Keynesian Macroeconomics:
Aggregate Supply
Mankiw Chapter 13
Williamson Chapter 12
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Aggregate Supply
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Frictions in Three Models
So far focus on Aggregate demand
Time to look at Aggregate Supply Curve
A bit more careful treatment of SRAS curve
(so far an extreme assumption is made:
prices are fixed in the short run!)
• Sticky Wage Model
• Sticky Price Model
• Imperfect Information Model (is in fact a
market clearing model)
– All three models predict upward sloping SRAS
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What determines SRAS?
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What determines SRAS?
• When the actual price level deviates from
its expected level, output deviates from its
natural (trend level)
Y = Y + α (P − Pe )
1/ α : slope of SRAS − Curve
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Sticky Wage Model
Sticky Wage Model
• In the micro-founded models we assumed that
labour market clears in each instant
• Here, it is not anymore the case
• Longer term wage contracts
• Sluggish adjustment of nominal wages
• When nominal wage is inflexible in the SR, a rise
in the price level lowers the real wage
• More hiring
• More output
• Nominal wage bargaining: labour unions and
efficiency wages keep the target real wage higher
than the market clearing wage
• W: nominal wage
ω: target real wage
• After the nominal wage is set and BEFORE hiring
materialized, firms observe the actual price level P
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Labour demand & supply
• Hiring is based on the actual real wage
• L=Ld(W/P)
• Nominal Wage
– In the micro-founded models Ld was solely determined by
marginal productivity of labour NOT Price level)
• Production takes place: Y=F(L)
W = ω Pe
• Model neglects the labour supply decision (once nominal
contract is signed, labour supply is guaranteed even if
actual real wages are lower than the target real wages!
• It implies countercyclical real wages! (opposite of the
stylized facts!)
• Role of productivity shocks
• Real Wage
W/ P=ω*Pe / P
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Imperfect Information Model (Lucas
Island Model)
Table 10-1
• Goods and labour markets clear in each instant
• However SRAS and LRAS differ because of temporary
misperception about prices
• Suppose an overall price level increases unexpectedly
• As a producer (worker) you have to decide how much to
produce (offer labour as in the micro-founded model)
• You have to make a decision based on the prices you
observe around you (e.g. market price of the good that you
produce (or help to produce via labour supply))
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Imperfect Information Model
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Table 11-1
• Mechanism: Nominal wage rise is perceived as being
real wage riseÎ Labor supply increasesÎ Labor
market eq´m: higher employment and lower real
wages ÎLabor realizes that prices have also risenÎ
labor supply curve shifts backÎ initial eq´m
reestablishes
• Confusion between overall change in prices with
relative prices
Y = Y + α (P − P e)
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Pricing Decision
Sticky Price Model
• Firms do not adjust their prices instantaneously
w.r.t. AD shocks
• Depends here on two macro-variables
• 1. Aggregate price level: the higher the
aggregate price level the higher the costs of
production, the higher the price of the
individual good
• 2. Aggregate Income: means also higher
demand for the individual good, higher final
prices
– Menu costs
– Imperfect competition (firms are price setters)
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Pricing Decision
Pricing Decision
• Desired prices
• Aggregate Prices will thus be
P = sP e + (1 − s )[ P + a (Y − Y )]
p = P + a (Y − Y )
• Two types of firms (flexible and rigid firms)
• Flexible firms (1-s):
• Subtract (1-s)P from both sides and rearrange for P
e
p = P e + a(Y e − Y )
P = P e + [(1 − s ) a / s ] (Y − Y )
α
• Rigid firms (s):
p = Pe
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• When firms expect higher inflation (higher
costs) set their prices high, others follow
• When output (Y) is high, demand is high.
Flexible firms set prices high (s matters)
Evidence
Evidence II
• If there is learning about AD fluctuations or if AD
is quite volatile (any change in Y-Ybar reflects
rather aggregate price level change instead of
relative price changes) α is expected to be smallÎ
flat SRAS Curve
• If AD is rather stable, a change in Y-Ybar is
expected to reflect relative price change , α is
expected to be large Î steep SRAS Curve
• Lucas (1973): finds evidence in support of
imperfect information model, i.e. AD changes
have largest impact on Y only in those countries
where Prices and AD are in general stable!
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• Sticky price model: high rate of inflation
calls for more frequent price adjustments
(high inflation countries face a large α (steep
SRAS)
(low inflation countries face a low α (flat SRAS)
– Confirmed by data
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Main Conclusion
• Imperfections cause SR monetary nonneutrality
• Compatible with LR monetary neutrality
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Inflation, Unemployment and
Phillips Curve
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Deriving the Phillips Curve
• Policymakers objectives may conflict
• Three factors drive PC
– Low inflation and high employment
– Phillips Curve
– Expected future inflation
– Cyclical unemployment
– Supply shocks
– i,.e.
π = π e − β (u − un ) +υ
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• Subtract Pt-1 from both sides
Deriving PC
P − P−1 = P e − P−1 +
• Rewrite AS equation as a function of P
P = Pe +
1
α
(Y − Y )
1
α
1
α
(Y − Y ) + υ
• i.e.
• Add υ to capture an exogenous AS shock (e.g. oil
prices, deregulation etc)
P = Pe +
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π =πe+
1
α
(Y − Y ) + υ
(Y − Y ) + υ
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• Use Okun’s Law that is
1
α
Essential Issue
(Y − Y ) = − β ( u − u n )
• PC and /or SRAS brake the classical
dichotomy in the Short run
• rewrite AS equation to obtain Phillips Curve such that
π = π e − β (u − u n ) + υ
• policy (more precisely monetary policy)
effectiveness
• Classical dichotomy breaks down in the short run!
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How to make PC Workable:
Adaptive Expectations
• backward looking behaviour
• Inflation inertia
• Agents form expectations by looking at the previous
period inflation data
• Past inflation affects current expectations
that affects wages and prices!
π = π t −1
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• Rewrite Phillips Curve accordingly (NAIRU)
e
π = π−1 − β (u − un ) +υ
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Causes of Rising and Falling
Inflation
• Demand pull inflation
• Cost push inflation
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− β (u − u n )
υ
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SR Trade-off between Inflation and
Unemployment
β determines the trade off between inflation
and unemployment
• Early evidence indicated a SR trade off
• Now very little support if any!
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Disinflation
• Under adaptive expectations disinflation is costly!
• In the absence of favourable supply shock (decline
in u via say a decline in energy prices) lowering
inflation requires an increase in unemployment
and decline in real output .
• If agents are rational, (as in the micro-founded
models) expectation formation should use all
available information. Less pain in terms of output
loss!
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Disinflation and Sacrifice Ratio
• Sacrifice ratio: percentage of a year’s GDP (or
unemployment: by Okun’s Law) that must be
foregone to reduce inflation by 1% point.
(estimates: for 1% inflation decline sacrifice about
5% of a year’s GDP)
π = π e − β (u − un ) +υ
1
α
(Y − Y ) = − β ( u − u n )
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Hysteresis
Conclusions
• Characterizes long lasting influence of AD on
natural rate..
• E.g. A long lasting recession
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– May cause loss of skills
– Reduction in desire to find a job
– Insiders/outsiders
Three theories of SRAS
Phillips Curve
Inertia: adaptive expectations
Natural rate hypothesis
– Permanent implications on the labour market
– Hysteresis raises the sacrifice ratio (output is
permanently lost even if disinflation is over)
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