Transcript Chapt13

Class Slides for EC 204
Spring 2006
To Accompany Chapter 13
Three Models of Short-Run
Aggregate Supply
• The Sticky-Wage Model
• The Imperfect Information Model
• The Sticky-Price Model
The Sticky-Wage Model
• When nominal wage is stuck, rise in price
level lowers real wage making labor cheaper
• Lower real wage induces firms to hire more
labor
• The additional labor produces more output
Workers and Firms Set Nominal Wage:
W = w x Pe
So real wage equals:
W/P = W = w x Pe/P
Output deviates from its natural level
when the price level deviates from the
expected price level:
Y = YN + a[P - Pe]
The Imperfect Information Model
• Markets clear--Wages and prices adjust to
balance supply and demand in goods and
labor markets
• Temporary misperceptions about prices
cause short-run and long-run aggregate
supply curves to differ
• Suppliers confuse changes in overall level
of prices with changes in relative prices
When Price Level rises unexpectedly:
• All Producers in economy see their
nominal price increase
• They treat this increase as partly a
relative price increase
• They work harder and expand output
Output deviates from its natural level
when the price level deviates from the
expected price level:
Y = YN + a[P - Pe]
The Sticky-Price Model
• Two Factors Determine Desired Price:
1. Overall level of prices--since costs are
higher.
2. Level of aggregate income--because
higher demand raises marginal cost of
production.
Firm’s Desired Price is given as:
p = P + a[Y - YN]
Assume 2 Types of Firms:
(1)Flexible-Price Firms:
p = P + a[Y - YN]
(2) Sticky-Price Firms:
Set price in advance according to expectations
about P and Y
p = Pe + a[Ye - YN]
Assume Sticky-Price Firms Expect Output to Equal
Its Natural Rate: Ye=YN
Then,
p = Pe
Now, suppose that s is fraction of firms with sticky prices
and [1-s] is fraction of firms with flexible prices.
Put together the two pricing relationships to yield:
P = sPe + [1-s][P + a[Y - YN]]
Rearrange to yield:
sP = sPe + [1-s][a[Y-YN]
or
P = Pe + [[1-s]a/s][Y-YN]
This can be expressed in a more familiar form:
Y = YN + a[P - Pe]
where a = s/[[1-s]a]
Some Evidence on Models of Aggregate
Supply
• Lucas International Comparison Paper -- Imperfect
Information Model:
Volatility of aggregate demand determines slope of shortrun aggregate supply curve.
Steeper supply curve for countries with greater volatility
in aggregate demand and hence in the price level.
Reason is that producers understand that high volatility
of the price level implies that movement in their own
price usually reflects movement in overall price level.
Some Evidence on Models of Aggregate Supply
• Ball, Mankiw and Romer Paper -- Sticky Price Model:
Steeper supply curve for countries with higher rates of
inflation.
Reason is that firms will not keep prices fixed for as long a
period of time when inflation is higher, so less of an output
response for any given change in the price level.
Greater volatility in aggregate demand also leads to steeper
supply curve.
Inflation, Unemployment, and the
Phillips Curve
• Expected Inflation
• Deviation of Unemployment from Natural Rate Cyclical Unemployment
• Supply Shocks
Phillips curve takes the following form:
p = pe - b[U-UN] + v
Derive from Aggregate Supply Curve:
P = Pe + [1/a][Y-YN] + v
where v represents “supply shocks”
Subtract P-1 from both sides:
P - P-1 = Pe - P-1 + [1/a][Y-YN] + v
p = pe + [1/a][Y-YN] + v
Use Okun’s Law to Relate
deviation of Y from YN to
deviation of U to UN:
[1/a][Y-YN] = -b[U-UN]
Substitute into earlier equation to obtain:
p = pe - b[U-UN] + v
Adaptive Expectations and
the NAIRU Theory :
pe = p-1
p = p-1 - b[U-UN] + v
Demand-Pull and Cost-Push Inflation
Disinflation and the Sacrifice Ratio
• Rational Expectations and the Possibility of
Painless Disinflation
• Sacrifice Ratio in Practice
• What about Hysteresis in the Natural Rate
of Unemployment?
Can Disinflation Be Painless?
• Rational Expectations
• Change in Fiscal or Monetary Policy will
change expectations
• Inflation may have less inertia than it first
appears
• Policy change can bring about a drop in
inflation with no output loss
Sacrifice Ratio in Practice:
The Volcker Disinflation
•
•
•
•
1981: Inflation 9.7 percent
1985: Inflation 3.0 percent
Drop of 6.7 percentage points
Unemployment exceeded natural rate by
cumulative 9.5 percentage points
• Translates to 19 percentage points of annual GDP
• Sacrifice Ratio = 19/6.7 = 2.8 -- Lower than
benchmark of 5.0
Hysteresis: Challenge to the Natural
Rate Hypothesis
• If aggregate demand affects output and
employment even in the long run, then
assumptions of natural-rate hypothesis break
down. History will matter for Un
• Reasons:
– Unemployed workers lose job skills
– Long unemployment may change attitude toward work
– Insider-Outsider effects
Possible reason for why Europe’s Unemployment has
remained so high