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Chapter 13 Short Run Aggregate Supply Curve

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Chapter 13 Short Run AggregateSupply Curve two models of aggregate supply in whichoutput depends positively on the price levelin the short run about the short-run tradeoff betweeninflation and unemployment known as thePhillips curve

Introduction In previous chapters, we assumed the price level Pwas “stuck” in the short run. This implies a horizontal SRAS curve. Now, we consider two prominent models ofaggregate supply in the short run: Sticky-price model (Markets not clear) Imperfect-information model (Markets clear)CHAPTER 13Aggregate Supply1

Introduction Both models imply:Y Y α (P EP )expectedprice levelagg.outputnatural rateof outputa positiveparameteractualprice level Other things equal, Y and P are positively related, sothe SRAS curve is upward-sloping. (intersection withY-axis)CHAPTER 13Aggregate Supply2

The sticky-price model Reasons for sticky prices: long-term contracts between firms and customers menu costs firms not wishing to annoy customers with frequentprice changes Assumption: Firms set their own prices(e.g., as in monopolistic competition).CHAPTER 13Aggregate Supply3

The sticky-price model An individual firm’s desired price is:p P a (Y Y )where a 0.Suppose two types of firms: firms with flexible prices, set prices as above firms with sticky prices, must set their price beforethey know how P and Y will turn out:p EPCHAPTER 13Aggregate Supply4

The sticky-price model To derive the aggregate supply curve,first find an expression for the overall price level. s fraction of firms with sticky prices.Then, we can write the overall price level as CHAPTER 13Aggregate Supply5

The sticky-price model Ps[ EP ] (1 s )[ P a (Y Y )]price set by stickyprice firmsprice set by flexibleprice firms Subtract (1 s)P from both sides:sP s[ EP ] (1 s )[a (Y Y )] Divide both sides by s :(1 s )aP EP(Y Y )sCHAPTER 13Aggregate Supply6

The sticky-price model(1 s )aP EP(Y Y )s High EP leads to High PIf firms expect high prices, then firms that must set pricesin advance will set them high.Other firms respond by setting high prices. High Y leads to High PWhen income is high, the demand for goods is high. Firmswith flexible prices set high prices.The greater the fraction of flexible price firms,the smaller is s and the bigger is the effect of deviationof Y on P.CHAPTER 13Aggregate Supply7

The sticky-price model(1 s )aP EP(Y Y )s Finally, derive AS equation by solving for Y :Y Y α (P EP ),where αCHAPTER 13Aggregate Supplys 0(1 s )a8

The imperfect-information modelAssumptions: All wages and prices are perfectly flexible,all markets are clear. Each supplier produces one good, consumes manygoods. Each supplier knows the nominal price of the goodshe produces, but does not know the overall pricelevel.CHAPTER 13Aggregate Supply9

The imperfect-information model Supply of each good depends on its relative price:the nominal price of the good divided by the overallprice level. Supplier does not know price level at the time shemakes her production decision, so uses EP. Suppose P rises but EP does not. Supplier thinks her relative price has risen,so she produces more. With many producers thinking this way,Y will rise whenever P rises above EP.CHAPTER 13Aggregate Supply10

Empirical Evidence Imperfect information model predictsChanges in aggregate demand have the biggest effecton output in those countries where aggregate demandand prices are most stable (Only surprises work!) Sticky price model predictsA high rate of inflation should make the short-runaggregate supply curve steeper.CHAPTER 13Aggregate Supply11

Summary & implicationsPLRASY Y α (P EP)P EPSRASP EPP EPYCHAPTER 13Aggregate SupplyYBoth models ofagg. supplyimply therelationshipsummarized bythe SRAS curve& equation.12

Summary & implicationsSRAS equation: Y Y α (P EP)Suppose a positiveAD shock movesSRAS2PLRASoutput above itsnatural rate andSRAS1P above the levelpeople had expected. P EP33P2Over time,EP2 P1 EP1EP rises,SRAS shifts up,and output returnsto its natural rate.CHAPTER 13Aggregate SupplyAD2AD1YY3 Y1 YY213

Inflation, Unemployment,and the Phillips CurveThe Phillips curve states that π depends on expected inflation, Eπ. cyclical unemployment: the deviation of the actualrate of unemployment from the natural rate supply shocks, ν (Greek letter “nu”).π Eπ β (u u ) νnwhere β 0 is an exogenous constant.CHAPTER 13Aggregate Supply14

Comparing SRAS and the Phillips CurveSRAS:Y Y α (P EP )Phillips curve:π Eπ β (u u n ) ν SRAS curve:Output is related tounexpected movements in the price level. Phillips curve:Unemployment is related tounexpected movements in the inflation rate.CHAPTER 13Aggregate Supply15

Adaptive and Rational expectationsWays of modeling the formation of expectations affectthe slope of the Phillips curve: adaptive expectations:People base their expectations of future inflation onrecently observed inflation. rational expectations:People base their expectations on all availableinformation, including information about current andprospective future policies.CHAPTER 13Aggregate Supply16

Adaptive expectations Adaptive expectations: an approach that assumespeople form their expectations of future inflation basedon recently observed inflation. A simple version:Expected inflation last year’s actual inflationEπ π 1 Then, P.C. becomesπ π 1 β (u un ) νCHAPTER 13Aggregate Supply17

Inflation inertiaπ π 1 β (u un ) νIn this form, the Phillips curve implies that inflation hasinertia: In the absence of supply shocks orcyclical unemployment, inflation willcontinue indefinitely at its current rate. Past inflation influences expectations of current inflation,which in turn influencesthe wages & prices that people set. The natural rate of unemployment is also called the nonaccelerating inflation rate of unemployment (NAIRU)CHAPTER 13Aggregate Supply18

Two causes of rising & falling inflationπ π 1 β (u un ) ν cost-push inflation:inflation resulting from supply shocksAdverse supply shocks typically raise production costsand induce firms to raise prices,“pushing” inflation up. demand-pull inflation:inflation resulting from demand shocksPositive shocks to aggregate demand causeunemployment to fall below its natural rate,which “pulls” the inflation rate up.CHAPTER 13Aggregate Supply19

Graphing the Phillips curveIn the shortrun, policymakersface a tradeoffbetween π and u .ππ Eπ β (u u n ) νβ1The short-runPhillips curveEπ νuCHAPTER 13Aggregate Supplynu20

Shifting the Phillips curvePeople adjusttheirexpectationsover time,so the tradeoffonly holds inthe short run.πEπ 2 νEπ 1 νE.g., an increasein Eπ shifts theshort-run P.C.upward.CHAPTER 13π Eπ β (u u n ) νAggregate Supplyunu21

CHAPTER 13Aggregate SupplyFigure 13.3 Inflation and Unemployment in the United States, 1960–2008Mankiw: Macroeconomics, Seventh EditionCopyright 2010 by Worth Publishers22

The sacrifice ratio To reduce inflation, policymakers cancontract agg. demand, causingunemployment to rise above the natural rate. The sacrifice ratio measuresthe percentage of a year’s real GDPthat must be foregone to reduce inflationby 1 percentage point. A typical estimate of the ratio is 5.CHAPTER 13Aggregate Supply23

The sacrifice ratio Example: To reduce inflation from 6 to 2 percent, mustsacrifice 20 percent of one year’s GDP:GDP loss (inflation reduction) x (sacrifice ratio) 4x5 This loss could be incurred in one year or spread overseveral, e.g., 5% loss for each of four years. The cost of disinflation is lost GDP.One could use Okun’s law to translate this cost intounemployment.CHAPTER 13Aggregate Supply24

Rational expectationsWays of modeling the formation of expectations: adaptive expectations:People base their expectations of future inflation onrecently observed inflation. rational expectations:People base their expectations on all availableinformation, including information about current andprospective future policies.CHAPTER 13Aggregate Supply25

Painless disinflation? Proponents of rational expectations believethat the sacrifice ratio may be very small: Suppose u un and π Eπ 6%,and suppose the Fed announces that it willdo whatever is necessary to reduce inflationfrom 6 to 2 percent as soon as possible. If the announcement is credible,then Eπ will fall, perhaps by the full 4 points. Then, π can fall without an increase in u.CHAPTER 13Aggregate Supply26

Calculating the sacrifice ratiofor the Volcker disinflation 1981: π 9.7%Total disinflation 6.7%1985: π 3.0%yearuunu u 6.01.1Total 9.5%CHAPTER 13Aggregate Supply27

Calculating the sacrifice ratiofor the Volcker disinflation From previous slide: Inflation fell by 6.7%,total cyclical unemployment was 9.5%. Okun’s law:1% of unemployment 2% of lost output. So, 9.5% cyclical unemployment 19.0% of a year’s real GDP. Sacrifice ratio (lost GDP)/(total disinflation) 19/6.7 2.8 percentage points of GDP were lost foreach 1 percentage point reduction in inflation.CHAPTER 13Aggregate Supply28

The natural rate hypothesisOur analysis of the costs of disinflation, and ofeconomic fluctuations in the preceding chapters, isbased on the natural rate hypothesis:Changes in aggregate demand affect outputand employment only in the short run.In the long run, the economy returns tothe levels of output, employment,and unemployment described bythe classical model (Chaps. 3-8).CHAPTER 13Aggregate Supply29

An alternative hypothesis: Hysteresis Hysteresis: the long-lasting influence of history onvariables such as the natural rate of unemployment. Negative shocks may increase un,so economy may not fully recover.CHAPTER 13Aggregate Supply30

Hysteresis: Why negative shocks mayincrease the natural rate The skills of cyclically unemployed workers maydeteriorate while unemployed, and they may not find ajob when the recession ends. Cyclically unemployed workers may losetheir influence on wage-setting;then, insiders (employed workers)may bargain for higher wages for themselves.Result: The cyclically unemployed “outsiders”may become structurally unemployed when therecession ends.CHAPTER 13Aggregate Supply31

Chapter Summary1. Two models of aggregate supply in the short run: sticky-price model imperfect-information modelBoth models imply that output rises above its naturalrate when the price level rises above the expected pricelevel.CHAPTER 13Aggregate Supply32

Chapter Summary2. Phillips curve derived from the SRAS curve states that inflation depends on expected inflation cyclical unemployment supply shocks presents policymakers with a short-run tradeoffbetween inflation and unemploymentCHAPTER 13Aggregate Supply33

Chapter Summary3. How people form expectations of inflation adaptive expectations based on recently observed inflation implies “inertia” rational expectations based on all available information implies that disinflation may be painlessCHAPTER 13Aggregate Supply34

Chapter Summary4. The natural rate hypothesis and hysteresis the natural rate hypotheses states that changes in aggregate demand can onlyaffect output and employment in the short run hysteresis states that aggregate demand can have permanenteffects on output and employmentCHAPTER 13Aggregate Supply35

CHAPTER 13 Aggregate Supply 7 The sticky-price model High EP leads to High P If firms expect high prices, then firms that must set prices in advance will set them high. Other firms respond by setting high prices. High Y leads to High P When income is high, the demand for goods is high. Firms with flexible prices set high prices.