MACROECONOMICS
Chapter 13
Aggregate Supply and
the Short Run Tradeoff
Between Inflation and
Unemployment
Short-Run Aggregate Supply
P
We assumed all prices
were sticky together and
they all moved together for
long-run adjustment.
 Now we will entertain two
theories to modify the
SRAS curves.
e
 Both will yield Y  Y   ( P  P )

Y
Y
 0
2
SRAS
Y  Y   (P  P )   0
e
P
LRAS
SRAS
P>Pe
PP 
e
1

Y

Y
Y
α
(1/α)ΔY
P=Pe
1
ΔY
1
P<Pe
P
Y
Y when P=Pe
Y Y
  (   e )
Y
 e 
1 Y Y
(
)
 Y
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Theory #1: Sticky Price Model
Long term contracts
 Fear of annoying customers
 Costly to alter prices
 Stable wages (stable costs of production)

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Theory #1: Sticky Price Model
Monopolistic competition models have
price determination for firms as MC +
premium where the more elastic is the
demand curve for the firm, the lower is the
premium.
 If MC responds to the overall price level P
and premium responds to higher GDP
(more GDP, more demand), then the firm
will determine its price, p, according to
p  P   (Y  Y )

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Theory #1: Sticky Price Model
Those firms that will follow the equation p  P   (Y  Y )
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).
P  sP e  (1  s)[P   (Y  Y )]
sP  sP e  (1  s)Y  (1  s) Y
(1  s)Y  (1  s) Y  sP e  sP
Y Y 
s
(P  P e )
(1  s)
The last equation is the same as
Y  Y   (P  Pe )
our new SRAS curve.
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Theory #2: Imperfect Information


No need to assume monopolistic competition.
Markets clear but temporary misperceptions
about prices in other markets than their own
separate LRAS and SRAS.


They know their own costs. They know their own
market with their competitors.
They do not know if the price increases in their
market are because of inflation or demand increase.
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Theory #2: Imperfect Information

If you see prices for your product is increasing,
you better increase production even if MC is
rising because it will yield higher profits.



More work, more output, more GDP!
If the price rise was because of inflation and you
increased production, eventually you will realize
that there is no extra demand and you will come
back to original output.
This is true for every producer.
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Theory #2: Imperfect Information
P
MC
P1
P0
Sticky wages
will keep MC
from shifting
left immediately.
Q
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Theory #2: Imperfect Information
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.
Y  Y   (P  P )
e
Again, we have an output response to higher
prices even though all the prices are increasing
because people do not have perfect information.
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Supply Shock
This specification came from tracing
the impact of AD shift on Y and P.
Y  Y   (P  P e )
What if Y and P were to respond to a
1
supply shock like a change in oil prices
e
P  P  (Y  Y ) or economy-wide wage negotiation

that affect costs of production.
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.
Y  Y   (P  P e )  v
1
e
P  P  (Y  Y )  v

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Phillips Curve
Y  Y   (P  P e )  v
PP 
e
1

(Y  Y )  v
P  P1  ( P e  P1 ) 
 e 

Y  Y  v


Y  Y  v

1
1
   e   (u  u n )  v
The book’s approach (above) is
not as satisfying as the
alternative approach on the right.
Y Y
 '   e  v
Y
  ' (u  u n )   ' (   e )  v


   e   (u  u n )  v
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.
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The Slope of SRAS

If one lived in a society where inflation was
rare, and one saw an increase in the price of
her market, what would be her reaction?
(a) Increase production;
(b) Keep production the same?
Static Expectations
P
Increase production
Y
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The Slope of SRAS

If one lived in a society where inflation
was a common occurrence, and one saw
an increase in the price of the product
one was supplying, what would be the
reaction?
(a)
(b)
Increase production;
Keep production the same?
P
Adaptive Expectations
Keep production the same
Y
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Phillips Curve
π
What happens when
inflationary expectations
rise?
πe + v
What happens when there
is a negative supply shock?
un
u
15
Y Y
Y
Static Expectations
IS
r
π
IS
LM
Fiscal expansion under static
expectations yield higher than
full employment Y indefinitely
because the population does
not adjust its inflationary expectations.
Y Y
Y
AD
SRAS
AD
0
Y Y
Y
π
LRPhC
π = πe + v
Y Y
Y
SRPhC
un
You can’t fool every one all the time!
U
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Inflation and Unemployment in the
United States, 1960–2008
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Inflation and Unemployment in the
United States, 1960–2008
π
’80-’83
’76-’79
’86-’93
’01-’08
’61-’69
u
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Y Y
Y
Adaptive Expectations
IS
r
π
IS
Fiscal expansion under adaptive
expectations yield higher than
full employment Y initially but as
inflationary expectations rise, SRAS
and LM shift leftward to reach LR
equilibrium eventually.
LM
Y Y
Y
AD
π
LRPhC
SRAS
0
Y Y
Y
SRPhC’
π = πe + v
AD
Y Y
Y
un
SRPhC
U
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Shifts in Aggregate Demand
Short 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.
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Y Y
Y
Rational Expectations
IS
r
π
IS
Fiscal expansion under rational
expectations keeps the economy at
full employment Y because the
population immediately adjusts
inflationary expectations fully.
LM
Y Y
Y
AD
π
LRPhC
SRAS
AD
0
Y Y
Y
Y Y
Y
SRPhC
π = πe + v
Pangloss Solution
un
U
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Test Question

Show static, adaptive, and rational
expectations when the Central Bank
increases the money supply.
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Sacrifice 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.
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Taylor Rule


it   t       t     Y
*
t
Y  Y 
t
t
Yt
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
i    2.0  0.5(  2.0)  0.5(GDPgap)
http://research.stlouisfed.org/publications/mt/page10.pdf
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