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5.3.3 The aggregate supply hypothesis

As with the rational expectations hypothesis, various explanations of the

aggregate supply hypothesis can be found in the literature. Having said this,

two main approaches to aggregate supply can be identified. Underlying these

approaches are two orthodox microeconomic assumptions: (i) rational decisions

taken by workers and firms reflect optimizing behaviour on their part;

and (ii) the supply of labour/output by workers/firms depends upon relative


The first new classical approach to aggregate supply focuses on the supply

of labour and derives from the work of Lucas and Rapping (1969). This

analysis is discussed more fully in Chapter 6 and in what follows we merely

outline the essence of the approach. During any period, workers have to

decide how much time to allocate between work and leisure. Workers, it is

assumed, have some notion of the normal or expected average real wage. If

the current real wage is above the normal real wage, workers will have an

incentive to work more (take less leisure time) in the current period in the

anticipation of taking more leisure (working less) in the future, when the real

wage is expected to be lower. Conversely, if the current real wage is below

the norm, workers will have an incentive to take more leisure (work less) in

the current period in the anticipation of working more (taking less leisure) in

the future, when the real wage is expected to be higher. The supply of labour

is postulated, therefore, to respond to perceived temporary changes in the real

wage. This behavioural response of substituting current leisure for future

leisure and vice versa is referred to as ‘intertemporal substitution’. Within the

intertemporal substitution model, changes in employment are explained in

terms of the ‘voluntary’ choices of workers who change their supply of

labour in response to perceived temporary changes in the real wage.

The second new classical approach to aggregate supply again derives from

the highly influential work of Lucas (1972a, 1973). In what follows we

illustrate the spirit of Lucas’s arguments by focusing on the goods market and

the supply decisions of firms. An important element of Lucas’s analysis

concerns the structure of the information set available to producers. It is

assumed that, while a firm knows the current price of its own goods, the

general price level for other markets only becomes known with a time lag.

When a firm experiences a rise in the current market price of its output it has

to decide whether the change in price reflects (i) a real shift in demand

towards its product, in which case the firm should respond (rationally) to the

increase in the price of its output relative to the price of other goods by

increasing its output, or (ii) merely a nominal increase in demand across all

markets, producing a general increase in prices which would not require a

supply response. Firms are faced by what is referred to as a ‘signal extraction’

problem, in that they have to distinguish between relative and absolute

price changes. Indeed, the greater the variability of the general price level,

the more difficult it will be for a producer to extract a correct signal and the

smaller the supply response is likely to be to any given change in prices (see

Lucas, 1973).

The analysis of the behaviour of individual agents in terms of the supply of

both labour and goods has led to what is referred to as the Lucas ‘surprise’

supply function, the simplest from of which is given by equation (5.3):

Since in new classical models expectations are formed rationally, we can

replace (5.3) with (5.4):

Yt YNt Pt E Pt t [ −( |−1)] (5.4)

Equation (5.4) states that output (Yt) deviates from its natural level (YNt) only

in response to deviations of the actual price level (Pt) from its (rational)

expected value [E(Pt |t−1)], that is, in response to an unexpected (surprise)

increase in the price level. For example, when the actual price level turns out

to be greater than expected, individual agents are ‘surprised’ and mistake the

increase for an increase in the relative price of their own output, resulting in

an increase in the supply of output and employment in the economy. In the

absence of price surprises, output will be at its natural level. For any given

expectation of the price level, the aggregate supply curve will slope upwards

in P–Y space, and the greater the value of , the more elastic will be the

‘surprise’ aggregate supply curve and the bigger will be the impact on real

variables of an unanticipated rise in the general price level (see Figure 5.3

and section 5.5.1).

An alternative specification of the Lucas surprise function states that output

only deviates from its natural level in response to a deviation of actual

from expected inflation (that is, in response to errors in inflation expectations):

Yt YNt Pt E Pt t t [ ˙ −( ˙ |−1)](5.5)

In equation (5.5) ˙Pt is the actual rate of inflation, E(Pt t ˙ |−1) is the rational

expectation of rate of inflation subject to the information available up to the

previous period, and t is a random error process. According to Lucas, countries

where inflation has been relatively stable should show greater supply

response to an inflationary impulse and vice versa. In his famous empirical

paper, Lucas (1973) confirmed that:

In a stable price country like the United States … policies which increase nominal

income tend to have a large initial effect on real output, together with a small

positive effect on the rate of inflation … In contrast, in a volatile price county like

Argentina, nominal income changes are associated with equal, contemporaneous

price movements with no discernible effect on real output.

Equation (5.4) can be reformulated to include a lagged output term (Yt–1 –

YNt–1) and this version was used by Lucas (1973) in his empirical work to deal

with the problem of persistence (serial correlation) in the movement of economic

aggregates. The surprise aggregate supply function now takes the form

shown in equation (5.6):

Yt YNt Pt E Pt t Yt YNt t [ ( |1)] ( 1 1 ) (5.6)

By invoking ‘Okun’s law’ (Okun, 1962), that is, that there is a stable and

predictable negative relationship between unemployment and GDP, the Lucas

surprise aggregate supply equation can be seen as simply an alternative

representation of the rational expectations-augmented Phillips curve shown

in equation (5.7):

P˙ E(P˙ | ) (U U ), t t t t Nt −1 −ϕϕ0 (5.7)

where Ut is the current rate of unemployment, and UNt is the natural rate of

unemployment. Rearranging (5.7), we get equation (5.8):

Ut UNt Pt E Pt t 1/ϕ[ ˙ −( ˙ |−1)] (5.8)

In this formulation an inflation surprise leads to a temporary reduction of

unemployment below the natural rate. In equations (5.6) and (5.8) a real

variable is linked to a nominal variable. But, as Lucas demonstrated, the

classical dichotomy only breaks down when a change in the nominal variable

is a ‘surprise’. Indeed, Lucas himself regards the finding that anticipated and

unanticipated changes in monetary growth have very different effects, as the

key idea in post-war macroeconomics (Snowdon and Vane, 1998). Furthermore,

Lucas (1996) notes that this distinction between anticipated and

unanticipated monetary changes is a feature of all rational expectations-style

models developed during the 1970s to explain the monetary non-neutrality

exhibited in short-run trade-offs.