MACROECONOMICS
17th - 18th Lecture
Aggregate Supply:
Instructor: Tamali Chakraborty
IIM Visakhapatnam
LEARNING OBJECTIVE
• What is Aggregate Supply?
• Theories of Aggregate Supply
Sticky Imperfect Sticky
price information wage
• Bringing AS-AD together
• Unemployment and Inflation Tradeoff (Phillips Curve)
Three models of aggregate supply
1. The sticky-price model
2. The imperfect-information model
3. The sticky-wage model
All three models imply:
Y = Y + (P − P e )
agg. the expected
output price level
a positive
natural rate parameter the actual
of output price
level
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 firms have some market power).
The sticky-price model
An individual firm’s 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 = P e + a (Y e −Y e )
The sticky-price model
p = P e + a (Y e −Y e )
Assume sticky price firms expect that output will equal
its natural rate. Then,
p =Pe
▪ To derive the aggregate supply curve, we first
find an expression for the overall price level.
▪ Let s denote the fraction of firms with sticky
prices. Then, we can write the overall price
level as…
The sticky-price model
P = s P e + (1 − s )[P + a(Y −Y )]
price set by sticky price set by flexible
price firms price firms
Subtract (1−s )P from both sides:
sP = s P e + (1 − s )[a(Y −Y )]
▪ Divide both sides by s :
(1 − s ) a
P = Pe + (Y − Y )
s
The sticky-price model
(1 − s ) a
P = Pe + (Y − Y )
s
High P High P
e
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 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 is the effect
of Y on P.
The sticky-price model
(1 − s ) a
P = Pe + (Y − Y )
s
Finally, derive AS equation by solving for Y :
Y = Y + (P − P e ),
s
where =
(1 − s )a
The sticky-price model: Implication
The sticky-price model implies a pro-cyclical real
wage:
Suppose aggregate output/income falls.
Then,
Firms see a fall in demand for their products.
Firms with sticky prices reduce production, and hence reduce
their demand for labor.
The leftward shift in labor demand causes the real wage to
fall.
The imperfect-information model
Assumptions:
• All wages and prices are perfectly flexible,
all markets 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.
The imperfect-information model
Supply of each good depends on its relative price: the
nominal price of the good divided by the overall price level.
Supplier does not know price level at the time she makes
her production decision, so uses the expected price level,
P e.
Suppose P rises but P e does not.
Supplier thinks her relative price has risen, so she
produces more.
With many producers thinking this way, Y will rise
whenever P rises above P e.
The sticky-wage model
Assumes that firms and workers negotiate contracts and
fix the nominal wage before they know what the price
level will turn out to be.
The nominal wage they set is the product of a target real
wage and the expected price level:
Target
real
W = ω P e wage
W Pe
=ω
P P
The sticky-wage model
W Pe
=ω
P P
If it turns out that then
Unemployment and output
P =Pe are at their natural rates.
Real wage is less than its target,
P Pe so firms hire more workers and
output rises above its natural
rate.
P Pe Real wage exceeds its target,
so firms hire fewer workers and
output falls below its natural
rate.
The sticky-wage model
• Implies that the real wage should be counter-
cyclical, should move in the opposite direction as
output during business cycles:
• In booms, when P typically rises, real wage should
fall.
• In recessions, when P typically falls, real wage
should rise.
• This prediction does not come true in the real world
Summary & implications
P LRAS Y = Y + (P − P e )
P Pe Each of the
three models of
SRAS
P =Pe agg. supply
imply the
P Pe relationship
summarized by
Y the SRAS
Y curve &
equation.
Putting AD and AS together
Suppose a positive SRAS equation: Y = Y + (P − P e )
AD shock moves
SRAS2
output above its P LRAS
natural rate and
SRAS1
P above the level
people had expected.
P3 = P3e
P2
Over time, AD2
e
P2e = P1 = P1e
P rises,
SRAS shifts up, AD1
and output Y
returns Y2
Y 3 = Y1 = Y
to its natural rate.
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.
measures the responsiveness of inflation to cyclical
unemployment.
The Phillips Curve and SRAS
SRAS: Y = Y + (P − P e )
Phillips curve: = 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.
Two causes of rising & falling inflation
= e − (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.
Graphing the Phillips curve
In the short = e − (u − u n ) +
run, policymakers
face a tradeoff
between and u.
1 The short-
+
e
run Phillips
curve
un u
Summary
1.Three models of aggregate supply in the short run:
sticky-price model
imperfect-information model
sticky-wage model
All three models imply that output rises
above its natural rate when the price level rises above
the expected price level.
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
Macroeconomics at a glance
https://www.youtube.com/watch?v=d8uTB5XorBw&t=4s
