A Theory of Supply Function Choice and Aggregate Supply

86 Pages Posted: 26 Jun 2023

See all articles by Joel P. Flynn

Joel P. Flynn

Yale University

Georgios Nikolakoudis

Princeton University

Karthik Sastry

Princeton University - Department of Economics

Date Written: October 4, 2023


Many modern theories of the business cycle generate demand-driven fluctuations by assuming that monopolistic firms set a price in advance and commit to supplying the market-clearing quantity. In this paper, we enrich firms' supply decisions by allowing them to choose any supply function: a description of the price charged at each quantity of production. By changing only the strategy space of firms and leaving fixed all other microfoundations in a standard monetary business cycle model, we provide a novel theory in which the nature of uncertainty and market power endogenously determine the aggregate supply curve. We find that aggregate supply flattens when there is: (i) lower inflation uncertainty, (ii) greater demand uncertainty, and (iii) increased market power. Money is maximally non-neutral if firms' quantities are perfectly elastic to prices (price-setting) and neutral if only if firms' quantities are perfectly inelastic to prices (quantity-setting). When mapped to the data, our theory explains: (i) the long-run flattening of the aggregate supply curve as an outcome of more hawkish monetary policy and rising market power and (ii) the steepening of aggregate supply in times of high inflation uncertainty (e.g., the 1970s and 2020s) but not times of high real uncertainty (e.g., the Great Recession).

Keywords: Supply Functions, Business Cycles, Uncertainty, Aggregate Supply, Phillips Curve

JEL Classification: E31, E32, E52

Suggested Citation

Flynn, Joel P. and Nikolakoudis, Georgios and Sastry, Karthik, Prices vs. Quantities: A Macroeconomic Analysis (June 24, 2023). Available at SSRN: https://ssrn.com/abstract=4490683 or http://dx.doi.org/10.2139/ssrn.4490683

Joel P. Flynn (Contact Author)

Yale University ( email )

493 College St
New Haven, CT CT 06520
United States

Georgios Nikolakoudis

Princeton University ( email )

Julis Romo Rabinowitz Building
Princeton, NJ 08544
United States
6093563619 (Phone)

Karthik Sastry

Princeton University - Department of Economics ( email )

Princeton, NJ 08544-1021
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Abstract Views
PlumX Metrics