Mankiw, Chp. 31: 691-693
We can complete the aggregate demand-aggregate supply model by adding an AS curve. Fortunately, we’ve already laid all the groundwork for the long-run AS curve. Refer once again to the production function model of output: Y = A F(L, K, H). As we have seen, money does not enter into the production function, so money is neutral in the long run. Note that the price level does not enter into the production function either. The economy’s long-run output level does not depend on whether the price level is high or low. But if Y and the price level are unrelated in the long run, then the LRAS curve is vertical.
Combining AD and LRAS, we have a model that gives us the equilibrium values of real GDP and the GDP deflator (price index). Note, however, that in this model a change in AD results only in a change in the price level. Real GDP is fixed by the production function and does not change.
Can such a model be used to examine economic fluctuations? Only if we believe that fluctuations in technological knowledge or in inputs cause Y to fluctuate up and down. We also should see large upward and downward movements in the price level over short time periods. Most economists find it hard to believe that sudden negative changes in technology or in factor inputs are responsible for observed economic fluctuations. Nor do we observe the price level rising and falling by large amounts in short periods of time. Thus, we need to spend some more time thinking about the nature of aggregate supply in the short run.
Let’s think about how firms react to changes in demand for their products. Most firms are not perfectly competitive; they are price setters. Thus, they face downward-sloping demand and marginal-revenue curves. That is, most firms are monopolistically competitive. They determine their profit-maximizing output level by equating MR and MC and finding the appropriate price on the demand curve. Price is equal to marginal cost plus a markup.
Although I didn’t stress the fact earlier in the semester, most firms also face marginal-cost curves that are horizontal over large ranges of production. These firms are able to produce additional units of output at the same marginal cost as previous units, since most firms aren’t producing at maximum capacity most of the time.
A final attribute, noted in our discussion of advertising, is that most firms depend on repeat customers for most of their sales. Retail outlets attract customers by offering the range of goods of a particular quality that their regular customers expect. They also charge prices that their regular customers expect. Thus, firms that depend on repeat buyers are cautious about raising prices; they don’t want to disappoint their regular customers, causing them to "shop around." They know that competing firms are always waiting to "steal" their customers by advertising lower prices.
When these three attributes are brought together, an interesting result emerges. Most retail firms change prices very little in response to changes in demand. Given the following facts:
most firms simply leave their prices unchanged unless they believe they need to change them by a significant amount. Thus, most firms respond to all but very large increases (or decreases) in demand by leaving prices unchanged in the short run.
This pattern of behavior implies that prices at the retail level – the prices that matter to consumers – don’t change much unless marginal costs change. But marginal costs depend on input prices – the prices of energy and raw materials and the wages of labor. So long as input prices remain constant, marginal cost remains constant, and firms tend to maintain constant prices for their products.
If typical firms in the economy behave as described above, then changes in aggregate demand produce, in the short run, not major changes in the price level (the average of all final-goods prices) but changes in output levels. Firms produce and sell more goods when AD rises and fewer goods when AD falls. In the short run – a period that lasts at least at year – the aggregate supply curve is essentially flat.
An increase in aggregate demand causes output to rise. The AD curve shifts to the right, and producers in most markets in the economy experience an increase in demand for their products. They respond by purchasing more inputs and producing more goods and services. Y rises, while the price level remains approximately constant.
A decrease in aggregate demand causes output to fall. The AD curve shifts to the left, and producers in most markets experience a decline in demand for their products. They respond by purchasing fewer inputs and producing fewer goods and services. Y falls, and the price level remains approximately constant.
The "short run" lasts until firms can no longer continue to purchase inputs at the same price when AD rises, or until input prices begin to fall when AD falls. When input prices begin to change, marginal cost curves shifts up (when input prices rise) or down (when input prices fall). Changes in marginal cost lead to changes in product prices, which result in shifts in the short-run AS curve.