Topic J

Aggregate Supply
 IN THIS TOPIC, YOU WILL LEARN:

 two models of aggregate supply in which output

depends positively on the price level in the short
run
 about the short-run tradeoff between inflation and
unemployment known as the Phillips curve

1
Introduction
 In previous topics, we assumed the price level P
was “stuck” in the short run.
 This implies a horizontal SRAS curve.
 Now, we consider two prominent models of
aggregate supply in the short run:
 Sticky-price model
 Imperfect-information model
Introduction
 Both models imply:
Y  Y   (P  EP)
agg. expected
output price level
a positive
natural rate actual
parameter
of output price level

 Other things equal, Y and P are positively

related, so the SRAS curve is upward sloping.
The sticky-price model
 Reasons for sticky prices:
 long-term contracts between firms and
customers
 menu costs
 firms not wishing to annoy customers with
frequent price changes
 Assumption:
 Firms set their own prices
(e.g., as in monopolistic competition).
 The sticky-price model
 An individual firm’s desired price is:
p  P  a(Y  Y )
where a > 0.
• Higher P => higher cost => higher p
• Higher Y => higher demand => higher MC => higher p

Suppose two types of firms:

• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
before they know how P and Y will turn out:

CHAPTER 14
p  EP  a( EY  EY )
Aggregate Supply 5
The sticky-price model
p  EP  a( EY  EY )
 Assume sticky-price firms expect that output will
equal its natural rate. Then,
p  EP
 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…
The sticky-price model
P  s[ EP]  (1 s)[ P  a(Y  Y )]
price set by price set by
sticky-price firms flexible-price firms

 Subtract (1−s)P from both sides:

sP  s[ EP]  (1 s)[a(Y  Y )]
 Divide both sides by s:
(1 s )a
P  EP  (Y  Y )
s
The sticky-price model
(1 s )a
P  EP  (Y  Y )
s
 High EP g 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 g High P
When income is high, the demand for goods is high.
Firms with flexible prices set high prices.
 The greater the fraction of flexible-price firms,
the smaller is s and the bigger the effect of ∆Y on P.
The sticky-price model
(1 s )a
P  EP  (Y  Y )
s
 Finally, derive AS equation by solving for Y :

Y  Y   (P  EP),
s
where    0
(1  s ) a
The imperfect-information model
Assumptions:
 All wages and prices are perfectly flexible,
all markets are clear.
 Each supplier produces one good, consumes
many goods.
 Each supplier knows the nominal price of the
good she produces, but does not know the
overall price level.
The imperfect-information model
 Supply of each good depends on its relative
price: the nominal price of the good divided by
the overall price level.
 Supplier does not know price level at the time
she makes 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.
Summary & implications

P LRAS
Y  Y  (P  EP)

P  EP
Both models
SRAS of AS imply
P  EP
the
P  EP relationship
summarized
Y by the SRAS
Y curve &
equation.
Summary & implications

Suppose a positive SRAS equation: Y  Y   (P  EP)

AD shock moves
P SRAS2
output above its LRAS
natural rate and SRAS1
P above the level
people had P3  EP3
expected.
P2
Over time, AD2
EP2  P1  EP1
EP rises,
SRAS shifts up, AD1
and output returns Y
to its natural rate. Y2
Y3  Y1  Y
Inflation, unemployment,
and the Phillips curve
The Phillips curve states that π depends on
 expected inflation, Eπ
 cyclical unemployment: the deviation of the
actual rate of unemployment from the natural rate
 supply shocks, 𝜐 (Greek letter “nu”).

  E   (u  u )  
n

where β > 0 is an exogenous constant.

Deriving the Phillips curve from SRAS
(1) Y  Y   (P  EP)

(2) P  EP  (1  )(Y Y )

(3) P  EP  (1  )(Y Y )  

(4) (P  P1 )  ( EP  P1 )  (1  )(Y Y )  

(5)   E  (1  )(Y Y )  
(6) (1  )(Y Y )    (u  un )

(7)   E   (u  un )  
Comparing SRAS and the Phillips curve

SRAS: Y  Y   (P  EP )
Phillips curve:   E   (u  un )  
 SRAS curve:
Output is related to
unexpected movements in the price level.
 Phillips curve:
Unemployment is related to
unexpected movements in the inflation rate.
Adaptive expectations

 Adaptive expectations: an approach that

assumes people form their expectations of future
inflation based on recently observed inflation.
 A simple version:
Expected inflation = last year’s actual inflation
E   1
 Then, Phillips curve eq’n becomes
   1   (u  un )  
Inflation inertia
   1   (u  un )  
In this form, the Phillips curve implies that
inflation has inertia:
 In the absence of supply shocks or
cyclical unemployment, inflation will
continue indefinitely at its current rate.
 Past inflation influences expectations of
current inflation, which in turn influences
the wages & prices that people set.
Two causes of rising & falling inflation
   1   (u  un )  
 cost-push inflation:
inflation resulting from supply shocks
Adverse supply shocks typically raise production
costs and induce firms to raise prices,
pushing inflation up.
 demand-pull inflation:
inflation resulting from demand shocks
Positive shocks to aggregate demand cause
unemployment to fall below its natural rate,
which pulls the inflation rate up.
Graphing the Phillips curve

In the short run, 𝜋

  E   (u  un )  
policymakers face
a tradeoff between
𝜋 and u. 
1 The short-run
E   Phillips curve

n u
u
 Shifting the Phillips curve

People adjust   E   (u  un )  
𝝅
their
expectations
over time,
E 2  
so the tradeoff
only holds in E1  
the short run.

E.g., an increase
in E shifts the
u
short-run P.C. u n

upward.
CHAPTER 14 Aggregate Supply 21
The sacrifice ratio
 To reduce inflation, policymakers can
contract agg. demand, causing
unemployment to rise above the natural rate.
 The sacrifice ratio measures
the percentage of a year’s real GDP
that must be forgone to reduce inflation
by 1 percentage point.
 A typical estimate of the ratio is 5.
The sacrifice ratio

 Example: To reduce inflation from 6 to 2 percent,

must sacrifice 20 percent of one year’s GDP:
GDP loss = (inflation reduction) × (sacrifice ratio)
= 4 × 5
 This loss could be incurred in one year or spread
over several, 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
into unemployment.
Rational expectations

Ways of modeling the formation of expectations:

 adaptive expectations:
People base their expectations of future inflation
on recently observed inflation.
 rational expectations:
People base their expectations on all available
information, including information about current
and prospective future policies.
The natural-rate hypothesis
Our analysis of the costs of disinflation, and of
economic fluctuations in the preceding chapters,
is based on the natural-rate hypothesis:

Changes in aggregate demand affect output

and employment only in the short run.
In the long run, the economy returns to
the levels of output, employment,
and unemployment described by
the classical model.
An alternative hypothesis: Hysteresis

 Hysteresis: the long-lasting influence of history

on variables such as the natural rate of
unemployment.
 Negative shocks may increase un,
so economy may not fully recover.
Hysteresis: Why negative shocks
may increase the natural rate
 The skills of cyclically unemployed workers may
deteriorate while unemployed, and they may not
find a job when the recession ends.
 Cyclically unemployed workers may lose
their 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 the
recession ends.
 TOPIC SUMMARY

1. Two models of aggregate supply in the short run:

 sticky-price model
 imperfect-information model
Both models imply that output rises above its natural
rate when the price level rises above the expected
price level.

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 TOPIC SUMMARY

2. Phillips curve
 derived from the SRAS curve
 states that inflation depends on
 expected inflation
 cyclical unemployment
 supply shocks
 presents policymakers with a short-run tradeoff
between inflation and unemployment

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 TOPIC SUMMARY

3. 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 painless

30
 TOPIC SUMMARY

4. The natural rate hypothesis and hysteresis

 the natural rate hypotheses
 states that changes in aggregate demand can
affect output and employment only in the short
run
 hysteresis
 states that aggregate demand can have
permanent effects on output and employment

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 Now You Try
An economy has the following equation for the Phillips curve: 𝜋 = 𝐸𝜋 − 0.5(𝑢 − 6)

People form expectations of inflation by taking a weighted average of the previous two years of inflation:

𝐸𝜋 = 0.7𝜋−1 + 0.3𝜋−2

Okun’s Law of this economy is

𝑌 − 𝑌−1
= 3.0 − 2.0(𝑢 − 𝑢−1)
𝑌−1

The economy begins at its natural rate of unemployment with a stable inflation rate of 5 percent.

a. What is the natural rate of unemployment for this economy?

b. Graph the SR tradeoff b/w inflation and unemployment that this economy faces. Label the point where the economy
begins as point A (be sure to give numerical values for point A).
c. A fall in AD leads to a recession, causing the unemployment rate to rise 4 percentage points above its natural rate. On
your graph, label the point the economy experiences that year as point B (be sure to give numerical values for point
B).
d. Unemployment remains at this high level for two years (the initial year and one more), after which it returns to its
natural rate. Create a table showing unemployment, inflation, expected inflation, and output growth for 10 years
beginning two years before the recession.
e. On the same graph you used before, graph the SR tradeoff the economy faces at the end of this 5-year period. Label
the point where the economy finds itself as point C (be sure to give numerical values for point C).

CHAPTER 14 Aggregate Supply 32

 Now You Try

How is the Phillips curve related to the aggregate

supply curve?

CHAPTER 14 Aggregate Supply 33

 Now Yor Try

Under what circumstances might it be possible to

reduce inflation without causing a recession?

CHAPTER 14 Aggregate Supply 34

 Now Yor Try
Explain two ways in which a recession might raise
the natural rate of unemployment

CHAPTER 14 Aggregate Supply 35