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The AS relation

At A-level you might have seen the AS curve presented in the form of a ‘short run’ AS curve which is horizontal, and a ‘long run’ AS curve which is vertical. In Blanchard’s textbook he presents it in a much more logical way – an upward sloping AS curve, which moves up and down according to expected price level. This is basically how you get from a horizontal short-run, to a vertical long-run, except Blanchard defines ‘long-run’ as ‘medium-run’, because long-run really means long term growth models like the Solow growth model that are not concerned with economic fluctuations but with the growth of the long run supply potential of the economy.

The upward sloping AS curve basically shows how output influences prices. As output rises, this drives up prices, which is one explanation for why you generally get inflation in a growing economy.

Start by combining the price-setting and wage-setting relations:
P=(1+\mu )W and W=P^e F(u,z) means P=(1+\mu )P^e F(u,z). This is the AS relation.

Now given that the AS model has P on the vertical axis and Y on the horizontal axis, if we are going to draw a curve from that relation, we need Y to be in there somewhere. Well it sort of is, because u is in there, we could express u as a function of Y.

The logic here is that there will be an inverse relation between u and Y. When there is greater demand for goods and Y increases, more workers are hired and so u falls. When Y is falling, there is less need for workers so workers are made redundant, and u rises. So really u in the AS relation kind of represents output, but in an inverse way, as rising Y means falling u.

So how does the AS curve link output to prices?

1 As output increases, more workers are hired to produce the extra output, so unemployment falls.
2 As unemployment falls, workers get more bargaining power, so the WS relation shifts up, wages rise.
3 As wages rise, the PS relation implies that higher W means higher P, so higher wages make prices rise.
4 As workers see prices are rising then expected prices rise. The WS relation implies that higher expected prices mean higher wages, so wages rise.
5 Return to part 3 and repeat.

This is the wage-price spiral and one reason why wages are a large component of driving inflation.

So we have an upward-sloping AS curve – higher Y leads to higher P:

The whole AS curve moves up or down depending on changes in expected prices, the ‘mark-up’ or the ‘catch-all’ variable:
The AS curve will shift up if expected prices rise, or if there is a negative supply shock which raises firms’ costs (eg rise in price of oil) and raises the ‘mark-up’. It would also shift up if there were changes in the catch-all variable that basically meant workers had more bargaining power to negotiate higher wages (eg higher trade union power, higher benefits etc).
The AS curve will shift down if expected prices fall, or if there is a positive supply shock which lowers firms’ costs (eg fall in price of oil, or development of new technology that cuts firms’ costs) and lowers the ‘mark-up’. The mark-up could also be lowered if you moved to a situation where you had more competitive markets. Changes in the catch-all variable that basically meant workers had less bargaining power to negotiate higher wages (eg lower trade union power, reduced benefits etc) would also shift the AS curve down.

Categories: Aggregate Supply, Macro
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