MACROECONOMICSMACROECONOMICS

Chapter 13Chapter 13

Aggregate Supply and Aggregate Supply and the Short Run Tradeoff the Short Run Tradeoff Between Inflation and Between Inflation and

UnemploymentUnemployment

22

Short-Run Aggregate SupplyShort-Run Aggregate Supply

We assumed all prices We assumed all prices were sticky together and were sticky together and they all moved together for they all moved together for long-run adjustment.long-run adjustment.

Now we will entertain two Now we will entertain two theories to modify the theories to modify the SRAS curves.SRAS curves.

Both will yieldBoth will yield

Y

P

)( ePPYY 0

Y

33

SRASSRAS

)( ePPYY 0 YYPP e

11

Y

P

ΔY

(1/α)ΔY

SRASLRAS

Y

P

Y

1α

when P=Pe

P=Pe

P>Pe

P<Pe

)( e

Y

YY )(

1

Y

YYe

44

Theory #1: Sticky Price ModelTheory #1: Sticky Price Model

Long term contractsLong term contractsFear of annoying customersFear of annoying customersCostly to alter pricesCostly to alter pricesStable wages (stable costs of production)Stable wages (stable costs of production)

55

Theory #1: Sticky Price ModelTheory #1: Sticky Price Model

Monopolistic competition models have Monopolistic competition models have price determination for firms as price determination for firms as MC + MC + premiumpremium where the more elastic is the where the more elastic is the demand curve for the firm, the lower is the demand curve for the firm, the lower is the premium.premium.

If MC responds to the overall price level P If MC responds to the overall price level P and premium responds to higher GDP and premium responds to higher GDP (more GDP, more demand), then the firm (more GDP, more demand), then the firm will determine its price, p, according to will determine its price, p, according to

)( YYPp

66

Theory #1: Sticky Price ModelTheory #1: Sticky Price Model)( YYPp Those firms that will follow the equation

will be able to alter their prices as P and Y changes.

These are the flexible price firms. Other firms will set their prices for a longer period and pick the expected price when the economy is at long term equilibrium . Suppose sticky firms are s percent of the economy and flexible firms are (1-s).

)]()[1( YYPssPP e

)()1(

)1()1(

)1()1(

e

e

e

PPs

sYY

sPsPYsYs

YsYssPsP

The last equation is the same as

)( ePPYY our new SRAS curve.

77

Theory #2: Imperfect InformationTheory #2: Imperfect Information

No need to assume monopolistic competition.No need to assume monopolistic competition. Markets clear but temporary misperceptions Markets clear but temporary misperceptions

about prices in other markets than their own about prices in other markets than their own separate LRAS and SRAS.separate LRAS and SRAS. They know their own costs. They know their own They know their own costs. They know their own

market with their competitors.market with their competitors. They do not know if the price increases in their market They do not know if the price increases in their market

are because of inflation or demand increase.are because of inflation or demand increase.

88

Theory #2: Imperfect InformationTheory #2: Imperfect Information

If you see prices for your product is increasing, If you see prices for your product is increasing, you better increase production even if MC is you better increase production even if MC is rising because it will yield higher profits.rising because it will yield higher profits. More work, more output, more GDP!More work, more output, more GDP!

If the price rise was because of inflation and you If the price rise was because of inflation and you increased production, eventually you will realize increased production, eventually you will realize that there is no extra demand and you will come that there is no extra demand and you will come back to original output.back to original output.

This is true for every producer.This is true for every producer.

99

Theory #2: Imperfect InformationTheory #2: Imperfect Information

P0

P1

MC

P

Q

Sticky wages will keep MC from shifting left immediately.

1010

Theory #2: Imperfect InformationTheory #2: Imperfect Information

)( ePPYY

If the prices are greater than expected prices, i.e. unexpected inflation, producers will mistake the Price rise in their own markets as higher demand and produce more.

Again, we have an output response to higher prices even though all the prices are increasing because people do not have perfect information.

1111

Supply ShockSupply Shock

)(1

)(

YYPP

PPYY

e

e

This specification came from tracing the impact of AD shift on Y and P. What if Y and P were to respond to a supply shock like a change in oil prices or economy-wide wage negotiation that affect costs of production.

vYYPP

vPPYY

e

e

)(1

)(

An increase in costs of production would raise P at each level of Y: a leftward shift of SRAS. We include that possibility as v in the SRAS equation.

1212

Phillips CurvePhillips Curve

To go from GDP to unemployment rate, we can use the Okun approach: a two percentage deviation of GDP from full-employment Y will affect the cyclical unemployment rate by one percentage point. At “natural rate of unemployment” (un) the economy is at full-employment and there is no pressure on prices.

vuu

vYY

vYYPPPP

vYYPP

vPPYY

ne

e

e

e

e

)(

1

1)(

)(1

)(

11

vuu

vuu

vY

YY

ne

en

e

)(

)(')('

'

The book’s approach (above) isnot as satisfying as the alternative approach on the right.

1313

The Slope of SRASThe Slope of SRAS

If one lived in a society where inflation was If one lived in a society where inflation was rare, and one saw an increase in the price of rare, and one saw an increase in the price of her market, what would be her reaction?her market, what would be her reaction?

(a)(a) Increase production; Increase production;

(b)(b) Keep production the same?Keep production the same?

Y

PStatic Expectations

Increase productionIncrease production

1414

The Slope of SRASThe Slope of SRAS

If one lived in a society where inflation If one lived in a society where inflation was a common occurrence, and one saw was a common occurrence, and one saw an increase in the price of the product an increase in the price of the product one was supplying, what would be the one was supplying, what would be the reaction?reaction?

(a)(a) Increase production; Increase production;

(b)(b) Keep production the same?Keep production the same?

Y

P

Adaptive Expectations

Keep production the sameKeep production the same

1515

Phillips Curve

un

πe + v

u

π What happens when inflationary expectations rise?

What happens when there is a negative supply shock?

1616

Static ExpectationsStatic Expectations

U

π

r

un

π = πe + v

Y

YY

Y

YY

0

πY

YY

Y

YY

IS LM

AD

SRAS

IS

AD

Fiscal expansion under static expectations yield higher than full employment Y indefinitely because the population does not adjust its inflationary expectations.

SRPhC

LRPhC

You can’t fool every one all the time!

1717

Inflation and Unemployment in the United States, 1960–2008

1818

Inflation and Unemployment in the United States, 1960–2008

’80-’83

’76-’79

’86-’93

’61-’69

’01-’08

u

π

1919

Adaptive ExpectationsAdaptive Expectations

U

π

r

un

π = πe + v

Y

YY

Y

YY

0

πY

YY

Y

YY

IS LM

AD

SRAS

IS

AD

Fiscal expansion under adaptiveexpectations yield higher than full employment Y initially but as inflationary expectations rise, SRAS and LM shift leftward to reach LR equilibrium eventually.

LRPhC

SRPhC

SRPhC’

2020

Shifts in Aggregate DemandShort run result: point B

Long run: prices rise until expected price is equal to the actual price: point C.

Show what happens when AD falls.

2121

Rational ExpectationsRational Expectations

U

π

r

un

π = πe + v

Y

YY

Y

YY

0

πY

YY

Y

YY

IS LM

AD

SRAS

IS

AD

Fiscal expansion under rationalexpectations keeps the economy at full employment Y because the population immediately adjustsinflationary expectations fully.

SRPhC

LRPhC

Pangloss Solution

2222

Test QuestionTest Question

Show static, adaptive, and rational Show static, adaptive, and rational expectations when the Central Bank expectations when the Central Bank increases the money supply.increases the money supply.

2323

Sacrifice RatioSacrifice Ratio

Using Okun’s Law of each one percentage point in unemployment will decrease GDP by two percent implies that in four years US lost one-fifth of its income to bring inflation down. This may or may not include the lost work skills.

2424

Taylor RuleTaylor Rule

t

ttYtttt

Y

YYi

*

Nominal federal funds rate = current inflation + “natural” real rate of interest + response of the Fed to the deviation of inflation from the target level of inflation + response of the Fed to the GDP gap

)(5.0)0.2(5.00.2 GDPgapi

http://research.stlouisfed.org/publications/mt/page10.pdf