Transcript mankiw7e-chap13_Supp..

Chapter 13-7th and 14-8th edition
Supplemental Slides From Class
Aggregate Supply
The sticky-wage model – not in
the 7th and 8th editions
 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 based on a target real
wage and the expected price level:
W
w e
P
The sticky-wage model
If it turns out that
P P
e
P Pe
P P
e
then
Unemployment and output are
at their natural rates.
Actual real wage is less than the
target, firms hire more workers and
output rises above its natural rate.
Actual 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.
The imperfect-information model
Assumptions:
 All wages and prices are perfectly flexible,
all markets are clear. (drops the assumption of
imperfect competition)
 Each supplier produces one good and consumes
a lot of others.
 Each supplier knows the nominal price of their
own good, but not all of the other goods - does not
know the overall price level.
The imperfect-information model, also called
the Misperceptions Theory
 Q: What is the best time for an individual producer to increase production?
 A: When there has been an increase in demand for her specific product
 In that case, price of the good she produces rises relative to the goods

that she consumes
Producer will want to take advantage of relative increase in demand
 Q: What will be the effect of an increase in aggregate demand (say, from
higher M)?
 A: All prices will rise
 But individual producers will not be able to distinguish this increase from

a shift in specific demand
So individual producers will increase production somewhat, at least
temporarily
Example: A bakery that makes bread
 The price of bread is the baker's nominal wage; the price of
bread relative to the general price level is the baker's real
wage. If the relative price of bread rises, the baker may
work more and produce more bread.
 If the baker can't observe the general price level as easily
as the price of bread, he or she must estimate the relative
price of bread
 If the price of bread rises 5% and the baker thinks inflation
is 5%, there's no change in the relative price of bread, so
there's no change in the baker's labor supply
 But suppose the baker expects the general price level to
rise by 5%, but sees the price of bread rising by 8%; then
the baker will work more in response to the wage increase
Generalizing this example
 With many producers thinking this way,
if everyone expects prices to increase 5% but they
actually increase 8%, they'll work more
 So an increase in the price level that is higher than
expected induces people to work more and thus
increases the economy's output
 Similarly, an increase in the price level that is lower than
expected reduces output
Summary & implications
P
LRAS
Producers rarely
fooled
Producers often
fooled
Y  Y   (P  P e )
P Pe
Y
Y
What shifts the curves?
Y  Y   (P  P )
e
Y  Y   (P  P )
e
 Change in Pe
 When P > Pe, expectations adjust and Pe rises over time
 This increase in Pe shifts the SRAS curve up
 When P < Pe, expectations adjust and Pe falls over time
 This decrease in Pe shifts the SRAS curve down
 Eventually, Y always returns to full employment
Imperfect Information - Misperceptions Theory
and the Non-neutrality of Money
 Monetary policy and the misperceptions
theory
 Because of misperceptions, unanticipated
monetary policy has real effects; but anticipated
monetary policy has no real effects because there
are no misperceptions
An unanticipated increase in the money supply
(same as Mankiw’s slide in the book)
Monetary policy and the misperceptions theory
 Initial equilibrium where AD1 intersects SRAS1 and
LRAS (point E)
 Unanticipated increase in money supply shifts AD
curve to AD2
 The price level rises to P2 and output rises above
its full-employment level, so money isn't neutral
 As people get information about the true price
level, their expectations change, and the SRAS
curve shifts left to SRAS2, with output returning to
its full-employment level
 So, unanticipated monetary policy isn't neutral in
the short run, but it is neutral in the long run
The Misperceptions Theory and the Nonneutrality
of Money
 Anticipated changes in the money supply
 If people anticipate the change in the money
supply and thus in the price level, they aren't
fooled, there are no misperception, and the SRAS
curve shifts immediately to its higher level
 So anticipated monetary is neutral in both the
short run and the long run
An anticipated increase in the money supply. Go
directly from P1 to P3 - directly from point E to H.
There is no SR equilibrium at point F as in the
earlier slide.