Class Slides for EC 204Spring 2006

To Accompany Chapter 13

Three Models of Short-Run Aggregate Supply

• The Sticky-Wage Model

• The Imperfect Information Model

• The Sticky-Price Model

The Sticky-Wage Model

• When nominal wage is stuck, rise in price level lowers real wage making labor cheaper

• Lower real wage induces firms to hire more labor

• The additional labor produces more output

Workers and Firms Set Nominal Wage:

W = x Pe

So real wage equals:

W/P = W = x Pe/P

Output deviates from its natural levelwhen the price level deviates from the

expected price level:

Y = YN + [P - Pe]

The Imperfect Information Model

• Markets clear--Wages and prices adjust to balance supply and demand in goods and labor markets

• Temporary misperceptions about prices cause short-run and long-run aggregate supply curves to differ

• Suppliers confuse changes in overall level of prices with changes in relative prices

When Price Level rises unexpectedly:

• All Producers in economy see their nominal price increase

• They treat this increase as partly a relative price increase

• They work harder and expand output

Output deviates from its natural levelwhen the price level deviates from the

expected price level:

Y = YN + [P - Pe]

The Sticky-Price Model

• Two Factors Determine Desired Price:

1. Overall level of prices--since costs are higher.

2. Level of aggregate income--because higher demand raises marginal cost of production.

Firm’s Desired Price is given as:

p = P + a[Y - YN]

Assume 2 Types of Firms:

(1)Flexible-Price Firms:

p = P + a[Y - YN]

(2) Sticky-Price Firms:Set price in advance according to expectations

about P and Y

p = Pe + a[Ye - YN]

Assume Sticky-Price Firms Expect Output to Equal Its Natural Rate: Ye=YN

Then,

p = Pe

Now, suppose that s is fraction of firms with sticky pricesand [1-s] is fraction of firms with flexible prices.

Put together the two pricing relationships to yield:

P = sPe + [1-s][P + a[Y - YN]]

Rearrange to yield:

sP = sPe + [1-s][a[Y-YN]or

P = Pe + [[1-s]a/s][Y-YN]

This can be expressed in a more familiar form:

Y = YN + [P - Pe]

where = s/[[1-s]a]

Some Evidence on Models of Aggregate Supply

• Lucas International Comparison Paper -- Imperfect Information Model:

Volatility of aggregate demand determines slope of short-run aggregate supply curve.

Steeper supply curve for countries with greater volatility in aggregate demand and hence in the price level.

Reason is that producers understand that high volatility of the price level implies that movement in their own price usually reflects movement in overall price level.

Some Evidence on Models of Aggregate Supply

• Ball, Mankiw and Romer Paper -- Sticky Price Model:

Steeper supply curve for countries with higher rates of inflation.

Reason is that firms will not keep prices fixed for as long a period of time when inflation is higher, so less of an output response for any given change in the price level.

Greater volatility in aggregate demand also leads to steeper supply curve.

Inflation, Unemployment, and the Phillips Curve

• Expected Inflation• Deviation of Unemployment from Natural Rate -

Cyclical Unemployment• Supply Shocks

Phillips curve takes the following form:

= e - [U-UN] + v

Derive from Aggregate Supply Curve:

P = Pe + [1/][Y-YN] + vwhere v represents “supply shocks”

Subtract P-1 from both sides:

P - P-1 = Pe - P-1 + [1/][Y-YN] + v

= e + [1/][Y-YN] + v

Use Okun’s Law to Relatedeviation of Y from YN to

deviation of U to UN:

[1/][Y-YN] = -[U-UN]

Substitute into earlier equation to obtain:

= e - [U-UN] + v

Adaptive Expectations and the NAIRU Theory :

e =

- [U-UN] + v

Demand-Pull and Cost-Push Inflation

Disinflation and the Sacrifice Ratio

• Rational Expectations and the Possibility ofPainless Disinflation

• Sacrifice Ratio in Practice

• What about Hysteresis in the Natural Rateof Unemployment?

Can Disinflation Be Painless?

• Rational Expectations

• Change in Fiscal or Monetary Policy will change expectations

• Inflation may have less inertia than it first appears

• Policy change can bring about a drop in inflation with no output loss

Sacrifice Ratio in Practice:The Volcker Disinflation

• 1981: Inflation 9.7 percent• 1985: Inflation 3.0 percent• Drop of 6.7 percentage points• Unemployment exceeded natural rate by

cumulative 9.5 percentage points• Translates to 19 percentage points of annual GDP• Sacrifice Ratio = 19/6.7 = 2.8 -- Lower than

benchmark of 5.0

Hysteresis: Challenge to the Natural Rate Hypothesis

• If aggregate demand affects output and employment even in the long run, then assumptions of natural-rate hypothesis break down. History will matter for Un

• Reasons: – Unemployed workers lose job skills– Long unemployment may change attitude toward work– Insider-Outsider effectsPossible reason for why Europe’s Unemployment has

remained so high