A Theory of Supply Function Choice and Aggregate Supply

Abstract

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