MACROECONOMICS Chapter 13 Aggregate Supply and the Short Run Tradeoff Between Inflation and Unemployment

Short-Run Aggregate Supply We assumed all prices were sticky together and they all moved together for long-run adjustment. Now we will entertain two theories to modify the SRAS curves. Both will yield Y

SRAS P LRAS SRAS P>Pe Y (1/α)ΔY α P=Pe ΔY 1 P<Pe P Y when P=Pe

Theory #1: Sticky Price Model Long term contracts Fear of annoying customers Costly to alter prices Stable wages (stable costs of production)

Theory #1: Sticky Price Model Monopolistic competition models have price determination for firms as MC + premium where the more elastic is the demand curve for the firm, the lower is the premium. If MC responds to the overall price level P and premium responds to higher GDP (more GDP, more demand), then the firm will determine its price, p, according to

Theory #1: Sticky Price Model Those firms that will follow the equation will be able to alter their prices as P and Y changes. These are the flexible price firms. Other firms will set their prices for a longer period and pick the expected price when the economy is at long term equilibrium . Suppose sticky firms are s percent of the economy and flexible firms are (1-s). The last equation is the same as our new SRAS curve.

Theory #2: Imperfect Information No need to assume monopolistic competition. Markets clear but temporary misperceptions about prices in other markets than their own separate LRAS and SRAS. They know their own costs. They know their own market with their competitors. They do not know if the price increases in their market are because of inflation or demand increase.

Theory #2: Imperfect Information If you see prices for your product is increasing, you better increase production even if MC is rising because it will yield higher profits. More work, more output, more GDP! If the price rise was because of inflation and you increased production, eventually you will realize that there is no extra demand and you will come back to original output. This is true for every producer.

Theory #2: Imperfect Information MC P1 P0 Sticky wages will keep MC from shifting left immediately. Q

Theory #2: Imperfect Information If the prices are greater than expected prices, i.e. unexpected inflation, producers will mistake the Price rise in their own markets as higher demand and produce more. Again, we have an output response to higher prices even though all the prices are increasing because people do not have perfect information.

Supply Shock This specification came from tracing the impact of AD shift on Y and P. What if Y and P were to respond to a supply shock like a change in oil prices or economy-wide wage negotiation that affect costs of production. An increase in costs of production would raise P at each level of Y: a leftward shift of SRAS. We include that possibility as v in the SRAS equation.

Phillips Curve To go from GDP to unemployment rate, we can use the Okun approach: a two percentage deviation of GDP from full-employment Y will affect the cyclical unemployment rate by one percentage point. At “natural rate of unemployment” (un) the economy is at full-employment and there is no pressure on prices. The book’s approach (above) is not as satisfying as the alternative approach on the right.

The Slope of SRAS If one lived in a society where inflation was rare, and one saw an increase in the price of her market, what would be her reaction? Increase production; Keep production the same? P Static Expectations Increase production Y

The Slope of SRAS If one lived in a society where inflation was a common occurrence, and one saw an increase in the price of the product one was supplying, what would be the reaction? Increase production; Keep production the same? P Adaptive Expectations Y Keep production the same

Phillips Curve What happens when inflationary expectations rise? π What happens when inflationary expectations rise? πe + v What happens when there is a negative supply shock? u un 15

Static Expectations You can’t fool every one all the time! IS IS LM r Fiscal expansion under static expectations yield higher than full employment Y indefinitely because the population does not adjust its inflationary expectations. π LRPhC AD π SRAS π = πe + v AD SRPhC un U You can’t fool every one all the time!

Inflation and Unemployment in the United States, 1960–2008 17

Inflation and Unemployment in the United States, 1960–2008 π ’80-’83 ’76-’79 ’86-’93 ’01-’08 ’61-’69 u 18

Adaptive Expectations IS IS LM Fiscal expansion under adaptive expectations yield higher than full employment Y initially but as inflationary expectations rise, SRAS and LM shift leftward to reach LR equilibrium eventually. r π LRPhC AD π SRAS AD SRPhC’ π = πe + v SRPhC U un

Shifts in Aggregate Demand Short run result: point B Long run: prices rise until expected price is equal to the actual price: point C. Show what happens when AD falls. 20

Rational Expectations IS Fiscal expansion under rational expectations keeps the economy at full employment Y because the population immediately adjusts inflationary expectations fully. IS LM r π LRPhC AD π SRAS AD SRPhC π = πe + v U un Pangloss Solution

Test Question Show static, adaptive, and rational expectations when the Central Bank increases the money supply.

Sacrifice Ratio Using Okun’s Law of each one percentage point in unemployment will decrease GDP by two percent implies that in four years US lost one-fifth of its income to bring inflation down. This may or may not include the lost work skills. 23

Taylor Rule Nominal federal funds rate = current inflation + “natural” real rate of interest + response of the Fed to the deviation of inflation from the target level of inflation + response of the Fed to the GDP gap http://research.stlouisfed.org/publications/mt/page10.pdf