CHAPTER
14
Aggregate Supply and the
Short-Run Tradeoff Between
Inflation and Unemployment
Modified for ECON 2204
by Bob Murphy
2016 Worth Publishers, all rights reserved
IN THIS CHAPTER, 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
Introduction
In previous chapters, 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
CHAPTER 14
Aggregate Supply
Introduction
Both models imply:
Y = Y + (P EP )
expected
price level
agg.
output
natural rate
of output
a positive
parameter
actual
price level
Other things equal, Y and P are positively
related, so the SRAS curve is upward sloping.
CHAPTER 14
Aggregate Supply
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).
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Aggregate Supply
The sticky-price model
An individual firms desired price is:
p = P + a(Y Y )
where a > 0.
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:
p = EP + a( EY EY )
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Aggregate Supply
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
CHAPTER 14
Aggregate Supply
The sticky-price model
P = s[ EP ] + (1 s )[ P + a(Y Y )]
price set by
sticky-price firms
price set by
flexible-price firms
Subtract (1s)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
CHAPTER 14
Aggregate Supply
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.
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Aggregate Supply
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
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Aggregate Supply
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.
Supplier knows history of price movements and
can compute variances of prices.
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Aggregate Supply
10
The imperfect-information model
Output from producer, i, should respond positively to the relative price of
good i:
yi = yi + ri
where:
ri = pi P
But relative price of good i depends on the overall price level, which is not
observed. The producer observes only his/her own nominal price, so output
depends on expected value of the relative price conditioned on their own
nominal price:
yi = yi + E[ri | pi ]
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Aggregate Supply
11
The imperfect-information model
Since the relative price equals nominal price minus overall price level, we
can rearrange to express nominal price equal to relative price plus price
level:
pi = ri + P
Assuming that the relative price is uncorrelated with the overall price level,
we can express the variance of the nominal price as:
Var[ pi ] = Var[ri ] + Var[P]
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Aggregate Supply
12
The imperfect-information model
We need to compute the expected value of the relative price
conditioned on the nominal price:
E[ri | pi ] = ?
We can do this by running a regression (extracting the signal
from the nominal price):
ri = [ pi P]
where:
CHAPTER 14
Cov[ri , pi ] Cov[ri ,ri + P]
=
=
Var[ pi ]
Var[ri + P]
Var[ri ]
=
Var[ri ] + Var[P]
Aggregate Supply
13
The imperfect-information model
So this implies:
E[ri | p]i = [ pi EP]
And implies the following supply function for producer i:
yi = yi + [ pi EP]
Aggregating over all producers (who are identical) gives the
short-run aggregate supply equation:
y = y + [P EP]
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Aggregate Supply
14
The imperfect-information model
Using the earlier notation for the short-run aggregate supply curve:
y = y + [P EP]
where:
Note that b (and therefore a) will be small (and the aggregate supply
curve will be steep) when the variance of the relative price is small
compared with the variance of the overall price level. And b (and
therefore a) will be large (and the aggregate supply curve will be flat)
when the variance of the relative price is large compared with the
variance of the overall price level.
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Aggregate Supply
15
The imperfect-information model
Supply of each good depends on its relative
price: the nominal price of the good minus the
overall price level.
Supplier does not know price level at the time
but does observe her own price. When she
makes her production decision, she uses EP.
Suppose P rises but EP does not.
Supplier sees own price increase and thinks her
relative price has risen, so she produces more.
With many producers thinking this way,
Y will rise whenever P rises above EP.
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Aggregate Supply
16
Summary & implications
P
LRAS
Y = Y + (P EP)
P > EP
SRAS
P = EP
P < EP
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Aggregate Supply
Both models
of agg. supply
imply the
relationship
summarized
by the SRAS
curve &
equation.
17
Summary & implications
SRAS equation: Y = Y + (P EP)
Suppose a positive
AD shock moves
SRAS2
P
LRAS
output above its
natural rate and
SRAS1
P above the level
people had
P3 = EP3
expected.
P2
Over time,
EP2 = P1 = EP1
EP rises,
SRAS shifts up,
and output returns
to its natural rate.
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Aggregate Supply
AD2
AD1
Y
Y3 = Y1 = Y
Y2
18
Inflation, unemployment,
and the Phillips curve
The Phillips curve states that depends on
expected inflation, E
cyclical unemployment: the deviation of the
actual rate of unemployment from the natural rate
supply shocks, (Greek letter nu).
= E (u u ) +
n
where > 0 is an exogenous constant.
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Aggregate Supply
19
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 P1 ) = ( EP P1 ) + (1 )(Y Y ) +
(5)
= E + (1 )(Y Y ) +
(6)
(1 )(Y Y ) = (u un )
(7)
= E ( u u n ) +
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Aggregate Supply
20
Comparing SRAS and the Phillips curve
SRAS:
Phillips curve:
Y = Y + (P EP )
= E (u u n ) +
SRAS curve:
Output is related to
unexpected movements in the price level.
Phillips curve:
Unemployment is related to
unexpected movements in the inflation rate.
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Aggregate Supply
21
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 years actual inflation
E = 1
Then, Phillips curve eqn becomes
n
= 1 (u u ) +
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Aggregate Supply
22
Inflation inertia
= 1 (u u ) +
n
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.
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Aggregate Supply
23
Two causes of rising & falling inflation
= 1 (u u ) +
n
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.
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Aggregate Supply
24
Graphing the Phillips curve
In the short run,
policymakers face
a tradeoff between
and u.
= E (u u n ) +
The short-run
Phillips curve
E +
u
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Aggregate Supply
25
Shifting the Phillips curve
People adjust
their
expectations
over time,
so the tradeoff
only holds in
the short run.
E 2 +
E 1 +
E.g., an increase
in E shifts the
short-run P.C.
upward.
CHAPTER 14
= E (u u n ) +
Aggregate Supply
26
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 years real GDP
that must be forgone to reduce inflation
by 1 percentage point.
A typical estimate of the ratio is 5.
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Aggregate Supply
27
The sacrifice ratio
Example: To reduce inflation from 6 to 2 percent,
must sacrifice 20 percent of one years GDP:
GDP loss = (inflation reduction) (sacrifice ratio)
=
4
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 Okuns law to translate this cost
into unemployment.
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Aggregate Supply
28
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.
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Aggregate Supply
29
Painless disinflation?
Proponents of rational expectations believe
that the sacrifice ratio may be very small:
Suppose u = un and = E = 6%,
and suppose the Fed announces that it will
do whatever is necessary to reduce inflation
from 6 to 2 percent as soon as possible.
If the announcement is credible,
then E will fall, perhaps by the full 4 points.
Then, can fall without an increase in u.
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Aggregate Supply
30
Calculating the sacrifice ratio
for the Volcker disinflation
1981: = 9.7%
Total disinflation = 6.7%
1985: = 3.0%
year
un
uu n
1982
9.5%
6.0%
3.5%
1983
9.5
6.0
3.5
1984
7.4
6.0
1.4
1985
7.1
6.0
1.1
Total 9.5%
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Aggregate Supply
31
Calculating the sacrifice ratio
for the Volcker disinflation
From previous slide: Inflation fell by 6.7%,
total cyclical unemployment was 9.5%.
Okuns law:
1% of unemployment = 2% of lost output.
Thus, 9.5% cyclical unemployment
= 19.0% of a years real GDP.
Sacrifice ratio = (lost GDP)/(total disinflation)
= 19/6.7 = 2.8 percentage points of GDP were lost
for each 1 percentage point reduction in inflation.
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Aggregate Supply
32
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 (Chaps. 39).
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Aggregate Supply
33
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.
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Aggregate Supply
34
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.
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Aggregate Supply
35
CHAPTER 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.
36
CHAPTER 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
37
CHAPTER 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
38
CHAPTER 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
39
