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Macroeconomics
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Chapter V. AS-AD
Chapter V. Aggregate Supply & Aggregate Demand Curve Analysis
1. Aggregate Demand
1) Algebraic Derivation
You may remember that the equilibrium national income from the IS-LM curve is
*
Y =
h
b
M
( C 0 - c1 T 0 + I 0 + G0 ) +
(
- u)
h(1 - c1 ) + kb
1 - c1 + kb P0
Let’s focus on the relationship between Y and P.
If all variables are constant except for Y and P, we can get an equation showing the
relationship between the two variables Y and P, such as Y = 500 + 200/P. This equation
carves up the relationship between two variables, Y and P, is called the Aggregate
Demand Curve.
P
( C 0 ; T 0 ; I 0 ; G 0 ; M ) s h i f t p a r a m e t e r s
AD
YP
In the discussion of monetary policy which involves a change in money supply M and its
impact on P and Y, we deliberately drop the intercept A, which is related to fiscal policies,
and frequently use Y = B/P = B’ (M/P) to carve up the relationship between the three key
variables, M, P, and Y (real income).
If we draw the graph of the above equation with Y on the horizontal axis
and P on the vertical axis, this is a hyperbola.
We know that Y = 1/X is a rectangular hyperbola. Y = A + B/X is
simply Y = 1/X shifted up by A and outward along the Y =X line by B.
The quantity theory of money postulates that the equation of exchange is M V = P Y, or
Y = V (M/P), where M is the supply of money, and V the velocity of circulation of
money. This equation is exactly the same as Y = B’ (M/P). This is a special case,
featuring monetary aspects, of the AD curve which embodies the impact of fiscal
policies along the others (∆C, ∆I) in the first term and that of monetary policies along
with monetary shocks (∆u) in the second term of the equation Y
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2) Graphic Derivation
We derive the AD curve by examining the impact of a changing price level on the LM curve
and consequently on the AD.

When the price level falls from P1 to P2, the real money supply rises from M/P1 to
M/P2. This shifts the LM curve to the right.

The equilibrium national income level rises in the IS-LM curve.
The corresponding point shifts in the AD setting. By linking the two points, we get
the AD curve.

LM (M/P1)
LM (M/P2)
P1
P2
AD
3) Shift of AD curve

∆ C0, ∆I0, ∆G0, - ∆T0  ∆IS  ∆AD

∆ M ∆LM  ∆AD

∆ md = ∆u  ∆LM  ∆AD
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In summary, the AD has six shift-parameters, C0, I0, G0, T0, M, and u.
 Out of them, C0, I0 and u are beyond the control of the government;

C0, I0 and u are called Aggregate Demand Shocks;
specifically, C0 and I0 (X0 and M0 as well in the open economy) are
goods market shocks, and
u is a monetary shock;

G and T are fiscal policy instruments;

M is monetary policy instrument.
To countervail the Aggregate Demand Shocks and thus to eliminate any impact on the
equilibrium national income, the government may control G, T, and M in counter-cyclical
ways. This is called ‘the Counter-cyclical policy’ or ‘Income stabilization policy’.
2. Aggregate Supply
1) What is the aggregate supply?
AS versus YS
The aggregate output is the sum of all the supplies of goods and services in the economy.
You may remember the 45 degree line of YS = Y in the Keynesian Cross Diagram. When
the aggregate output YS is drawn against a particular price level, that is the aggregate supply.
The only difference is that the AS is drawn again at the price level while YS is not. In a
sense, AS comes from YS. Then, our next question is, what determines YS?
2) Aggregate Production Function
AS is the aggregate outputs at a particular price level. Output results through production
process from inputs. The production function shows the relationship between the inputs and
the outputs: production combines production factors with a certain technology. The
production function summarizes all three aspects of the supply: Inputs, outputs, and
technology.
(1) Functional Form
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In microeconomics theories, an individual production function, say, a hamburger or i th
industry, is given by
Qi = f (K,L),
where K and L are capital and labor inputs, and Q output at the firm or industry level.
Technology is implied in the functional form.
The aggregate production function is obtained by summing up the production functions of all
industries. The aggregate production function shows the aggregate output YS as an
increasing function of capital and labor inputs. Again technology is implied in the functional
form. We use notation K for the capital stock or the amount of capital, and N for labor input
at the aggregate level of economy.
YS = F (K, N; T ).
Note that unlike the microeconomics which uses L for labor input, we use N for the
aggregate labor inputs, which is called the ‘level of employment’ in an economy. N may be
measured in total hours worked for a given period of time, which is equal to the number of
workers employed times the number of hours worked by each worker. Here T stands for
Technology employed in production.
(2) Derivation of the Aggregate Production Curve
Note that in the short-run, K remains fixed and T does not change. Thus the short-run
aggregate production function can be expressed as an increasing function of one variable N
or the level of employment of existing workers: the more workers employed for longer hours,
and then more aggregate output.
YS
Aggregate Production Curve

N
Let’s take a numerical example for the Short-run Aggregate Production Function:
YS = 100N – 0.3 N2
If the level of employment is given at 40 (say, million hours worked for a year), what
is YS? The answer is YS = 100 x 40 – 0.3 (40)2 = 3520.
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If N increases up to N = 60, then the aggregate outputs rise to a new level: 100X60 –
0.3 (60)2 = 4920.
These two points give us an aggregate production curve. It is upward sloping, and is
convex upwards. In the short-run, there is a one-to-one relationship between the level
of employment and the aggregate outputs: N*’ – AS* t in the short-run. An increase in
the level of employment leads to a movement along the given aggregate production
function.

Note that the slope of the tangent line to the Aggregate Production Curve is the
Marginal Product of Labor.
The shape of the above Aggregate Production Curve is part of a so-called ‘S curve’ of the
total (aggregate) production curve:
YS
N
The first phase or Phase I shows the concave upward and implies that as the input of labor
force or the level of employment goes up, the output increases by more than proportion due
to an increase in efficiency coming from specialization and cooperation, etc. That is an
increasing marginal product of labor or MPL increases in this phase.
Then there occurs a point of inflection. The curve become convex upwards and implies that
as the input(labor forces or level of employment) rises, the output increases by less than
proportion: This is the area where the diminishing marginal product of labor takes place. As
the level of N increases by one unit, the output increases but it does so by less and less. It is
called ‘Decreasing Marginal Product of Labor’. This is due to some imbalance between the
size of (given) capital (equipment and facilities) and the number of workers working in and
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Chapter V. AS-AD
with them, and the resultant inefficiency such as congestion(too many workers collide and
crowd, free-riders(some workers are not carrying their fair work load)etc.
Our earlier aggregate product curve is a cut out of the above S curve from and beyond the
inflection point. Why cut here? Because Phase I is important and beneficial for the
producer, but it is uninteresting. All the decision to be made is trivially to keep expanding
the employment (N up). When the inflection point comes, now the entrepreneur has to start
thinking of a very critical question: When to stop? He has to weigh the inefficiency, which
has started setting in, against other benefits, and has to make a decision to stop at the right
level of N. Thus, this part of S curve is important in terms of the entrepreneur’s corporate
decision making, and we are only looking at this part of the S curve of the total production
curve.
YS
N
(3) Shift of Aggregate Production Function
In the long-run, i) an increase in N, ii) an increase in K, and iii) the enhanced level of
technology are all possible, leading to an increase in Aggregate Output. However, an
increase in N leads to a movement along the Aggregate Output Curve, and the two others,
such as an increase in K or/and T leads to a shift of the Aggregate Output Curve.
i) Capital Accumulation: ∆K
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With more capital inputs, each level of employment will lead to a larger amount of aggregate
outputs: With more capital equipment, each worker can produce more outputs.
This will send the Aggregate Production Curve outward, or upward.
YS

Let’s take a numerical example,
N
Before: Y* = 100 N – 0.3 N2 (a Old production function)
N = 40 – Y* = 3520; N = 60 – Y* = 4920.
After: Y* = 250 N – 0.2 N2 (a New production function)
N = 40 – Y* = 5680; N = 60 – Y* = 8280.


Therefore, capital accumulation (∆K) leads to a upward shift of the production curve.
When the Aggregate Production Curve shifts up, at each level of N, the slope of the
tangent line gets steeper: The slope is equal to the marginal product of labor, and thus
the MP of labor rises.
Think about the decrease in capital, which will send the Aggregate Production Curve
downward.


Capital naturally wears and tears over time and it is called ‘Depreciation’
Capital can be destroyed during a war.
ii) Technical Innovation, or Technological Advances: ∆T
With an improved production technology, each level of employment will lead to a larger
amount of aggregate outputs.
Let’s take a numerical example:
Before: Y* = 100 N – 0.3 N2 ( a Old production function)
N = 40 – Y* = 3520; N = 60 – Y* = 4920.
After: Y* = 150 N – 0.2 N2 ( a New production function)
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N = 40 – Y* = 5680; N = 60 – Y* = 8280.

Therefore, technological advances also lead to a upward shift of the production curve.
The marginal product of labor rises, too.
YS
N
iii) A Growing Number of Workers: ∆Ns
This is a rightward shift of the labor supply curve. The equilibrium nominal wage rates fall:
So does the real wage rate. The equilibrium level of employment rises, which increases the
aggregate outputs along the aggregate production function.
This can happen in the long run due to population growth, or open-door immigration policies.
As N is on the horizontal axis, this leads to a movement along the aggregate production curve.
3) Aggregate Labor Supply and Demand Curve: Labor Market
Then, the question in order is how the level of employment or N* is determined to enter the
aggregate production function. N* is determined in the labor market through the interplay of
the aggregate labor supply and aggregate labor demand. Now, we note that we are
introducing one more market into the picture, and that is the labor market.
The supply of labor is an increasing function of real wages, which are money wage over the
price level ( w = W/P), and the demand for labor a decreasing function of real wages.
(1) Aggregate Labor Supply
The labor supply is an increasing function of real wages, which are equal to nominal wages
divided by the price level;
Ns = f (W/P; other variables)
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For a given level of P, as W rises, Ns rises as well.
If you put Ns on the horizontal axis and W on the vertical axis, the curve should be positively
sloped. And P becomes a shift parameter.
W/P
Ns

Numerical Example:
Ns = 100 + 3 (W/P).
If the nominal wage or money wage (rate per hour) is $10 per hour and the price level
is equal to 1, then the real wage (rate per hour) is 10/1 = 10, and the aggregate labor
supply would be 100+ 3 times 10/1 = 130.
The above is sufficient for the labor supply curve in macro. Note that the vertical axis is in
the real wage W/P. The labor supply is an increasing function of real wage.
However, in the macroeconomics, we would further separate real wage W/P into nominal
wage W and price level P. If we draw the aggregate labor supply curve Ns against the
nominal wage W, we can see impacts of P more clearly.
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How can we do that? First, hold P = 1 constant, then W/P becomes W, and draw the Ns
curve of the same shape:
W/1 = W
Ns (for P=1)
Ns
Note that now the vertical axis is W or nominal wage, and the horizontal axis is the level of
employment or N, and finally that the Ns curve or the aggregate labor supply curve is drawn
with the fixed price level of 1. Thus we should note that the price level is now the shift
variable of the Ns curve.
What will happen to the Ns curve for P =1 if the price level rises from 1 to, say, 2 while the
nominal wage (rate for hour) is held constant?
A Shift of the Ns curve:

In the short-run, a change in the price level shifts the Ns curve. As P rises, the Ns
curve shifts up as well; As P rises, for a given level of W, the real wage of W/P falls,
and thus labor supply falls.
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When P rises from P=1 to P=2,
Ns (for P=2)
Ns (for P=1)
W
Ns decreases
There are other variables that shift the Ns curve.

For example, in the long-run, as population grows, the aggregate labor supply curve
shifts to the right.
When population grows or more immigrants come, the Ns shifts to the right
Ns
Ns’
W
Ns increases
In summary, for the dimension of W and N, we can write the aggregate labor supply curve
as:
Ns = f (W(+) : P(-) , other variables such as population, immigration, etc.)
All other variables, except W and Ns, become shift variables. A change in these shift
variables leads to a shift of the Ns curve.
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Remember that an increase in the price level or P leads to the visually upward movement of
the Ns curve or a decrease in Ns.
(2) Aggregate Labor Demand:
Let us examine the labor demand first:
The aggregate labor demand is a decreasing function of real wages:
Nd = g (W/P; other variables).
If we draw a curve which shows the relationship between Nd and W. It will be downwardsloping; as W goes up, the entrepreneurs demand for labor falls. The third variable P
becomes a shift parameter.
W/P
Nd
By holding P = 1 constant, we can get a Nd curve corresponding to P=1.
W/1
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Nd (P=1)
Nd
Background-You may recall the following Microeconomics theory of labor
demand:
The entrepreneur does demand labor and hires workers. If s/he is maximizing profits,
at the margin or for the last worker hire, the cost is equal to the benefit. The cost of
hiring the last worker in monetary terms is the money wage W, and the benefit from
hiring the worker is the marginal product MP (units of output the worker produces)
times the price of the output P. So at the profit maximizing level of employment, W
= P x MPL.
Numerical example) It costs $10 to hire a worker because W = $10. The last worker
increases the total products or outputs by 5 (5 units of outputs), and each unit of
output has the price of $2 in the market. The cost of hiring the last worker is $10,
and the benefit from hiring her/him is 5 times $2, being equal to $1.
We now know that at the equilibrium for the profit maximizing firm
W = P x MPL in dollar terms, or W/P = MPL in physical terms.
MPL is a decreasing function of the amount of labor inputs.
The real wage w= W/P is set by market forces, and is paid uniformly to all workers,
regardless of whether there are many or few workers.
When the real w = W/P is set at a certain level in the labor market, the entrepreneur
who is a price taker will hire workers in such a number that the last worker’s
marginal product is equal to the real wage set in the market. The entrepreneur is
making profits from hiring intra-marginal workers (all the workers except the last
worker hired) as their marginal products are higher than the real wage. S/he is not
marking any profit from hiring the last or marginal worker (MP = W/P) This implies
that the MPL curve itself drawn against real wages is the labor demand curve.
A Shift of the Nd curve:

As P or the price level rises, the real wages (W/P) falls for a given level of W. And
thus Nd rises: this is a rightward movement or upward movement of Nd curve.
As P rises, say from 1 to 2, while W is held constant,
W
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Nd(P’)
Nd(P)
N
Nd rises
where P =1, and P’ = 2 in this case.
There are other variables that shift the Nd curve:

In the long run, ∆K or an enhanced technology increases each worker’s productivity
or marginal product. The MPL shifts up, and the labor demand curve shifts up (or to
the right): some workers who used to be unproductive and thus unemployable
become now productive due to technical innovations and become employable. There
is an increase in the aggregate labor demand by the entrepreneurs.
W
Nd’
Nd
N
Nd rises
In summary, for the dimension of W and N, we can write the aggregate labor supply curve
as:
Nd = g(W (-) : P(+) , other variables such as population, immigration, etc.)
All other variables, except W and Ns, become shift variables. A change in these shift
variables leads to a shift of the Nd curve.
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Remember that an increase in the price level leads to the visually upward movement of
both Nd and Ns curves.
(3) Labor Market Equilibrium
The interplay of the Nd and NS determines the equilibrium level of employment N* and the
equilibrium level of real wages w*;
At equilibrium,
f(W/P) = g(W/P), or
f(W: P ) = g (W: P)
We can solve for the real wages or W/P at this equilibrium in the labor market.
And then, for a given price level, we can also get the nominal wages W for this equilibrium.
Graphically,
W
W*
N*
Nd
By plugging the value of W* back into the aggregate labor supply or demand function, we
can get N*
In summary, As – YS – N*- w* - W for a given level of P.
(4) Responses of Nominal Wages to Changing Price Levels: Flexible or Not?
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We would revisit the question of what will happen to the equilibrium real wage W/P = w
when the price level rises? This depends on what will happen to nominal wage or W when
the price level rises.
In the microeconomics, which belongs to the world of classical economics, there is an
assumption of flexibility of nominal wage. In other words, the nominal wage W will rise in
an exact proportion to the increase in P. As P rises, W rises by the same amount. Thus, W/P
= w or real wage does not change. There will be no change in the level of employment N,
and thereby no change in aggregate output YS or real national income Y.
The flexibility of nominal wage W ensure the separation of the world of nominal variables
such as W and P, and the world of the real variables such as N, YS, and Y. There is a
dichotomy between the real and the nominal variables.
However, in macroeconomics, there are different schools which have different assumptions
about the degree of flexibility of nominal wage. And the different degrees of flexibility of
nominal wage opens up the possibility of W not exactly following the movement of P and
thus lead to a change in real wage or w =W/P, level of employment N, aggregate output YS,
and real national income Y. An increase in the price level, which is a change in nominal
variable, can affect the real variables.
Let’s elaborate on this point:

If W is viewed to be flexible, just as assumed in the classical economics, and follows
the movement of P, a change in P will be accompanied by an equal movement of W,
leaving w unchanged.
First, the rising P shifts both the labor supply and demand curves up;
The new equilibrium occurs at E;
The new equilibrium nominal wages are proportionally higher than the previous one:
In other words, the increase in W is proportional to the increase in P;
Therefore the real wages (w= W/P) do not change;
The level of employment is the same as before.
W
W1
W0
E
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Nd
This flexibility of money wages and thus the consequent constancy of real wages belong to
the classical world, where i) there is no information asymmetry between the entrepreneurs
and the workers: There is no money illusion on the part of workers (it goes without saying
that any working, let along successful, entrepreneurs should NOT have any money illusion at
all); ii) there is no structural rigidity which hinders flexible changes of money wages in
response to a change in price level, particularly of downwards changes or falls to a falling
price level in the case of recession, such as labour unions, and finally iii) it is in the long-run
– enough of time has passed to make a full adjustment of money wages to a changing price
level.
However, John Maynard Keynes saw the real world differently: First, he argues that yes, in
the long-run, the money wages will adjust fully to a changing price level and everything will
be fair and square, but that in the long-run ‘we are all dead’. We may live through a series of
short-terms, and constant changes in equilibrium. In the short-run, money wages can be rigid
for many reasons. For one thing, it may be confusion on the part of the workers, such as
money illusion. Even in the long-run, money wages can be rigid even amid recession, and
they are so mainly due to institutional elements such as labor unions. Why did the Great
Depression last for such a long period of time – 10 years or so? It was mainly due to the
rigidity of money wages backed by labor unions, and also due to ‘confusion’ by a political
leader. Let’s listen to Professor G. Smiley in her contribution of ‘The Great Depression” in
the Concise Encyclopedia of Economics:
“….In previous depressions, wage rates typically fell 9-10 percent during a one- to
two-year contraction; these falling wages made it possible for more workers than
otherwise to keep their jobs. However, in the Great Depression, manufacturing firms
kept wage rates nearly constant into 1931, something commentators considered quite
unusual. With falling prices and constant wage rates, real hourly wages rose sharply
in 1930 and 1931. Though some spreading of work did occur, firms primarily laid off
workers. As a result, unemployment began to soar amid plummeting production,
particularly in the durable manufacturing sector, where production fell 36 percent
between the end of 1929 and the end of 1930 and then fell another 36 percent
between the end of 1930 and the end of 1931.
Why had wages not fallen as they had in previous contractions? One reason was that
President Herbert Hoover prevented them from falling. He had been appalled by the
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Chapter V. AS-AD
wage rate cuts in the 1920-1921 depression and had preached a “high wage” policy
throughout the 1920s. By the late 1920s, many business and labor leaders and
academic economists believed that policies to keep wage rates high would maintain
workers’ level of purchasing, providing the “steadier” markets necessary to thwart
economic contractions. When President Hoover organized conferences in December
1929 to urge business, industrial, and labor leaders to hold the line on wage rates and
dividends, he found a willing audience……”
Perhaps, it wasn’t Mr. Hoover who found the audience, but it was the general public
(workers) that found Mr. Hoover as a populist politician. He meant to have represented the
workers by supporting an artificially high money wages, but in the end, he prolonged the
depression into the Great one in history.
Thus the Keynesian world goes as follows:

If W is fixed, particulary downwardly rigid: An increase in P may or may not be
accompanied with a commensurate increase in money wages or W, and thus may lead
to a decrease in real wages or w. However, more apparently, a decrease in P during
the recession may not lead to a corresponding fall in money wages or W. It may be
due to three things: money illusion on the part of workers; labor unions, and/or in the
short-run. In any case, it will lead to an increase in real wages or w: an increase in
the real labor cost on the part of entrepreneurs and thus their demand for labor
decreases.
First, the increasing P shifts both the labor supply and demand curves visually up.
However, the nominal wages are set at a fixed level, shown by the horizontal line;
nominal wages cannot be nothing other than the fixed level.
The new equilibrium should come at E where the labor demand curve and the
horizontal nominal wage line (effective labor supply curve) intersect.
At the new equilibrium, compared with the previous equilibrium, the nominal wages
are the same, and the equilibrium level of employment N is higher.
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Ns
W
E
E
(effective labour supply)
Nd
N
*
N
*
0
Nd
The first position is taken by the classical economics, which is the same as the
microeconomics, and the second is by the Keynesian economists. The second is true
when there is structural impediment to the flexible mobility of W or nominal wage. This
is the case when there is a union which insists on having fixed nominal or monetary
amount of wage. In other words, when workers’ unions have ‘money illusion’ and
thereby focus on the nominal value of wage instead of real value or purchasing power of
the wage. This is also the case when the time-period of observation is too short. In a
very short-run, the change in the price level is not reflected in the wage level. The third
possibility is when the people (= the workers) have some kind of ‘money illusion’. The
money illusion refers to the situation where, being faced with a changing price level P,
the people really should focus on the real wages w = W/P but they in fact have ‘hang-up’
on the nominal wages, and thus they try to stick to the fixed nominal wage( W bar). The
end result is that real wage instead changes and so do N*, YS, and Y.
On the other hand, if there are no impediments on the mobility of nominal wage W and
workers are more or less fully employed W will move in the same direction as the
changing P in the long-run. ∆P means an increase in living –costs for workers, and
workers will eventually demand a higher money wage or ∆W.
Basically, the AS analysis hinges upon what is happening when the price level changes:
What is the impact of a change in the price level on real wages and on the equilibrium
employment level?
4) Derivation of Aggregate Supply Curve
(1)Different Aggregate Supply Curves
You may remember that the AS is assumed to be vertical in the classical economics, and
horizontal or upward sloping in the Keynesian economics.
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You may recall that the classical AS curve is vertical; the AS is fixed at a certain level. The
fixed level of AS is called ‘the full employment level’.
Note: The full employment does not mean zero unemployment, but a low yet positive
rate of unemployment. A certain positive rate of unemployment is inevitable for an
economy where new comers are looking for best-fitting jobs and some workers are
upgrading their skills and consequently searching for another jobs. Some
unemployment is even desirable as it provides some reserves in the economy; without
it the man/women-power situation is too tight, and a firm which is faced with even
temporary rise in the demand for its products would have extreme difficulties in
hiring extra workers. As a consequence, we will observe a shortage of the good or a
rise in its price. We need a small ‘buffer’ of unemployed workers. This positive rate
of unemployment compatible with a smooth working economy at the ‘full
employment level’ is called ‘the natural rate of unemployment’. The corresponding
national income is the ‘natural real national income.’
In the short-run, there may be some temporary deviation of the actual national income from
the full employment N.I., but the price level will adjust to push the economy back to the
equilibrium. The Business Cycles can occur due to the demand shocks. However, it is only
temporary, and is of no big concern as the economy, if left alone, automatically gravitates
toward a unique equilibrium N.I.
What is the role of the government in the economy?
If there is no factor in the economy which blocks the above tatonnement, the government
should not create anything which can get in the way of this natural adjustment process of
recovering the equilibrium. Actually it should eliminate any impediments in this process and
facilitate the adjustment process by promoting competition.
You may also recall that the Keynesian Aggregate Supply curve is upward-sloping; the AS
responds positively to the (output) price level.
(2) Fundamental Cause of Different AS curves.
Flexible Nominal/Money Wages  A vertical AS curve.
(Neo Classical)
Rigid Nominal./Money Wages  a Positively Sloping AS curve. (Keynesian)
The reasons for rigidity:
Money Illusion; a kind of stupidity at the individual level
Union, etc: a kind of ‘social’ and ‘structural’ rigidity
To derive the Aggregate Supply Curve, first you need a Four-Panel graph of AS-AD, Ns and
Nd, and Aggregate Production Curve and a 45 degree-line of converting YS into Y.
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The AS curve shows the relationship between the different levels of prices, or Ps, and the
corresponding levels of real national income, orYs. Thus, you have to kick up and down the
price level or P, and to find the corresponding Y.
(3) Classical Aggregate Supply Curve: A Vertical AS Curve
Under what circumstances would the money wage be flexible?
i)
The economy is at full employment level: all available workers are fully
employed; there are no other workers who are willing to work for the real wage
lower than the prevailing rate;
ii)
There is no structural rigidity of money wage: no impediment on the equilibrating
force in the labor market;
iii)
The workers are free of ‘Money Illusion’;
iv)
In the long-run: an enough amount of time has elapsed since ∆P.
This is a graphic and somewhat mechanical derivation:

1.) Choose a price level, say, P1.

2.) For this given price level, we can have the labor supply and demand curves;
Ns = f (W/P); and Nd = g (W/P) become
Ns = f (W: P1); and Nd = g (W: P1).
Or, by simply showing the shift variables, we can write down
Ns (P1); and Nd (P1).

3.) The intersection of the labor supply and demand curves gives the equilibrium real
wage w= W/P, in the labor market; N* and W* for a given P (thus w*).

4.) The equilibrium N* feeds into the aggregate production function of
YS = F (K, N*; T) for a given K and T in the short-run.

5.) YS = Y the third panel.

6.) Y goes down to the fourth panel and matches the starting price level P1.

7.) Suppose that the price level goes up to P2.
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Chapter V. AS-AD
8.) As P rises, both labor supply and demand curves shift up.
Now we get Ns (P2); and Nd (P2).
These are shown with broken lines in the graph below.

9.) We get the new equilibrium. At this new equilibrium, the new nominal wages are
higher than the previous nominal wage by the same proportion of the increase in P.
And thus, the real wages do not change; the level of employment does not change,
either.

10.) The same level of employment feeds into the aggregate production function, and
leads to the same level of YS.

11.) The same level of Y in the third panel.

12.) The same Y goes down to the fourth panel and matches the new price level P2.

13.) By linking the two points in the fourth panel, we get the AS curve.
YS
YS
N
Y
W
AS (w)
W*2
Ns(P1
)
P2
P1
W*1
P
2
1
Y
Nd(P1)
N*
Y*
Note that along this AS curve the real wage is constant but money wage is not: at
point 1 the corresponding money wage is W*1, and at point 2 the corresponding
money wage is W*2. However, at both points, the real wage is equal to w.
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An intuitive explanation is as follows:
When P rises, W will rise proportionately. The revenues (P Q) and the costs (W L)
are increasing proportionately, and thus the profit margin does not change. There is
no reason for entrepreneurs to attempt to expand production scale. The AS remains
constant at the macroeconomic level, too.
P increases and W increases  W/P remains unchanged  N remains unchanged
YS remains unchanged  Y remains unchanged, and thus a vertical AS we get.
(Supplement: Why does W/P determine the profit margin?)
Production decisions are made ultimately by producers, or entrepreneurs who weigh the
situations in the output market (which determines revenues) and the input market (which
determines costs).
Entrepreneurs make supply decisions by weighing the ratio of output price to input price,
which is the key variable for their profits which constitute their prime motivation.
Entrepreneurs are orchestrating production processes (borrowing capital, hiring workers,
etc.) in order to earn profits.
Formally, the aggregate production function shows the relationship between inputs such
as capital (K) and labor (L), and outputs. These aggregate outputs are the aggregate
supply or Y in Y – YS: Y = F (K,L)
We know that an increase in K and L leads to an increase in Y. However, it does not
happen by itself. In order to have a larger amount of inputs and consequently more
outputs, entrepreneurs should exert themselves to organize more K and L. What would be
the incentive for entrepreneurs to produce more? They respond to a larger profit margin.
Profit is revenues minus costs. Revenues are Output Price times Quantity.
Costs are Input Price times Input Quantity. Profit = Total Revenue – Total Cost = P Q – (
r K + W L). In the short-run, P and W determines the magnitude of profits; an increase in
P increases profits, and an increase in W decreases profits.
(4) Keynesian Aggregate Supply Curve
Basic assumptions are as follows:
i)
ii)
iii)
The time is too short for W to change,
There are impediments on the flexibility of W, or
There is unemployment; there are other workers other than the present employees,
who are willing to work for less than the present real wage.
Graphic Derivation is as follows:

Start with P1.
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Chapter V. AS-AD
For the given price level, get the labor supply and labor demand curve in the second
panel.
The intersection of the labor supply and demand curves gives the equilibrium level of
employment N1.
This feeds into YS1 in the aggregate production function.
YS1 = Y1 in the third panel.
Now in the fourth panel, Y1 matches with P1.
Suppose that the price level goes up to P2.
This sends both the labor supply and demand curves up.
However, the level of nominal wages does not change due to unions or money
illusion. It is the effective labor supply curve; note that it replaces the shift labor
supply curve, which is meaningless.
The new equilibrium level of employment is given at N2.
This feeds into the aggregate production function to give YS2 = Y2.
Y2 goes down to match P2.
By linking the two points of Y in the fourth panel, we get the Keynesian Aggregate
Supply Curve. It is upward-sloping.
(W)
P2
E’
Fixed W*
N1*

N2*
P1
Y1
Y2
Along the Keynesian AS curve, the nominal wage rates are fixed at W*. However,
real wages vary along the AS curve. That is because the money wage is fixed along
the AS curve, but the price level varies: The real wage (=W/P) must vary along the
curve.
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This contrasts with the fact that along the previous classical AS curve, which is
vertical, the real wage is fixed but money wage varies.
Suppose that there is a huge excess capacity of production: this is possible as the
economy is just coming out of a big recession. Even a very small increase in the
price level leads to some increase in the revenues of companies (= P x Q), and the
entrepreneurs will respond to this increase in revenues in a big way by hiring a lot of
new workers back to the production process. We can have a very flat AS curve as
well.
Depending on the elasticity of the supply side, we can get the almost horizontal SAS
curve as we have seen in Chapter 1.
(W)
E’
Fixed W*
N1*
N2*
P2
P1
Y1
Y2
Intuitive Explanation for the upward sloping AS curve is as follows:
When P rises, W remains constant. The revenues increase while the costs are fixed, and thus
the profits increases. The larger profits will give a greater incentive for entrepreneurs or
employers to expand production scale by hiring more workers. If this expansion of output
happens to all firms, the aggregate supply will increase.
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Chapter V. AS-AD
P increases with W being fixed  w(=W/P) decreases  Nd increases  N*
increases  AS = y = F (K, N) increases
The opposite can happen, too.
P decreases with fixed W w(=W/P) increases  Nd decreases  N* decreases 
AS = y = F (K, N) decreases
Let us explain the same thing in terms of real wages, which is nothing but the ratio of W and
P or W/P. The profitability is related to the ratio of W to P (=W/P), which is real wage or
constitutes ‘real’ cost of hiring workers.
1) When W/P falls, the real cost of hiring workers is falling, the profit margin
widens, and thus more (incentive for) production (on the part of the
entrepreneurs):
Real wage (W/P) decreases  Nd increases  Actual N* increases  AS = y = F
(K, N) increases
2) When W/P rises, the real cost of hiring workers is rising, the profit margin is
reduced, and thus less (incentive for) production (on the part of the
entrepreneurs).
W/P increases  Nd decreases  Actual N* decrease  AS = y = F (K, N)
decreases
Note: a larger W/P sounds like good news for the workers. You may be wrongly
reasoning: “a larger W/P means a larger incentive for the workers to work. The
longer and harder the workers are working, the larger the output. And the workers
will have more money to spend.” (This is the very wrong idea that Mr. Hoover had
during the Great Depression).
But it is not workers but entrepreneurs that make production decision. In the above
case, who will hire the larger number of more willing workers at such a high real
wage level? The willing workers will not be hired as they cannot force the
entrepreneurs to hire them above and beyond the latter want to.
So we are assuming that the actual amount of employment is determined along an
entrepreneur’s labor demand curve, not along the worker’s labor supply curve, and
the effective labor supply curve, which is basically the horizontal line from the fixed
money wage or W.

Can you mathematically express the AS curves of the Keynesian and the Classical
economists?
Classical AS curve: Y = F(K, Nf) = Yf, say, 1000.
Keynesian AS curve: Y = F(K, Nf + dN) = Y – a (W/P), say = 1500 – 100 (W/P):
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Some may argue that the Classical AS curve is valid in the long-run; and the Keynesian AS
curve is valid in the short-run;
Short-run AS = Keynesian AS
Long-run AS = Classical AS
One might have the SAS curve in the short-run when the time is too short for W to change
and the LAS curve in the long-run when enough time elapses for the adjustment of W.
5) Shift of Aggregate Supply Curves

i)
ii)
iii)
iv)
The Long-run AS shifts(to the right) when
∆K
∆Technology
∆Population
Positive Supply shocks
As the long-run AS shifts to the right, the level of long-run real national income or
full-employment real income rises.
The first two shifts the Aggregate Production Curve up and, at the same time, the
Aggregate Labor Demand curve up.
Population growth shifts the aggregate labor supply curve to the right (downward
visually).
The last one, positive supply shocks, may send the aggregate production curve up.
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Combined or not, the shifts of the aggregate production curve and the corresponding
aggregate labor supply or demand lead to an increase in YS and Y as we can easily
illustrate on the 4 panel graph.
Over time, the first three happen to a growing economy. And it is called ‘economic
growth’, and the annual economic growth rate is measured by a percentage change in
real national income.
These issues will be examined in details in a later chapter of economic growth
theories.

The Short-run AS shifts (to the right) when
The above four shift factors, and
v) ∆ Decreases in Money Wage
When the LRAS curve moves, the SRAS shifts, too, at all times.
However, it is not necessarily the case that when the SRAS shifts, the LRAS shifts: When
there is an increase in money wages, the SRAS shifts to the left (visually up), but the LRAS
stays put.
(1)An Increases in Money Wages or W:
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Suppose that unions raise the fixed nominal wages to a higher level;
YS
YS
N
Y
P2
W
New Fixed
W*’
P2
* Fixed W
P1
Nd(P2)
Ns
(W)
(W*’)
d
N (P1)

N
N1*
Y1
N2*
Along the AS curve, the nominal wage rates are fixed at W*.
Y2
Y
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(2)Technical Innovation
If we assume that there is no change in labor demand, but the technical innovation shifts up
the aggregate production function only, then
(W)
P2
E’
Fixed W*
N1*
N2*
P1
Y1
Y2
We can see that the LAS and SAS curves all shift to the right by the same amount and at the
same time: the height of the intersection of tej SAS and LAS curves stays the same.
A more realistic assumption is that the technical innovation shifts up the aggregate
production function and it also raises the marginal productivity of labour and thus increases
the labour demand by shifting it out. In this case, the equilibrium level of employment will
be higher than N1 and N2 respectively for P1 and P2. And thus the SAS and LAS shift more
to the right than the above graphs. Can you draw the shift of all the relevant curves?
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(3)An Increase in Production Cost(except for money wages) such as Oil Shock
In general, this is called ‘adverse or negative supply shock’. It shifts the aggregate
production function downward.
This permanently shifts the LRAS and SRAS to the left by the same amount.
(W)
P2
E’
Fixed W*
N1*
N2*
P1
Y1
Y2
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3. ‘Grand Equilibrium’ of Aggregate Demand and Supply
1) Grand Equilibrium
P
Long-run AS
P*
Short-run AS
AD curve
Y*
Y
The intersection of the AD curve and the Long-run Aggregate Supply curve gives the
long-run equilibrium.
The intersection of the AD curve and the Short-run Aggregate Supply curve gives the
short-run equilibrium.
There are the corresponding equilibrium national income and the equilibrium price
level for the short-run and the long-run equilibrium respectively.
2)Short-run Adjustment to the Long-run equilibrium
What if the long-run equilibrium and the short-run equilibrium do not coincide with each
other?
The long-run adjustment depends on the flexibility of Money Wage: If nominal wage or W is
flexible, then the SAS curve will move around so that the intersection of all three curves, i.e.,
LAS, SAS, and AD, come to one point.
However, please note that the above adjustment of the SAS to the LAS is not automatic. It
critically depends on the background of the economy, particularly on the flexibility versus
rigidity of nominal wages.
If for some reasons money wage or nominal wage is not flexible in the long-run, the SAS
will stay suspended. This was the case of the Great Depression.
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Chapter V. AS-AD
Suppose that the short-run equilibrium Y < long-run equilibrium Yf;
P
AD
LAS
SAS
-- deflationary gap  Y leads to more competition among workers
Y1
For instance, Yf is below the long-run equilibrium or full employment income Yf.
The deflationary gap leads to a competition among unemployed workers and thus
lower nominal wages. The falling nominal wages shift the short-run aggregate
supply curve to the right. Eventually, a new short-run equilibrium will coincide with
the long-run equilibrium.
However, if there is an impediment to the flexibility of money wages, the SAS will
stay suspended, and will not move to the new position given by the solid broken line
as shown above. And the equilibrium national income Y1 will last for a long period of
time, which is below the full employment national income Yf. It is a sustained
economic recession.

If initially short-run Y*>long-run Yf* and money wages are flexible, then there
will be an inflation gap developing, which will lead to upward pressure on
money wage. As money wage goes up, the SAS goes up as well. Eventually all the
three curves of SAS, LAS and AD, intersect at one point:
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Chapter V. AS-AD
P
---
inflationary gap
The short-run equilibrium national income exceeds the long-run or full employment
national income. This inflationary gap leads to an increase in the price level. The
labor supply in the market is tight. The competition for workers leads to a rising
nominal wage. Thus the labor supply curve will shift to the left until it passes
through the long-run equilibrium point where the AD and the Long-run AS curves
intersect.
3)Applications of the AS-AD Curve Model: Economic History of the U.S.
(1)Industrial Revolution (1869 – 1897)
Statistical data shows:
Y*
100.00
299.00
Y*
1869
1897
P
LAS0
LAS1
P*
100.00
63.40
P*
SAS0
SAS1 SAS2
P1869
(100.00)
P1897
(63.40)
Yf1869
(100.00)
Yf1897
(299.00)
AD
Y
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Chapter V. AS-AD
mainly due to LAS (SAS), which was in turn due to K, L, T during the
American Industrial Revolution
AD was stable due to no (slow) increase in (gold) money supply
An increase in population might have added, through an increase in C, I, and so forth,
but the overall it is no stronger than an increase in AS.
When LAS0 moves to LAS1, SAS0 moves to SAS1 by the same amount at the same
time(note that the intersections of the LAS and SAS before and after have the same
height). That is not the end of the story.
Note that the SAS moves once again from SAS1 to SAS2: Because the short-run
equilibrium national income given by the intersection of SAS1 and AD leads to a
short-run equilibrium national income Y (not indicated above: you may do so), and it
is below the new full employment or long-run equilibrium national income Yf 1987.
In this case, just as we have learned, the SAS should move to the long-run
equilibrium. As SAS moves to the right for this reason, there is an additional
increase in Y and a fall in P.
(2)The Great Depression (1929 – 1939)
1929
1933
1939
P
Y*
100.00
70.00
105.00
LAS
P*
100.00
75.00
100.00
SAS
AD193
AD193
AD9192
3
9
Y
Y* << Yf
- puzzling question: Why SAS did not shift to the right when P level fell between
1929 and 1933?
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Chapter V. AS-AD
The answer lies in the institutional downward rigidity of money wages that kept the
SAS there for a long period of time.
If the money wages had fallen, YSR* would not have stayed below Yf for such a long
period of time:
P
LAS
SAS0
99
SAS1
AD39
AD29
Y
Y f  YSR  YLR
*
*
(This situation did not happen in 1929-1939)
(3)Pax Americana (1945 – 1962)
-
a resumed economic growth, shifting LAS and SAS (and is coupled with an increase
in AD due to the post-war expansion of government expenditures, consumption, and
investment)
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LAS 0
L A S1
P
SAS 0
Chapter V. AS-AD
SAS1
E'
e
Y 1*
Yf
Y f'
Y
(4)Evolution of Inflationary Spiral (1968 – 1969 – 1980’s)
Where people to do not have inflationary expectations, the economy
moves from (a) to (b) in the SR. As the general public catch on what
-: is happening to the price level, they demand a higher money wage and
the higher wage is reflected in the shift of the SAS curve from (b) to
(c) in the LR.
When people revise inflation expectations at the same time along with
: the actual increase in the price level: one movement is from (c) to (d).
When inflation expectations are excessive, being higher than the
actual increase in the price level, and, in addition, the excessively
higher money wages are actually obtained by strong labour unions,
: one movement is from (a) to (e)  The result is a decrease in Y below
Yf, and it is called STAGFLATION, which is the combination of
STAG(nation) plub (in)FLATION.
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LA S 0
Chapter V. AS-AD
SAS3 LAS1
e

SAS2

d
SAS1
SAS 0

c
b
a
AD3



AD0
Y
*

AD2
AD1
Yf
Y
(5)Oil Shocks (1972 – 1975)
Oil shocks – permanent (negative) AS shocks, shift LAS and SAS to
: the left
: Additional adjustment of AS curve
P
LAS1
LA S 0

SAS2

SAS1
 SAS 0
AD0
Y
'
f
Yf
Y
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Chapter V. AS-AD
4. Rational Expectations Revolution and New Classical Model
1) Assumptions
(1)Revised Labor Supply and Demand Curves
The entrepreneurs make a decision on labor demand on the basis of the actual real wages,
which are equal to nominal wages divided by the actual price level;
Nd = f (W: P, other variables).
This is the same as any previous models.
On the other hand, the workers make a labor-supply decision on the basis of their ‘perceived
real wages’, which are equal to nominal wages divided by the ‘expected price level’ of the
current period, being carried from the last period.
Ns = g (W: Pe, other variables).
We draw Ns curve with W or money wages on the vertical axis and N on the horizontal axis.
Pe becomes a shift parameter.
Ns (Pe1)
W
W1
Nd (P1)
N1
Y
(2)Information Asymmetry is a norm for Unannounced Policies.
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At time period t-1, workers and employers do form expectations as to the price level to
prevail at time period t, that is, Pe.
At time t, the actual price level turns out to be equal to P. Of course, there is no guarantee
that Pe = P.
As soon as the price level reveals, the employers or entrepreneurs are updated, and do have
correct information about the current price level P. On the other hand, the workers do not
have information about it. The workers do have just the expected price level Pe, which is
carried from the last period.
a)Derivation of Lucas Aggregate Supply Curve for a fixed Price Expectations on the
part of Workers:
i)Information Asymmetry and the New Classical Labor Supply and Demand Curve:
Suppose that there is an increase in P, which the entrepreneurs recognize but the workers do
not. In other words, let us assume that there is information asymmetry between the
employers and the employees about the price level.
In this case, what will happen to the Nd (P1) and Ns (Pe1) curves?

This increase in P is unexpected on the part of workers, and thus Pe remains
unchanged. Thus the labor supply curve stays put.

However, the entrepreneurs are updated on the increase in P. Thus the labor demand
curve shifts up.
Ns (Pe1)
W
Nd (P2)
Nd (P1)
Y
ii)Information Asymmetry and the New Classical AS Curve:
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Chapter V. AS-AD
actual price levelP > 0 while expected price leve Pe = 0
Note that still the equilibrium money wage will go up W* >0
P > W* > Pe = 0
YS
YS
YS = Y
450
N
Y
W
P
P2
W*
Lucas’s
AS
P1

P
Y
N1* N2*
Y1
Y2
Along the Keynesian AS curve, the nominal wage rates are fixed at W*.
Notation Issue:
The resultant AS is called “Lucas’s AS curve”(abbreviation: LAS) or “ExpectationsAugmented AS curve(EAS)”. It is unfortunate that the long-run aggregate supply has
the same abbreviation as Lucas’s AS curve. And thus when the long-run aggregate
supply is used along with Lucas’s aggregate supply curve, it is indicated with the
‘LRAS(Long Run Aggregate Supply) curve. Or some authors use LAS for the long-run
aggregate supply and EAS for the expectations augmented aggregate supply.

Note that along this Lucas AS curve, the expectations about the price level are
constant. In other word, the expected price level is the shift variable for Lucas
Aggregate Supply Curve. As the workers or the general public revise their
expectations as to the price level (up: it is a numerical increase), Lucas’s AS curve
shifts (it is visually a upward movement, but a numerical decrease in AS).
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Note that the increase in the nominal wages W is smaller than the increase in P.
As a result, in the mind of a worker, the perceived real wages have gone up: The
expected price level remains unchanged while the actual nominal wages have gone
up somehow. The labor supply rises along the curve.
However, the actual real wages, the nominal wages divided by the actual price level,
have gone down; the numerator has changed less than the denominator has.
iii)Revised Expectations and the Shift of Lucas Aggregate Supply Curve
Recall that, as P1 goes up to P2, Nd curve shifts up on the part of entrepreneurs but Ns
remains constant reflecting a constant Pe on the part of workers: This is needed to derive
Lucas AS(Pe1 ) curve.
Now what will happen if the workers revise their expectations? The Ns will shift up as
shown below, there will be two corresponding points to the two different price level P1 and
P2.
Pe2
Lucas AS (Pe2)
Pe1
P2
Lucas AS (Pe1)
W*
P2
P1
P1
N3
N1*
N2*
Y3
Y1
Note that Y1 here coincides with the full employment national income.
Y2
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iv)A vertical Long-Run Aggregate Supply Curve is still valid here as well.
(3) Policy Invariance Theorem for Fully Anticipated Government Policies
How convincing is the assumption of Information Asymmetry as assumed above?
Generally it did make a sense prior to the 1980s. However, in today’s world of the postinformation-revolution society where the general public has access to all kinds of
information including government policies, information asymmetry may not be sustainable.
The general public has the same access to information of the government’s policy model and
all the input data. With this parity-of-information between the general public and the
government or the policy maker, the assumption of information asymmetry between the
employers(entrepreneurs) and employees(workers) is unsustainable. It is all the more so in a
democratic society where every has equal access to all kinds of information and information
is efficiently propagated. This is particularly so when government announces its proposed
policy and its forecast economic impacts in advance. The ‘honest’ government may be
educating the general public in this case.
A well-announced economic policy with deterministic rules will not have any impact on
the real variables such as real national income- Policy Invariance Theorem
Suppose that even the workers are fully updated on a change in the price level: The
government announces its policy well in advance to the general public and carries out the
policy in the honest and open way. The general public have time to understand the impact of
the proposed policy on the price level and thus to revise their expectations about the price
level. What will happen to the labor supply and demand curves?
Ns (Pe2)
Ns (Pe1)
W
Nd (P2)
Nd (P2)
P
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Note that P = Pe = W* > 0 in this case.
What is the resultant AS curve in this case?
AS
P2
W*
P1

N1* N2*
Y1
Y2
Along the Keynesian AS curve, the nominal wage rates are fixed at W*.
The resultant AS is the same as the long-run AS curve.

Note that the increase in the nominal wages W is proportional to the increase in P.

This happens in the long-run when the workers are fully updated on what is
happening to the price level, and the money wages become flexible even if they are
not so in the short-run.

Another way of looking at the above is as follows:
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Chapter V. AS-AD
We can think of the above vertical long-run AS curve as Lucas’s AS curve shifts up
as the expectations are revised as given below:.
Lucas AS(Pe2)
P2
Lucas AS (Pe1)
W*
P1
N1*

N2*
Y1
Y2
Along the Keynesian AS curve, the nominal wage rates are fixed at W*.
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4. New Keynesian AS curves
1) Assumptions
i)Rigidity of Nominal Wages;
In the New Keynesian model of labor market, the nominal wage is set at t-1 through
labor contracts, and the level of employment is to be determined at time period t.
ii) Long-term Non-indexed Labor Contract: Just like the Keynesian AS curve model, the
wages are set in advance through the long-term non-indexed contract.
iii) The labor contract sets nominal wages at time t-1. The workers are bound by the
contract to work at the set wage rates as much as is required by the entrepreneurs. The
level of employment is flexible to be determined according to the labor demand at time t.
Ex-post revisions of expected price levels do happen, and shift the labor supply and
demand curves around. However, the labor supply curve is redundant as it is effectively
replaced with the wage line, which is set through the contract. The equilibrium takes
place where the horizontal nominal wage line intersects the newly shifted labor demand
curve.
2) Derivation of New Keynesian AS curve
Graphic Derivation is as follows:












Start with P1.
For the given price level, get the labor supply and labor demand curve in the second
panel.
The intersection of the labor supply and demand curves gives the equilibrium level of
employment N1.
This feeds into YS1 in the aggregate production function.
YS1 = Y1 in the third panel.
Now in the fourth panel, Y1 matches with P1.
Suppose that the price level goes up to P2.
This sends both the labor supply and demand curves up.
However, the level of nominal wages does not change due to unions or money
illusion. It is the effective labor supply curve; note that it replaces the shift labor
supply curve, which is meaningless.
The new equilibrium level of employment is given at N2.
This feeds into the aggregate production function to give YS2 = Y2.
Y2 goes down to match P2.
By linking the two points of Y in the fourth panel, we get the New Keynesian
Aggregate Supply Curve. It is upward-sloping.
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Chapter V. AS-AD
YS = Y
450
(New
Classical)
NKAS
P2
Fixed W*
P1
N1*
N2*
Y1
Y2
3)Comparison of the New Classical and the New Keynesian AS curves

Note that the slope of New Keynesian AS curve is flatter than the corresponding New
Classical AS curve: if we look at the labor market only for a unexpected rise in the
price level, the comparison is as follows:
New Classical Eq.
Ns (Pe1)
New Keynesian Eq.
Nd P2)
Nd (P1)
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Chapter V. AS-AD
Comparison of New Classical and New Keynesian equilibriums:
YS = Y
450
New
Classical
NKAS
P2
Fixed W*
P1
N1*

N2*
Y1
Y2
Note that the slope of New Keynesian AS curve is flatter than the corresponding New
Classical AS curve: if we look at the labor market only for a unexpected rise in the
price level, the comparison is as follows:
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Chapter V. AS-AD
5. Putting them all together in a complete macroeconomic model with the Lucas AS,
Long-run AS and AD curves in the New Classical Framework.
In the New Classical world, there is no institutional rigidity of money wage. However, there
could be information asymmetry between the workers and the employers in the short-run.
So far we just assume that there is an increase in the price level P. Why or how does it
happen, or what causes this rise in the price level?
In reality a rise in the price level or inflation is most likely the result of government’s
expansionary fiscal or monetary policies, which shift the AD curve.
Suppose that government increases nominal money supply or MS. It will put a train of
economic sectors in motion:
First, the real money supply curve ms will shift to the right.
Second, the LM curve will shift to the right.
Third, the AD curve will shift to the right.
Now, when it comes to the response of the AS side, there are different assumptions for
different circumstances:
1) Unexpected Increase in AD
(1) If the increase in Money Supply is unanticipated or unexpected for the
workers or the general public, then the SAS curve does not move at all in the
short-run.
LRAS
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Chapter V. AS-AD
(2) Even if the expansionary monetary policy is unexpected, eventually in the
long-run the general public will figure out the consequent increase in the
price level. Suppose that there is no institutional wage rigidity in the labour
market. As they demand a higher money wage so as to recover the real wage,
the money wage will rise and the SAS will reflect the wage(labour cost)
increase and thus decrease(shifting to the left or up visually).
LRAS
Note that all short-run misalignment of Lucas’s AS and LRAS will be corrected by
itself as time goes by in the long-run.
2) Expected increase in AD
If the expansionary monetary policy is announced well in advance and is executed by
the monetary authority as announced, and at the same time, if there is no institutional
money wage rigidity, then there is the Policy Ineffectiveness Theorem holding once-forall, i.e., in the short-run as well as in the long-run. There will be no increase in Y even
in the short-run.
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Chapter V. AS-AD
LRAS
3)Over-expected Increase in AD
If the workers expect a certain increase in AD, for instance, due to an increase in money
supply, then they will have a projection of where the new AD will be. The expected new
position of AD will give the expected new long-run equilibrium price level at its intersection
with the LRAS. The workers will accordingly demand a higher wage commensurate to the
new expected long-run equilibrium price level. Thus Lucas’s AS will move up by that
amount.
However, in reality, the actual increase in AD, for instance due to an increase in money
supply, may fall short of the expected increase in AD. Thus, the workers may have overexpected the increase in AD.
Then, as the wage level is too high for the full employment, there will be an increase in
unemployment rate at least in the short-run.
However, in the long-run, if there is no downward (money) wage rigidity, the labour market
will correct the short-run misalignment by itself: In the long-run, the workers will find out
their forecast errors and revise their expected new AD and the expected long-run equilibrium
price level downward. And Lucas’s AS curve will come down. It is quicker than the
adjustment of the conventional adjustment process where the presence of unemployment
above the natural rate of unemployment will lead to competition among the (not-hired)
workers and thus to a lower money wage rate.
Can you illustrate the above points in one graph of LRAS, Lucas’s AS, and the initial AD
and the over-expected new AD curve and the actual new AD curve?
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Chapter V. Appendix