Chapter 13: Aggregate Supply

The Model The relationship between production of goods and services and the general price level Y = Y + α (P – Pe) Where Y = actual level of output Y = full-employment level of output P = actual price level Pe = expected price level

Aggregate Supply Price level Long-run AS where P = Pe Short-run AS where P > or < Pe P Y Output, Income

Sticky Wage Model Nominal wages are sticky downward. They adjust to price changes slowly. Demand for Labor: Ld = L(W/P) Production Function: Y = F(L,K) As price (P) increases, the real wage (W/P) falls, firms respond by hiring more labor (L) and producing more output (Y).

Sticky Wage Model Y Short-run AS Real Wage Output Y1 Y2 W/P1 W/P2 Ld Labor Labor L1 L2 L1 L2 Price Short-run AS P2 P1 Output Y1 Y2

Workers Misperception Model Workers confuse nominal “wage” changes with “real” wage changes when the price level changes unexpectedly Demand for Labor: Ld = L(W/P) Supply for Labor: Ls = L(W/Pe) Write the “expected” real wage as W/Pe = W/P * P/Pe As P increases, W/P declines but P/Pe increases. Workers confuse the real wage decline with a nominal wage increase, hence supplying more labor services

Workers Misperception Model Real Wage Price Ls1 Short-run AS Ls2 P2 W/P1 P1 W/P2 Ld Output Labor L1 L2 Y1 Y2

Imperfect Information Model Firms track price changes of their own product more closely than changes of the general price level. Perceptions of an increase in the “relative” price level causes the labor demand, employment, and output to rise. Let PW = price of wheat and P = general price level. With inflation, farmers perceive Pw/P is increased, hence hiring more labor and producing more output

Imperfect Information Model Real Wage Output Ls Y1 Y Y2 W/P2 W/P1 Ld2 Ld1 Labor Labor L1 L2 L1 L2 Price Short-run AS PW2 PW1 Output Y1 Y2

Sticky Price Model Two kinds of firms: p = Pe Flexible-price firms: those with market power to adjust their prices in response to market changes p = P + α (Y – Y) Fixed-price firms: those with no market power, hence unable to adjust their prices p = Pe

P = sPe + (1-s)[P + α (Y – Y)] Sticky Price Model The general price level is the “weighted” average price charged by the flexible-price and fixed-price firms P = sPe + (1-s)[P + α (Y – Y)] Here s is the market share of the fixed-price firms and (1-s) is the market share of the flexible-price firms

Sticky Price Model The aggregate supply curve is: Y = Y + α’ (P – Pe) Where α’ = s / α(1-s)

Shift in Aggregate Demand Assume the AD rises due to greater expenditures in the economy, increasing the level of price and output. People adjust their expectations for higher prices. A higher expected price level results in a lower expected real wage. The supply of labor declines, reducing the AS and the level of output. Long-run equilibrium is achieved at the natural level of output, but a higher price level

Shift in Aggregate Demand Price level Long-run AS SRAS2 SRAS1 C P3 P2 B P1 A AD2 AD1 Y Y1 Output, Income

The Phillips Curve The relationship between inflation rate and unemployment rate, In the short-run: π = π* - β(u- u*) + v π = actual inflation rate π* = expected inflation rate u = actual unemployment rate u* = natural unemployment rate v = cost-push factor β = the output adjustment factor

The Phillips Curve There is a “trade-off” between inflation and unemployment In the long-run, u = u* and v = 0, so π = π*: no trade-off between inflation and unemployment Stagflation is depicted by a shift of the Phillips Curve, resulting in higher unemployment and inflation

Shift of the Phillips Curve Inflation Rate π2 B P2 π1 A P1 u2 u1 Unemployment Rate