The AS curve
The AS curve captures the effects of output on the price level.
Lets take a closer look at the AS curve to see what this all means:
As always it is important to make sure that you know what is measured on the axes of the
diagram. On our vertical axis the price level P is measured while on the horizontal axis the level
of output and income Y is measured.
Looking at the AS curve you will see that it is upwards sloping and therefore have a positive
slope. This means that between the level of output and income and the price level a positive
relationship exits. The causality in the case of the AS curve is from a change in the level of
output to a change in the price level. For instance an increase in the level of output leads to an
increase in the price level and a decrease in the level of output leads to a decrease in the price
level.
The first thing you need to understand about the AS curve is why it is that a change in the level
of output causes a change in the price level.
Lets look what happens with the price level if the level of output increases in the economy.
An increase in the level of output implies that more labour are needed to produce this increase in
output and consequently the level of employment increases. This increase in the level of
employment causes a decrease in the level of unemployment. As the level of unemployment
decreases the bargaining position of workers strengthen which leads to higher nominal wages
which in return causes an increase in the price level.
The link between lower unemployment and higher nominal wages is captured by the wage
setting relationship. What the wage-setting relation tells us is that the lower the unemployment
rate, the higher the wage workers can bargain for. Lower unemployment increases the bargaining
power of labour and the lower the level of unemployment the more bargaining power workers
have and the higher the wage they can and will bargain for.
The link between an increase in wages and an increase in the price level is provided by the price
setting relationship. According to the price setting relationship the price level is equal to a mark
up over costs, which in this case is the wage costs. As wages increases the wage costs goes up
and so does the price level.
The opposite happens when the level of output decreases. As the level of output decreases the
employment falls and unemployment increases. An increase in unemployment erodes the
bargaining power of workers and nominal wages decline which eventually leads to a decline in
the price level.
A movement along the AS curve therefore indicates a change in the level of output, employment,
unemployment, nominal wages and the price level.
Because of the way in which the price level is determined in the economy namely as a mark up
over costs at any point on the AS curve the real wage is the same. An increase in employment
leads to an increase in nominal wages, which in turn increases the price level. The increase in the
nominal wage is therefore offset by an increase in the price level causing the real wage to remain
unchanged. Workers can determine their nominal wage but not the real wage since the real wage
is the outcome of the price setting behaviour in the economy.
At any point on the AS curve the expected price level is also the same. The reason for this is
that when the wage setting relation and the price setting relation, which is what is behind the
positive slope of the AS curve, were derived we assumed a given and unchanged expected price
level. A change in the expected price level will cause a shift of the AS curve.
Another important feature of the AS curve is that a given AS curve passes through a point where
the level of output is equal to the natural level of output and the actual price level = the expected
price level . This point is indicated by point a. At[point a the price level is P2 and the expected
price level is also P2. This is also the point where the level of unemployment is such that the
bargained real wage is equal to the real wage implied by price setting.
At points to the right of the natural level of output the actual price level is higher than the
expected price level. At an output level such as point b, which is higher than the natural level of
output, the actual price level is for instance P3, but the expected price level is P2.
At points to the left of the natural level of output the actual price level is lower than the expected
price level. For instance at an output level such as point c, which is lower than the natural level
of output, the actual price level is P1 while the expected price level is P2.
At an output level such as point b, which is higher than the natural level of output, the actual
price level is for instance P3, but the expected price level is P2.
At an output level such as point c, which is lower than the natural level of output, the actual price
level is P1 while the expected price level is P2.
At any point on the AS curve the real wage is the same.
An increase in employment leads to an increase in nominal wages, which in turn increases the
price level. The increase in the nominal wage is therefore offset by an increase in the price level
causing the real wage to remain unchanged. In other words, if an increase in output and
employment leads to a 10% increase in nominal wages then prices will also increase by 10% and
the real wage will be unchanged.
The positive slope of the AS curve indicates that as the level of output increases the price level
increases. The increase in the price level is the result of the impact of a decrease in
unemployment on wages and prices and can be presented by the following chain of events:
Y  N  u  W  P
As the level of output increases the level of employment increases (Y N). The increase in the
level of employment causes a decrease in the level of unemployment (N  u). As the level of
unemployment decreases the bargaining position of workers increases which leads to an increase
in nominal wages (u  W). This process is captured by the wage-setting relationship W =
PF(u,z). Since prices are determined by firms as a mark up over wage costs, the price level
increases as wages increase (W P). This process is captured by the price-setting relationship
(P = (1 + µ)W) which also determines the real wage that is paid.
The expected price level is given along a given supply curve.
The aggregate supply curve is derived from the wage-setting and price-setting relationships dealt
with in study unit 6 where is was assumed that the expected price level is given.
A given AS curve passes through a point where the level of output is equal to the natural
level of output (Y = Yn) and the actual price level = the expected price level (P = Pe).
In terms of our labour market, this is the point where the level of unemployment is such that the
bargained real wage is equal to the real wage implied by price setting.
At points to the right of the natural level of output the actual price level is higher than the
expected price level (P > Pe), and at points to the left the actual price level is lower than the
expected price level (P < Pe).
At an output level such as point b, which is higher than the natural level of output, the actual
price level is for instance P3, but the expected price level is P2.
At an output level such as point c, which is lower than the natural level of output, the actual price
level is P1 while the expected price level is P2.
At any point on the AS curve the real wage is the same.
An increase in employment leads to an increase in nominal wages, which in turn increases the
price level. The increase in the nominal wage is therefore offset by an increase in the price level
causing the real wage to remain unchanged. In other words, if an increase in output and
employment leads to a 10% increase in nominal wages then prices will also increase by 10% and
the real wage will be unchanged.
Using a chain of events this relationship can be described as follows:
A decrease in the price level (14) increases the level of output and income (15) and an increase
in the price level (16) decreases the level of output and income (17).
What you should ask yourself now is why is there a negative relationship between the price level
and the level of output and income?
And the answer is:
A change in the price level, for instance an increase in price level (18) initially impacts of the
financial market where the real money supply (19) decreases and the interest rate increases
(20)as a result. The increase in the interest rate then causes a decrease in investment spending
(21) in the goods market and consequently the demand for goods decreases (22) causing a
decline in the level of output and income (23). Note that behind the Ad curve is the events in the
financial market (24) and the goods market (25).
Another way of understanding the AD curve is to look at its graphical derivation (26). The key to
the graphical derivation of the AD curve is the events that take place on the financial (27) and
goods markets (28) when the price level changes (29).
The IS-LM model is represented in Figure 1 (30) and the AD curve in Figure 2 (31) . The
horizontal axes in both diagrams are the same and measure the level of output and income (32).
The vertical axes differ, however. In Figure 1 the interest rate is measured (33) while in Figure 2
the price level (34) is measured.
At a given price level of P1 (35) in Figure 2, there are corresponding IS (36) and LM (37)curves
in Figure 1. The IS curve is drawn for a given level of government spending and taxes (38) and
the LM curve is drawn for a given value of the nominal money supply (39).
In Figure 1at a price level of P1 (40), equilibrium in the goods and financial markets occurs at
point a (41). At this equilibrium position the equilibrium interest rate is i1 (42) and the
equilibrium level of output is Y2 (43).
To plot the first point of the AD curve the equilibrium level of income in Figure 1 is extended as
a dotted vertical line to Figure 2 (44). The first point of the AD curve is plotted at the intersection
of the dotted vertical Y2-line with the dotted horizontal P1-line and is called point a (45). This
point A indicates that at a price level of P1 (46) the goods and financial markets are in
equilibrium at an income level of Y2 (47). This point a in Figure 2 corresponds to point a in
Figure 1 (48).
To plot the second point we assume an increase in the price level from P1 to P2 (49) in Figure 2.
This increase in the price level implies that on the financial market (50) the real money supply
decreases. The real money supply curve shifts (51)to the left and the interest rate rises (52). In
terms of the IS-LM model this is represented by a leftward shift of the LM curve in figure 1 (53).
As the interest rate rises (54) investment spending declines (55) causing the demand for goods to
decrease (56) and consequently the level of output declines (57) in the goods market. This is
presented as a movement along the IS curve (58).
This increase in the interest rate, which causes a decrease in investment spending, the demand
for goods and the level of output, continues until an new equilibrium is reached at point b (59).
At this new equilibrium position the interest rate is i2 (60) and the equilibrium level of output is
Y1 (61).
To plot the second point of the AD curve the new equilibrium level of income Y1 in Figure 1 is
extended as a dotted vertical line to Figure 2 (62). The second point of the AD curve is then
plotted at the intersection of the dotted vertical Y1-line with the broken horizontal P2-line and is
called point b (63). This point b indicates that at a price level of P2 (64)the goods and financial
markets are in equilibrium at an income level of Y1 (65). This point b in Figure 2 corresponds
to point b in Figure 1 (66).
By repeating the same exercise for different price levels a series of goods and financial market
equilibrium points can be plotted in Figure 2 (67), which eventually gives us the AD curve. We
will take a short cut and draw a downward sloping curve through points a and b in Figure 2 (68)
and label it AD (69). This then is our AD curve which shows a negative relationship between the
price level and the level of output and represents combinations of price levels and the levels of
output where the goods and financial markets are in equilibrium (70).
Comparing point a (71) with point b (72) it is clear that at point b (73) the price level is higher
(74), the real money supply is lower(75), the interest rate is higher(76), investment(77), the
demand for goods is lower (78) and the level of output and income (79) is lower. Our
autonomous variables namely government spending, taxation and the nominal money supply is
the same (80). A change in any these variables will cause a shift of the Ad curve but that is a
topic for another time.