13 1 aggregate supply

Chapter Thirteen 1
A PowerPoint™Tutorial
to Accompany macroeconomics, 5th ed.
N. Gregory Mankiw
®
Aggregate Supply

Chapter Thirteen 2
When we introduced the aggregate supply curve of chapter 9, we
established that aggregate supply behaves differently in the short run
than in the long run. In the long run, prices are flexible, and the
aggregate supply curve is vertical. When the aggregate supply curve is
vertical, shifts in the aggregate demand curve affect the price level, but
the output of the economy remains at its natural rate. By contrast, in
the short run, prices are sticky, and the aggregate supply curve is not
vertical. In this case, shifts in aggregate demand do cause fluctuations
in output. In chapter 9, we took a simplified view of price stickiness
by drawing the short-run aggregate supply curve as a horizontal line,
representing the extreme situation in which all prices are fixed. So,
now we’ll refine our understanding of short-run aggregate supply.
When we introduced the aggregate supply curve of chapter 9, we
established that aggregate supply behaves differently in the short run
than in the long run. In the long run, prices are flexible, and the
aggregate supply curve is vertical. When the aggregate supply curve is
vertical, shifts in the aggregate demand curve affect the price level, but
the output of the economy remains at its natural rate. By contrast, in
the short run, prices are sticky, and the aggregate supply curve is not
vertical. In this case, shifts in aggregate demand do cause fluctuations
in output. In chapter 9, we took a simplified view of price stickiness
by drawing the short-run aggregate supply curve as a horizontal line,
representing the extreme situation in which all prices are fixed. So,
now we’ll refine our understanding of short-run aggregate supply.

Chapter Thirteen 3
Let’s now examine three prominent models of aggregate supply, roughly
in the order of their development. In all the models, some market
imperfection causes the output of the economy to deviate from its
classical benchmark. As a result, the short-run aggregate supply curve
is upward sloping, rather than vertical, and shifts in the aggregate
demand curve cause the level of output to deviate temporarily from
the natural rate. These temporary deviations represent the booms and
busts of the business cycle.
Although each of the three models takes us down a different theoretical
route, each route ends up in the same place. That final destination is a
short-run aggregate supply equation of the form…

Chapter Thirteen 4
Y = Y + α (P-Pe
) where α > 0
Output
Actual price level
positive constant:
an indicator of
how much
output responds
to unexpected
changes in the
price level.
Natural
rate of output
Expected
price level
This equation states that output deviates from its natural rate when the
price level deviates from the expected price level. The parameter α
indicates how much output responds to unexpected changes in the price
level, 1/α is the slope of the aggregate supply curve.

Chapter Thirteen 5
The sticky-wage model shows what a sticky nominal wage implies for
aggregate supply. To preview the model, consider what happens to the
amount of output produced when the price level rises:
1) When the nominal wage is stuck, a rise in the price level lowers the
real wage, making labor cheaper.
2) The lower real wage induces firms to hire more labor.
3) The additional labor hired produces more output.
This positive relationship between the price level and the amount of
output means the aggregate supply curve slopes upward during the time
when the nominal wage cannot adjust.
The workers and firms set the nominal wage W based on the target real
wage ω and on their expectation of the price level Pe
. The nominal wage
they set is:
W = ω × Pe
Nominal Wage = Target Real Wage × Expected Price Level

Chapter Thirteen 6
W/P = ω × (Pe
/P)
Real Wage=Target Real Wage ×(Expected Price Level/Actual Price Level)
This equation shows that the real wage deviates from its target if the
actual price level differs from the expected price level. When the actual
price level is greater than expected, the real wage is less than its target;
when the actual price level is less than expected, the real wage is greater
than its target.
The final assumption of the sticky-wage model is that employment is
determined by the quantity of labor that firms demand. In other words,
the bargain between the workers and the firms does not determine the
level of employment in advance; instead, the workers agree to provide
as much labor as the firms wish to buy at the predetermined wage. We
describe the firms’ hiring decisions by the labor demand function:
L = Ld
(W/P),
which states that the lower the real wage, the more labor firms hire and
output is determined by the production function Y = F(L).

Chapter Thirteen 7
Labor, L
Y = F(L)
Income, Output, Y
Labor, L
L = Ld
(W/P)
Y=Y+α(P-Pe
)
realwage,W/P
Income,Output,YPricelevel,P
An increase in the price level,
reduces the real wage for a given
nominal wage, which raises
employment and output and
income.
An increase in the price level,
reduces the real wage for a given
nominal wage, which raises
employment and output and
income.

Chapter Thirteen 8
The second explanation for the upward slope of the short-run aggregate
supply curve is called the imperfect-information model. Unlike the
sticky-wage model, this model assumes that markets clear-- that is, all
wages and prices are free to adjust to balance supply and demand. In this
model, the short-run and long-run aggregate supply curves differ because
of temporary misperceptions about prices.
The imperfect-information model assumes that each supplier in the
economy produces a single good and consumes many goods. Because the
number of goods is so large, suppliers cannot observe all prices at all
times. They monitor the prices of their own goods but not the prices of all
goods they consume. Due to imperfect information, they sometimes
confuse changes in the overall price level with changes in relative prices.
This confusion influences decisions about how much to supply, and it
leads to a positive relationship between the price level and output in the
short run.

Chapter Thirteen 9
Let’s consider the decision of a single wheat producer, who earns income
from selling wheat and uses this income to buy goods and services. The
amount of wheat she chooses to produce depends on the price of wheat
relative to the prices of other goods and services in the economy. If the
relative price of wheat is high, she works hard and produces more wheat.
If the relative price of wheat is low, she prefers to work less and produce
less wheat. The problem is that when the farmer makes her production
decision, she does not know the relative price of wheat. She knows the
nominal price of wheat, but not the price of every other good in the
economy. She estimates the relative price of wheat using her expectations
of the overall price level.
If there is a sudden increase in the price level, the farmer doesn’t know if it
is a change in overall prices or just the price of wheat. Typically, she will
assume that it is a relative price increase and will therefore increase the
production of wheat. Most suppliers will tend to make this mistake.
To sum up, the notion that output deviates from the natural rate when the
price level deviates from the expected price level is captured by:
Y = Y + α(P-Pe
)

Chapter Thirteen 10
A third explanation for the upward-sloping short-run aggregate supply
curve is called the sticky-price model. This model emphasizes that firms
do not instantly adjust the prices they charge in response to changes in
demand. Sometimes prices are set by long-term contracts between firms
and consumers.
To see how sticky prices can help explain an upward-sloping aggregate
supply curve, first consider the pricing decisions of individual firms
and then aggregate the decisions of many firms to explain the economy
as a whole. We will have to relax the assumption of perfect competition
whereby firms are price takers. Now they will be price setters.

Chapter Thirteen 11
Consider the pricing decision faced by a typical firm. The firm’s
desired price p depends on two macroeconomic variables:
1) The overall level of prices P. A higher price level implies that the
firm’s costs are higher. Hence, the higher the overall price level, the
more the firm will like to charge for its product.
2) The level of aggregate income Y. A higher level of income raises
the demand for the firm’s product. Because marginal cost increases at
higher levels of production, the greater the demand, the higher the
firm’s desired price.
The firm’s desired price is:
p = P + a(Y-Y)
This equations states that the desired price p depends on the overall
level of prices P and on the level of aggregate demand relative to its
natural rate Y-Y. The parameter a (which is greater than 0) measures
how much the firm’s desired price responds to the level of aggregate
output.

Chapter Thirteen 12
Now assume that there are two types of firms. Some have flexible prices:
they always set their prices according to this equation. Others have sticky
prices: they announce their prices in advance based on what they expect
economic conditions to be. Firms with sticky prices set prices according to
p = Pe
+ a(Ye
- Ye
),
where the superscript ‘e’ represents the expected value of a variable. For
simplicity, assume these firms expect output to be at its natural rate so
that the last term a(Ye
- Ye
), drops out. Then these firms set price so
that p = Pe
. That is, firms with sticky prices set their prices based on what
they expect other firms to charge.
We can use the pricing rules of the two groups of firms to derive the
aggregate supply equation. To do this, we find the overall price level in the
economy as the weighted average of the prices set by the two groups.
After some manipulation, the overall price level is:
P = Pe
+ [(1-s)a/s](Y-Y)]

Chapter Thirteen 13
P = Pe
+ [(1-s)a/s](Y-Y)]
The two terms in this equation are explained as follows:
1) When firms expect a high price level, they expect high costs. Those
firms that fix prices in advance set their prices high. These high prices
cause the other firms to set high prices also. Hence, a high expected price
level Pe
leads to a high actual price level P.
2) When output is high, the demand for goods is high. Those firms
with flexible prices set their prices high, which leads to a high price level.
The effect of output on the price level depends on the proportion of firms
with flexible prices. Hence, the overall price level depends on the
expected price level and on the level of output. Algebraic rearrangement
puts this aggregate pricing equation into a more familiar form:
where α = s/[(1-s)a]. Like the other models, the sticky-price model says
that the deviation of output from the natural rate is positively associated
with the deviation of the price level from the expected price level.
Y = Y + α(P-Pe
)

Chapter Thirteen 14
Start at point A; the economy is at full employment Y and the
actual price level is P0. Here the actual price level equals the
expected price level. Now let’s suppose we increase the price
level to P1.
Since P (the actual price level) is now greater than Pe
(the
expected price level) Y will rise above the natural rate, and we
slide along the SRAS(Pe
=P0)curve to A' .
Remember that our new SRAS (Pe
=P0) curve is defined by the
presence of fixed expectations (in this case at P0). So in terms
of the SRAS equation, when P rises to P1, holding Pe
constant
at P0, Y must rise.
The “long-run” will be defined when the expected price level equals the actual price level. So, as price level
expectations adjust, Pe
⇒P2, we’ll end up on a new short-run aggregate supply curve, SRAS (Pe
=P2) at point B.
Hooray! We made it back to LRAS, a situation characterized by perfect information where the actual price
level (now P2) equals the expected price level (also, P2).
↑Y = Y + α (↑P-Pe
)
Y = Y + α (P-Pe
)
Y = Y + α (↑P-↑Pe
)
In terms of the SRAS equation, we can see that as Pe
catches up with P, that entire “expectations gap”
disappears and we end up on the long run aggregate supply curve at full employment where Y = Y.
SRAS (Pe
=P2)
BP2
A'
Y'
SRAS (Pe
=P0)
P
Output
A
P0
LRAS*
Y
AD
AD'
P1

Chapter Thirteen 15
The Phillips curve in its modern form states that the inflation rate
depends on three forces:
1) Expected inflation
2) The deviation of unemployment from the natural rate, called
cyclical unemployment
3) Supply shocks
These three forces are expressed in the following equation:
π = πe
−β(µ−µn
) + ν
Inflation β × Cyclical
Unemployment
Supply
Shock
Expected
Inflation

Chapter Thirteen 16
The Phillips-curve equation and the short-run aggregate supply equation
represent essentially the same macroeconomic ideas. Both equations
show a link between real and nominal variables that causes the
classical dichotomy (the theoretical separation of real and nominal
variables) to break down in the short run.
The Phillips curve and the aggregate supply curve are two sides of the
same coin. The aggregate supply curve is more convenient when
studying output and the price level, whereas the Phillips curve
is more convenient when studying unemployment and inflation.

Chapter Thirteen 17
To make the Phillips curve useful for analyzing the choices facing
policymakers, we need to say what determines expected inflation. A
simple often plausible assumption is that people form their expectations
of inflation based on recently observed inflation. This assumption is
called adaptive expectations. So, expected inflation πe
equals last year’s
inflation π-1. In this case, we can write the Phillips curve as:
which states that inflation depends on past inflation, cyclical
unemployment, and a supply shock. When the Phillips curve is written in
this form, it is sometimes called the Non-Accelerating Inflation Rate of
Unemployment, or NAIRU.
The term π-1 implies that inflation has inertia-- meaning that it keeps going
until something acts to stop it. In the model of AD/AS, inflation inertia
is interpreted as persistent upward shifts in both the aggregate supply
curve and aggregate demand curve. Because the position of the SRAS
will shift upwards overtime, it will continue to shift upward until
something changes inflation expectations.
π = π-1 −β(µ−µn
) + ν

Chapter Thirteen 18
The second and third terms in the Phillips-curve equation show the two
forces that can change the rate of inflation. The second term, β(u-un
),
shows that cyclical unemployment exerts downward pressure on inflation.
Low unemployment pulls the inflation rate up. This is called
demand-pull inflation because high aggregate demand is responsible for
this type of inflation. High unemployment pulls the inflation rate down.
The parameter β measures how responsive inflation is to cyclical
unemployment. The third term, ν shows that inflation also rises and falls
because of supply shocks. An adverse supply shock, such as the rise in
world oil prices in the 70’s, implies a positive value of ν and causes
inflation to rise.
This is called cost-push inflation because adverse supply shocks are
typically events that push up the costs of production. A beneficial
supply shock, such as the oil glut that led to a fall in oil prices in the
80’s, makes ν negative and causes inflation to fall.

Chapter Thirteen 19
un
π
Unemployment, u
πe
+ ν
In the short run, inflation and unemployment
are negatively related. At any point in time, a
policymaker who controls aggregate demand
can choose a combination of inflation and
unemployment on this short-run Phillips
curve.
In the short run, inflation and unemployment
are negatively related. At any point in time, a
policymaker who controls aggregate demand
can choose a combination of inflation and
unemployment on this short-run Phillips
curve.

Chapter Thirteen 20
un
Π
Unemployment, u
LRPC (u=un
)
5%
10%
SRPC (Πe
=0%)
SRPC (Πe
=10%)
SRPC (Πe
=5%)
D
B C
E
Suppose there is an increase in the rate of growth of the money supply causing LM and AD to shift out
resulting in an unexpected increase in inflation. The Phillips curve equation Π = Πe
– β(u-un
) + v implies
that the change in inflation misperceptions causes unemployment to decline. So, the economy moves to a
point above full employment at point B.
A
As long as this inflation misperception exists, the economy will
remain below its natural rate un
at u'.
Let’s start at point A, a point of price stability (Π=0%) and full employment (u=un
).
When the economic agents realize the new level of inflation, they
will end up on a new short-run Phillips curve where expected
inflation equals the new rate of inflation (5%) at point C, where
actual inflation (5%) equals expected inflation (5%).
Remember, each short-run Phillips curve is defined by the presence of fixed expectations.
If the monetary authorities opt to obtain a lower u again,
then they will increase the money supply such that Π is
10%, for example. The economy moves to point D, where
actual inflation is 10% but, Πe
is 5%.
When expectations adjust, the
economy will land on a new SRPC, at
point E, where both Π and Πe
equal
10%.
u'

Chapter Thirteen 21
Rational expectations make the assumption that people optimally use all
the available information about current government policies, to forecast
the future. According to this theory, a change in monetary or fiscal
policy will change expectations, and an evaluation of any policy change
must incorporate this effect on expectations. If people do form their
expectations rationally, then inflation may have less inertia than it first
appears.
Proponents of rational expectations argue that the short-run Phillips
curve does not accurately represent the options that policymakers have
available. They believe that if policy makers are credibly committed to
reducing inflation, rational people will understand the commitment and
lower their expectations of inflation. Inflation can then come down
without a rise in unemployment and fall in output.

Chapter Thirteen 22
Our entire discussion has been based on the natural rate hypothesis.
The hypothesis is summarized in the following statement:
Fluctuations 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.
Recently, some economists have challenged the natural-rate hypothesis
by suggesting that aggregate demand may affect output and employment
even in the long run. They have pointed out a number of mechanisms
through which recessions might leave permanent scars on the economy
by altering the natural rate of unemployment. Hyteresis is the term
used to describe the long-lasting influence of history on the natural
rate.

Chapter Thirteen 23
Sticky-wage model
Imperfect-information model
Sticky-price model
Phillips curve
Adaptive expectations
Demand-pull inflation
Cost-push inflation
Sacrifice ratio
Rational expectations
Natural-rate hypothesis
Hyteresis
Sticky-wage model
Imperfect-information model
Sticky-price model
Phillips curve
Adaptive expectations
Demand-pull inflation
Cost-push inflation
Sacrifice ratio
Rational expectations
Natural-rate hypothesis
Hyteresis

13 1 aggregate supply

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13 1 aggregate supply