, so more labor services may be offered even if real wages decline. This is shown in Figure 4. Initially, Q0 workers are hired at a wage of $10 per hour (at point a where DL(P=100) and SL(P=100) cross). Since the price level is 100, real wages (w/P) is also $10 ($10.00/1.00 = $10.00).
Figure 4 Labor Markets and Changes in Inflation Rates
Workers are aware that higher prices lower their real wages, but there is often a lag between inflation and labor's recognition of this loss. Rising prices (P=120) increase the demand for labor and the employment moves from the original equilibrium at point a to point b. Initially, more labor is supplied at $11.00 per hour. Eventually, however, workers realize that this higher nominal wage is less than the original real wage of $10.00 and labor supply shifts to SL(P=120) and the new equilibrium is point c where employment declines to Q0 and real wages return to $10.00 ($12.00/1.20 = $10.00).
Firms hire more labor to produce more output if they perceive increased profit opportunities---output prices that rise faster than nominal wages. Rising prices (P=120) generate additional demands for labor equal to DL(P=120) and employment grows to Q1 and wages rise to $11.00 per hour. In the short run, workers fail to revise their expectations about changes in the price level and are fooled because they believe the original price level will prevail. Notice that real wages (w/P) have actually fallen to $9.17 per hour ($11.00/1.20 = $9.17). Workers may suffer from inflation illusion in the very short run, but
their misconceptions are unlikely to persist.
Labor Markets: The Longer Run
The long-run orientation of classical reasoning represents the polar extreme from Keynesian analysis. New classical economics assumes that workers react to changes in real wages almost instantly, keeping the economy close to full employment. At the very least, there can be no involuntary unemployment.
Workers try to base decisions about work on real wages, not on nominal money wages--- what their earnings will buy, not the money itself. In the longer run, workers recognize that price hikes reduce their real wages (w/P) and react by reducing the real supply of labor. This is shown as a reduction in labor supply to SL(P=120) in Figure 4. This restores the labor market to long-run equilibrium at point c where Q0 workers are employed at a real wage of $10.00 ($12.00/1.20 = $10.00).
To summarize, suppose Aggregate Demand grows in an economy that is close to full employment. Higher money wages may temporarily lure more workers into the labor force if they expect the price level to remain constant. Once workers recognize that prices have risen, they demand commensurate raises. This yields the vertical long-run Aggregate Supply curve shown as the classical range in Figure 3.
In reality, workers react slowly to changes in real earnings. A couple of reasons help explain why individual workers may be more easily "fooled" by inflation than are the firms that employ them. First, a major decision by a big firm may put millions of dollars on the line, while individual workers have only their salary at risk. Thus, firms devote more resources to forecasts of inflation. Second, a firm only needs to estimate how much extra revenue will be generated if extra workers are hired to know how much of a monetary wage (w) it can profitably afford to pay. This calculation requires only estimates of the worker's physical productivity and a forecast of the price (pi) at which the firm will be able to sell its own product.
Thus, the real wage paid a worker from the vantage point of the firm is w/pi. Workers, on the other hand, must have forecasts of all the prices of all goods they expect to buy (e.g., the CPI) before they can estimate the future purchasing power of their monetary wages. The real wage from the point of view of a typical worker equals w/CPI, where CPI is the price level. Thus, firms may need less information about future prices (only pi) to make profitable decisions than workers need (forecasts of most prices in the CPI) as a guide for personally beneficial decisions.
Finally, in reality, when real wages drop, the options open to most workers are limited. Quitting and looking for a new position involves significant transactions costs including search, interview, lost wages and possibly uprouting of family and moving to another region of the country. Labor immobility and high information and transactions costs may mean that labor isn't "fooled" but simply can only adequately adjust in the longer term.
As a result, firms have better access to information about inflation while actually needing less information than workers do to react to changes in the price level. Workers also respond relatively slowly because (a) most long-term union contracts set nominal wages for the lives of these agreements, (b) both emplyers and employees often implicitedly agree to contracts where wages are adjusted only at scheduled intervals, and (c) changing jobs often entails considerable "search time" and lost income.
Shifts in Aggregate Supply
The Aggregate Supply curve shifts when technology changes or when resource availability or costs change. Technological advances boost Aggregate Supply, while disruptions in resource markets, higher tax rates, or inefficient new government regulations are among negative shocks to Aggregate Supply.
Shocks Operating Through the Labor Market
The notion that enhanced incentives to supply resources would boost Aggregate Supply was at the heart of the 25 percent cut in tax rates during 1981--1983 and was also partially responsible for attempts to cut growth in government transfer payment. The Reagan administration felt that this strategy would boost Aggregate Supply more than these tax cuts increased Aggregate Demand, so that substantial growth would more than offset any emerging inflationary pressure. Naturally, higher marginal tax rates would reduce the effective supply of labor and consequently, Aggregate Supply.
A second type of labor market disturbance would occur if the power of unions grew and they commanded higher wages. Wage hikes raise production costs and push up prices, shrinking Aggregate Supply. This potential problem has diminished in importance over the last two decades as union membership as a percent of the workforce has declined not only in the U.S. but worldwide.
More recently, the restructuring of American industry has led to serious changes in most labor markets. global competition, rapidly changing technology, expanded labor legislation and a broader legal liability of firms for vaious labor issues have resulted in corporate down-sizing and the added use of a contingency labor force. The wholesale trimming of employees in many companies has led some to argue that many corporate employees are becoming "overworked".
Another problem area would be any rise in the inflation rate workers expect. Inflationary expectations continuously shift labor supply curves leftward as workers try to protect the purchasing power of their earnings. Naturally, decreases in inflationary expectations or in union power will shift the labor supply and Aggregate Supply curves toward the right. Finally, people's preferences between work and leisure obviously affect Aggregate Supply.
Some analysts think that "incomes policies" may moderate inflationary expectations. The term incomes policy refers to measures intended to curb inflation without altering monetary or fiscal policies. These methods include jawboning, wage-and-price guidelines or controls, and wage-price freezes of the type imposed in 1971. President Nixon hoped the freeze would reduce expected inflation and halt continuous shrinkage of Aggregate Supply. Ideally, it might have increased the supplies of labor and output, shown as the shift of the Aggregate Supply curve from AS0 to AS2 in Figure 5.
Figure 5 Events that Shift the Aggregate Supply Curve
Unfortunately, incomes policies may perversely affect inflationary expectations and Aggregate Supply. If workers and firms share a belief that prices will soar soon after controls are lifted, they may withhold production from the market now in hopes of realizing higher wages or prices later. For example, suppose you face the following choices: You can (a) work during a period when wages are frozen and save money to cover your college expenses, or (b) borrow to go to college during a freeze and then repay the loan from funds you earn after the lid is removed from wage hikes. You (and many other people) might delay working until after the freeze. Incomes policies also hinder necessary relative price adjustments.
Other Shocks Affecting Productive Capacity
New regulations that hamper production shift the Aggregate Supply curve to the left (a movement from AS0 to AS1 in Figure 5), but elimination of inefficient regulation shifts the curve rightward. From the mid-1970s onward, deregulation and privatization of parts of our economy have been aimed at removing inefficiency and boosting Aggregate Supply.
Technological advances expand Aggregate Supply, while external shocks that raise costs for imports or resources will shrink Aggregate Supply. Shocks to the U.S. economy occurred when OPEC coalesced in 1973 and world oil prices quadrupled shortly thereafter. Most industrialized countries endured painful leftward shifts in their Aggregate Supply curves. Rightward shifts occur when new resources are found. For example, Great Britain discovered oil in the North Sea, and exploiting of huge pools of Mexican oil during the late 1970s helped Mexico. Gluts of oil on world markets and the relative instability of OPEC drove prices down; energy costs fell from the mid-1980s onward, boosting our Aggregate Supply to the right.
Influences that shift Aggregate Supply are listed in Figure 5. Understanding macroeconomic movements requires a good grasp of these concepts. We will now survey some recent theories developed by "new Keynesian" economists to explain why wages are sticky, causing involuntary unemployment to persist during some periods.