CHAPTER 14

Key Takeaways on Aggregate Supply (AS):

1.​ Classical Theory = Starting Point:​

○​ Just like physics uses “no friction” to simplify problems, economics

uses classical theory to understand the basics—even though it's
not always realistic.​

2.​ Reality Has Frictions:​

○​ In the real world, things like sticky prices and wages cause
imperfections in the economy. These stop it from working
perfectly all the time.​

3.​ Two Models of SRAS:​

○​ Economists use two simple models to explain short-run aggregate

supply (SRAS). Both show how real-world problems (frictions)
affect how much the economy produces.​

4.​ SRAS Curve Slopes Upward:​

○​ Unlike the long-run aggregate supply (which is vertical), the SRAS

curve slopes upward. This means output (Y) changes when
demand changes.​

5.​ Booms and Busts:​

○​ Because of frictions, the economy can produce more or less than

normal. This causes booms (high output) and busts (low output),
also known as the business cycle.​

6.​ Key Equation:​

Y=Yˉ+a(P−E UPORE P)

Y = actual output

○​ 𝑌̅ = natural output (if no frictions)​

 ○​ P = actual price level​

○​ EP = expected price level​

○​ a = how sensitive output is to price surprises​

7.​ Meaning of the Equation:​

○​ When prices turn out different than expected, output changes:​

■​ If P > EP (prices are higher than expected) → Output

increases​

■​ If P < EP (prices are lower than expected) → Output

decreases​

8.​ Both Models, One Conclusion:​

○​ No matter how they explain it, both models agree:​

→ Unexpected price changes lead to changes in output in the
short run.​

1. Why SRAS Slopes Upward

●​ The short-run aggregate supply (SRAS) curve slopes upward because

some firms can’t adjust prices quickly when demand changes.​

●​ So when demand or output (Y) increases, prices rise, and firms produce
more.

🧊 2. Why Are Prices “Sticky”?

Prices don’t change quickly for several reasons:

●​ Contracts: Long-term price deals can’t be changed instantly.​

●​ Customer Relationships: Firms avoid upsetting loyal customers with

constant price changes.​
 ●​ Menu Costs: Changing prices (tags, menus) costs time and money.​

●​ Sticky Wages: Worker wages adjust slowly, which keeps overall costs
(and prices) stable.​

🏭 3. How Firms Set Prices

Firms set prices based on:

●​ P = overall price level in the economy (costs).​

●​ Y − 𝑌̅ = how far current output is from normal (natural) output.​

Formula for flexible firms:

p=P+a(Y−Yˉ)
Where a shows how much price changes with output.​

👥 4. Types of Firms
●​ Flexible-Price Firms:​

○​ Can change prices anytime.​

○​ Use: p=P+a(Y−Yˉ)

Sticky-Price Firms:​

○​ Set prices in advance based on expected prices and output.​

○​ Use: p=EP+a(EY−EYˉ)
○​ If they expect normal output: p=EPp = E^Pp=EP​

🧮 5. Overall Price Level (P)

To find the total price level:

●​ Let:​
 ○​ s = % of sticky-price firms​

○​ (1 − s) = % of flexible-price firms​

Price formula:

P=s⋅EP+(1−s)⋅[P+a(Y−Yˉ)]P = s \cdot E^P + (1 - s) \cdot [P + a(Y -

\bar{Y})]P=s⋅EP+(1−s)⋅[P+a(Y−Yˉ)]

●​ Sticky firms charge based on expectations (EP).​

●​ Flexible firms adjust to the real economy.​

📉 6. Final Simplified Formula

After solving the equation, we get:

P=EP+(1−s)⋅as(Y−Yˉ)

This tells us:

●​ If expected prices (EP) rise → actual prices (P) also rise.​

●​ If output (Y) rises above normal → prices increase.​

●​ The effect depends on how many firms can’t change prices (s).​

Final Form: The Aggregate Supply Equation

Y=Yˉ+a(P−EP

✅ What This Equation Means:

●​ Y = actual output​

●​ 𝑌̅ = natural (normal) level of output​

●​ P − EP = difference between actual and expected prices​

●​ a = responsiveness of output to unexpected price changes​

 💡 When prices are higher than expected, output increases.​
💡 When prices are lower than expected, output decreases.
🧊 Sticky-Price Model: Key Points
●​ Some firms can’t change prices quickly (sticky prices).​

●​ Reasons: contracts, menu costs, customer relationships, sticky wages.​

●​ So when actual prices rise, flexible firms increase output, but sticky
firms don’t.​

●​ Overall output increases a little, not a lot.​

●​ The more sticky-price firms there are, the weaker the output response.​

🌍 Imperfect-Information Model: Key Points

●​ Assumes prices can change freely (markets clear).​

●​ Firms/producers have limited information about overall economy.​

●​ When a firm’s own prices rise, it’s not sure if:​

○​ All prices rose (inflation)​

○​ Just their own price rose (higher relative value)​

●​ So they assume demand for their product increased → they produce

more.​

●​ When many firms do this, overall output rises.​

🔗 What Both Models Have in Common:

●​ Short-run output (Y) depends on unexpected changes in price level.​

●​ Both explain why the SRAS curve slopes upward.​

 ●​ Both lead to the same equation:​
Y=Yˉ+a(P−EP)

🧠 Modern Insight:
●​ Newer versions of the imperfect-information model say:​

○​ It’s not just about bad guesses.​

○​ It’s also about limited ability to process complex economic info.​

●​ Either way, the conclusion stays the same.​

📌 Conclusion – In Simple Words:

●​ The economy produces more than normal when prices are unexpectedly
high.​

●​ It produces less when prices are lower than expected.​

●​ This happens because of either:​

○​ Sticky prices (firms can't adjust fast), or​

○​ Imperfect information (firms make decisions based on limited

info).​

●​ Both models help explain the short-run ups and downs in output—also
known as the business cycle.​

🔁 Aggregate Supply & Demand: Key Takeaways

📊 1. Understanding the Curves in the Figure
●​ LRAS (Long-Run Aggregate Supply):​

○​ Vertical line → Output in the long run doesn’t depend on prices.​

 ○​ Depends on resources, technology, and policy, not on inflation.​

●​ SRAS (Short-Run Aggregate Supply):​

○​ Upward-sloping → Output increases when actual prices exceed

expected prices.​

○​ Built on a fixed expected price level (EP).​

○​ If expectations change, the whole SRAS curve shifts.​

🔁 2. Relationship Between Prices and Output

●​ If P > EP → Actual prices are higher than expected → Firms produce
more → Output rises.​

●​ If P < EP → Actual prices are lower than expected → Firms produce less
→ Output falls.​

📉 3. How Aggregate Demand Affects Short-Run

Output
📍 Point A: Long-Run Equilibrium
●​ P = EP → No surprise.​

●​ Output = 𝑌̅ (natural level).​

●​ Full employment, stable prices.​

🚀 Point B: Demand Increases Unexpectedly

 ●​ Causes: More government spending, lower interest rates, stronger
consumer confidence, etc.​

●​ Price level rises from P1 to P2.​

●​ Since P > EP, firms earn more than expected → They increase output.​

●​ The economy moves up along the SRAS curve, to a short-run boom at

point B.​

🕒 Point C: Expectations Catch Up

●​ Over time, people adjust their expectations:​

○​ Workers demand higher wages.​

○​ Firms raise prices.​

○​ Expected price level (EP) increases to match new reality.​

●​ SRAS shifts upward (left).​

●​ Output returns to 𝑌̅ (natural level), but at a higher price level.​

●​ Economy reaches a new long-run equilibrium at point C.​

🔄 4. Summary of the Transition

Poin What Happens Output Price Level
t (Y) (P)

A Economy in 𝑌̅ P1 = EP
balance (normal)

B AD rises Above 𝑌̅ P2 > EP

unexpectedly
C Expectations Back to 𝑌̅ Even higher
adjust (P3)

🧠 Final Thought:
●​ Short-run fluctuations in output happen because of unexpected
changes in demand.​

●​ In the long run, the economy always returns to its natural level of
output—but with adjusted prices and expectations.​

●​ This is a key idea behind the business cycle: short-term booms and busts
driven by surprises in demand and expectations.​

🔁 Key Takeaways: AD–AS Interaction (Easy Version)

📍 1. Starting Point: Long-Run Equilibrium (Point A)
●​ The economy starts at point A where:​

○​ Price level (P1) = Expected price level (EP2)​

○​ Output = 𝑌̅ (natural level)​

○​ No inflation surprises → Everything is stable​

⚡ 2. Short-Run Impact of Rising Aggregate Demand (Point B)

●​ Something boosts aggregate demand (AD):​

○​ Example: Lower interest rates or monetary expansion​

●​ This leads to:​

○​ Price level rises → P1 → P2​

 ○​ Output rises → Y1 → Y2​

●​ Since P > EP, firms increase production → temporary economic boom​

●​ But expectations have not changed yet, so this is only a short-run effect​

✅ This is called Monetary Nonneutrality:​

→ In the short run, changes in money affect real output

⏳ 3. Long-Run Adjustment (Point C)

●​ Over time, people realize prices went up:​

○​ Workers demand higher wages​

○​ Firms expect higher costs​

○​ Everyone updates price expectations → EP2 → EP3​

●​ This causes:​

○​ SRAS curve shifts upward​

○​ Price level rises again → P2 → P3​

○​ Output falls back to Y̅ (normal level)​

✅ This is called Monetary Neutrality:​

→ In the long run, money only affects prices, not output

💡 4. Big Lesson
●​ Short run: Prices are a surprise, so output can increase or decrease​

●​ Long run: Expectations adjust, and output returns to 𝑌̅​

 ●​ Money affects output only in the short run, not in the long run​

●​ This dynamic helps explain economic booms and corrections​

Poin What Happens Price Output

t Level (Y)

A Long-run equilibrium P1 = EP2 Y̅

B AD increases → short-run boom P2 > EP2 Y2 > Y̅

C Expectations adjust → long-run

balance

📉 Key Takeaways: The Phillips Curve Made Easy

📌 1. What Is the Phillips Curve?
●​ The Phillips Curve shows a short-run trade-off between:​

○​ Inflation (π)​

○​ Unemployment (u)​

●​ Lower unemployment → higher inflation​

●​ Higher unemployment → lower inflation​

🛠️ 2. The Phillips Curve Equation

π=Eπ−b(u−un)+v\pi = E\pi - b(u - u^n) + vπ=Eπ−b(u−un)+v

Where:

●​ π = actual inflation​

●​ Eπ = expected inflation​
 ●​ u = actual unemployment​

●​ uⁿ = natural rate of unemployment​

●​ (u − uⁿ) = cyclical unemployment​

●​ b = how sensitive inflation is to unemployment​

●​ v = supply shock (like oil price hike, war, etc.)​

🔄 3. What the Equation Tells Us

●​ If u > uⁿ → inflation falls​

●​ If u < uⁿ → inflation rises​

●​ Negative supply shock (v > 0) → inflation rises no matter what​

●​ The minus sign on the b term shows the inverse relationship between
unemployment and inflation.​

🧠 4. How It Connects to Aggregate Supply (AS)

The Phillips Curve comes from the AS equation:

1.​ Start with AS:​

P=EP+1a(Y−Yˉ)P = EP + \frac{1}{a}(Y - \bar{Y})P=EP+a1​(Y−Yˉ)
2.​ Add a supply shock:​
P=EP+1a(Y−Yˉ)+vP = EP + \frac{1}{a}(Y - \bar{Y}) + vP=EP+a1​(Y−Yˉ)+v
3.​ Turn price levels into inflation:​
Subtract last year’s price level to get:​
π=Eπ+1a(Y−Yˉ)+v\pi = E\pi + \frac{1}{a}(Y - \bar{Y}) +
vπ=Eπ+a1​(Y−Yˉ)+v
4.​ Use Okun’s Law to replace output with unemployment:​
1a(Y−Yˉ)=−b(u−un)\frac{1}{a}(Y - \bar{Y}) = -b(u -
u^n)a1​(Y−Yˉ)=−b(u−un)
 5.​ Final form:​
π=Eπ−b(u−un)+v\pi = E\pi - b(u - u^n) + vπ=Eπ−b(u−un)+v

🧩 5. Big Insight
●​ The Phillips Curve and the Aggregate Supply curve are two sides of the
same coin:​

○​ AS shows how output responds to price changes​

○​ Phillips Curve shows how unemployment responds to inflation​

🔍 6. Why It Matters
●​ Helps policymakers understand the trade-off:​

○​ Reducing unemployment may raise inflation​

○​ Reducing inflation may raise unemployment​

●​ Explains short-run policy dilemmas — and how expectations and shocks

affect outcomes.​

🔄 Inflation, Expectations & the Phillips Curve: Key

Takeaways

📌 1. Adaptive Expectations
●​ Definition: People form expectations based on the past.​

●​ Example: If inflation was 5% last year, they expect 5% this year.​

●​ Implication: Inflation tends to continue unless something changes it.​

🧠 Resulting Phillips Curve:
π=π−1−b(u−un)+v\pi = \pi_{-1} - b(u - u^n) + vπ=π−1​−b(u−un)+v

●​ π₋₁: Last year’s inflation​

●​ u − uⁿ: Cyclical unemployment​

●​ v: Supply shock​

●​ b: Sensitivity of inflation to unemployment​

🔄 2. Inflation Inertia
●​ Meaning: Inflation tends to “keep going” unless a force stops it.​

●​ Why?​

○​ People expect inflation to stay the same​

○​ Firms and workers act on these expectations​

●​ Therefore, to reduce inflation, a shock or policy is needed.​

📊 3. NAIRU (Non-Accelerating Inflation Rate of Unemployment)

●​ The unemployment rate at which inflation remains stable​

●​ Also known as the natural rate of unemployment​

●​ Key tool for central banks to understand inflation dynamics​

🔻 Disinflation & the Sacrifice Ratio

📉 4. Disinflation
●​ Definition: Reducing the inflation rate​

●​ Causes: Often requires:​

○​ Higher interest rates​

○​ Lower spending → reduces demand​

⚠️ Side effect: Higher unemployment & lower output (temporary)

🔢 5. Sacrifice Ratio
●​ Definition: % of GDP lost to reduce inflation by 1 percentage point​

●​ Typical estimate: 5​
→ To reduce inflation by 1%, lose 5% of one year's GDP​

With Okun’s Law:​

→ Reducing inflation by 1% = 2.5% increase in unemployment

🧮 Example:
●​ Reduce inflation by 4% →​
4 × 5 = 20% GDP lost,​
2.5 × 4 = 10% higher unemployment​

⏱️ 6. Disinflation Strategies
Strategy Output Time
Loss

Cold 10% 2 years

Turkey

Moderate 5% 4 years
Gradual 2% 10
years

All equal total cost (20% of GDP), but differ in timing

🧠 7. Rational Expectations Theory

💡 What is it?
●​ People use all available info, not just the past​

●​ If government is credible, people will expect lower inflation right away​

🧠 Thomas Sargent’s View:

●​ Inflation is not unstoppable​

●​ If policy changes credibly, inflation can drop quickly and cheaply​

✅ How Can Disinflation Be Painless?

Only possible if:

1.​ The anti-inflation plan is announced early​

2.​ People believe the government will follow through​

If both happen:​
→ Expectations shift quickly​
→ No need for deep recession to cut inflation
📉 8. Hysteresis: When Recession Has Long-Term
Effects

📌 Natural-Rate Hypothesis
●​ Economy always returns to full employment in the long run​

●​ Recessions only affect short-run output & jobs​

❗ But Hysteresis Challenges That

●​ Hysteresis = A recession causes permanent damage​

●​ Natural rate of unemployment may rise after a recession​

🔁 Two Main Causes of Hysteresis

1️⃣ Loss of Skills & Motivation:

●​ Long-term jobless people may never return to work​

●​ Natural rate of unemployment increases​

2️⃣ Change in Wage-Setting Power:

●​ Jobless workers lose bargaining power (e.g., union access)​

●​ Remaining workers (insiders) protect their wages​

→ Firms hire less → Higher structural unemployment​

📅 Post-2008 Relevance
 ●​ After the Great Recession:​

○​ Unemployment fell by 2014​

○​ But employment-to-population ratio stayed low​

●​ Suggests permanent labor market damage​

📚 Final Summary Table

Concept Explanation

Adaptive People expect inflation based on last year

Expectations

Inflation Inertia Inflation keeps going unless policies or shocks stop it

Phillips Curve Trade-off between inflation and unemployment in the

short run

NAIRU The unemployment rate where inflation is stable

Sacrifice Ratio GDP loss needed to cut inflation by 1 percentage point

Rational People use all info, adjust faster if policy is credible

Expectations

Painless Possible if the public believes in policy early enough

Disinflation

Hysteresis Long-term effects of recessions on employment and

economy

Wage-Setting Unemployed lose voice, insiders protect high wages →

Changes structural joblessness

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