1. Chapter 14 8th and 9th edition
Aggregate Supply and the Short-run Tradeoff Between Inflation and Unemployment
Chapter 13 has two parts. The first concerns aggregate supply. In the preceding chapters, we made the simple and extreme assumption that all prices were “stuck” in the short run. This assumption implied a horizontal short-run aggregate supply curve. More realistic models of aggregate supply imply an upward-sloping SRAS curve. Chapter 13 presents three of the most prominent models.
The second half of the chapter is devoted to the Phillips curve and related issues. The section uses a few lines of algebra to derives an expression for the Phillips curve from the SRAS equation. This is followed by a discussion of adaptive and rational expectations, and the sacrifice ratio. The chapter concludes by contrasting the notion of hysteresis to the natural rate hypothesis.
To master the material, it would be helpful to assign homework or in-class exercises in which students use the models to analyze the effects of policies and shocks. Right before the introduction of the Phillips curve would be a good place to have students work an exercise using the IS-LM-AD-AS model with a postively-sloped SRAS curve. The key difference is that, in the short run, a shift in AD causes P to change, which changes M/P, which shifts LM a bit, which explains why the short-run change in output is smaller when SRAS is upward-sloping than when it is horizontal.

2. We cover…
models of aggregate supply in which output depends positively on the price level in the short run.
the short-run tradeoff between inflation and unemployment known as the Phillips curve.
Discuss the Phillips curve formulation presented in Chapter 15.

3. More realistic SRAS P Y SRAS in between the two extreme assumptions we
All wages and prices flexible
Figure 13-3, p.357
Idiosyncracy alert:
If  is constant, then the SRAS curve should be linear, strictly speaking. However, in the text, it is drawn with a bit of curvature (which I have reproduced here). Y P
LRAS
SRAS
Some wages and prices flexible
The following is not in the text, but you and your students may find it worthwhile:
There are good reasons to believe that the SRAS curve is bow-shaped in the real world; that is, the curve is steeper at high levels of output than at low levels of output. And there are good reasons why we should care about this.
Why the SRAS curve is bow-shaped:
At low levels of output, there are lots of unutilized and under-utilized resources available, so it is not terribly costly for firms to increase output, and therefore firms do not require a big increase in prices to make them willing to increase output by a given amount. In contrast, at very high levels of output, when unemployment is below the natural rate and capital is being used at higher than normal intensity levels, it is relatively costly for firms to increase output further. Hence, a larger increase in prices is required to make firms willing to increase their output.
Why the curvature matters:
When policymakers increase aggregate demand, output rises (good) and prices rise (not good). An important question arises: how much of the bad thing (price increases) must we tolerate to get some of the good thing (an increase output)? The answer depends on how steep the SRAS curve is.
When President Reagan cut taxes in the early 1980s, the economy was just coming out of a severe recession, and was on the flatter part of the SRAS curve; hence, the tax cuts affected output a lot and inflation very little. In contrast, when the current President Bush proposed huge tax cuts during the 2000 election season, we were on the steeper part of the SRAS curve, so the tax cuts would likely have been inflationary. Of course, by the time they were implemented, the economy was in recession, and in any case the bulk of the tax cuts were to be spread out over 10 or 11 years, so they have not proved inflationary.
VSRAS: P = 𝐏
All wages and prices
fixed
SRAS in between the two extreme assumptions we
considered before.

4. Three models of aggregate supply - 2 models presented in the book
The sticky-price model
The imperfect-information model
The sticky-wage model (not in the book)
All three models imply:
agg. output
natural rate of output
a positive parameter
the actual price level
the expected price level

5. How the SRAS equation works
Figure 13-3, p.357
Idiosyncracy alert:
If  is constant, then the SRAS curve should be linear, strictly speaking. However, in the text, it is drawn with a bit of curvature (which I have reproduced here). Y P
LRAS
SRAS
The following is not in the text, but you and your students may find it worthwhile:
There are good reasons to believe that the SRAS curve is bow-shaped in the real world; that is, the curve is steeper at high levels of output than at low levels of output. And there are good reasons why we should care about this.
Why the SRAS curve is bow-shaped:
At low levels of output, there are lots of unutilized and under-utilized resources available, so it is not terribly costly for firms to increase output, and therefore firms do not require a big increase in prices to make them willing to increase output by a given amount. In contrast, at very high levels of output, when unemployment is below the natural rate and capital is being used at higher than normal intensity levels, it is relatively costly for firms to increase output further. Hence, a larger increase in prices is required to make firms willing to increase their output.
Why the curvature matters:
When policymakers increase aggregate demand, output rises (good) and prices rise (not good). An important question arises: how much of the bad thing (price increases) must we tolerate to get some of the good thing (an increase output)? The answer depends on how steep the SRAS curve is.
When President Reagan cut taxes in the early 1980s, the economy was just coming out of a severe recession, and was on the flatter part of the SRAS curve; hence, the tax cuts affected output a lot and inflation very little. In contrast, when the current President Bush proposed huge tax cuts during the 2000 election season, we were on the steeper part of the SRAS curve, so the tax cuts would likely have been inflationary. Of course, by the time they were implemented, the economy was in recession, and in any case the bulk of the tax cuts were to be spread out over 10 or 11 years, so they have not proved inflationary.
is full employment output from chapter 3 assuming
perfect competition and flexible wages and prices.

6. The sticky-wage model (not in the book) but conveys a lesson – skip the next group of slides on sticky wage, sticky P and mis-perceptions this semester. I will summarize in class.
Assumes that firms and workers negotiate contracts and fix the nominal wage (W) before they know what the price level (P) will turn out to be.
The nominal wage, W, they set is based on a target real wage and the expected price level:
At the target real wage, the labor market is in equilibrium, meaning that unemployment equals its natural rate. This implies that output equals its natural rate (aka full-employment output).

7. The sticky-wage model If it turns out that 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.
Intuition for the positive relationship between P and Y, for a given value of the expected price level.
Actual real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate.

8. I’ve included Figure 13-1 from the text here as a “hidden slide” in case you wish to “unhide” and include it in your presentation. This figure uses graphs to derive the aggregate supply curve under the assumption of sticky wages.
As you can see, three-panel diagrams do not translate well to the big screen. Fortunately, though, most students readily grasp the intuition on the preceding slide, which sums up as follows:
If the nominal wage is fixed, then increases in the price level cause the real wage to fall, which causes firms to hire more workers and produce more output.

9. 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 – which is why Mankiw dropped the theory from the book.

10. The cyclical behavior of the real wage. The real wage is pro-cyclical-5 -4 -3 -2 -1 1 2 3 4 5 6 7 8
1974
1979
1991
1972
2004
2001
1998
1965
1984
1980
1982
1990
Percentage change in real wage
Figure 13-2, p.380
The real wage is procyclical in the U.S., contrary to the sticky wage theory.
Percentage change in real GDP

11. So What’s Going ON?
Sticky wage model assume labor demand curve does not shift over the business cycle.
The previous slide is consistent with demand for labor changing over the business cycle.

12. The equilibrium real wage
Units of output
Units of labor, L
Labor supply
Labor demand
equilibrium real wage
The labor supply curve is vertical: We are assuming that the economy has a fixed quantity of labor, Lbar, regardless of whether the real wage is high or low.
Combining this labor supply curve with the demand curve we’ve developed in previous slides shows how the real wage is determined.

13. The imperfect-information/misperceptions model – skip this semester
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 her own good, but not all of the other goods - does not know the overall price level.

14. What shifts the curves?
Re-write in deviation form
Change in price expectations (Pe) shifts the SAS:
Pe = P => Y = 𝑌
Pe > P => Y < 𝑌 , increase in Pe shifts
SAS up to the left.
Pe < P => Y > 𝑌 , decrease in Pe shifts SAS
down to the right.

16. Summary & implications
Suppose a positive AD shock moves output above its natural rate (to Y2) and P rises to P2, above the level people had expected.
SRAS equation:
SRAS2 Y P
LRAS
AD2
SRAS1
AD1 H
As the price level rises, over time, P e rises. The SRAS shifts up, and output returns to its natural rate. F
This graph has two lessons for students:
First, changes in the expected price level shift the SRAS curve (this should be clear from the equation, as should the fact that a change in the natural rate of output will shift the SRAS curve).
The second lesson concerns the adjustment of the economy back to full-employment output. E

17. Imperfect Information - Misperceptions Theory and the Non-neutrality of Money
unanticipated monetary policy has real effects; but anticipated monetary policy has no real effects because there are no misperceptions
The previous slide showed the effect of an unanticipated demand shock. For example, and unanticipated change in the money supply.

18. 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

19. The AD and SRAS curves shift simultaneously.
With an anticipated increase in the money supply, go directly from P1 to P3, directly from point E to H.
SRAS equation:
The AD and SRAS curves shift simultaneously.
Notice: there is no
SR equilibrium
point “F”.
The economy goes directly from E
to H
SRAS2 Y P
LRAS
AD2
SRAS1
AD1 H
This graph has two lessons for students:
First, changes in the expected price level shift the SRAS curve (this should be clear from the equation, as should the fact that a change in the natural rate of output will shift the SRAS curve).
The second lesson concerns the adjustment of the economy back to full-employment output. E

20. Inflation, Unemployment, and the Phillips Curve

21. 5½ % = zero inflation

22. 5½ %

23. Unemployment and Inflation: Is There a Trade-off?
Some economist think there is a trade-off between inflation and unemployment
In the 1960’s such a trade-off existed. This suggested that policymakers could choose the combination of unemployment and inflation they most desired
But the relationship fell apart in the following three decades
The 1970s were a particularly bad period, with both high inflation and high unemployment, inconsistent with the Phillips curve

24. 1970 – 1983
What happened?

25. Supply-Side Inflation
Adverse supply shocks
Oil price increases: ,
Costs increase, prices rise, output falls, unemployment increases

26. The Phillips Curve: A Historical Perspective 1960’s and 1970-80’s
12% 11 10
1974
1980 9
1979
1981
1975 8
1973
1978 7
1977
Inflation Rate
1968 6
1971
1972
1976
1969 5
1970
1982 4
1966
1956
1955
1984
1983
1965 3
1957
1954
1962
1967 2
1959
1958
1964
1961 1
1960
1963 1 2 3 4 5 6 7 8 9 10
Unemployment Rate in Percent

27. Supply-side Inflation
, favorable supply shocks
Lower oil prices, advances in technology
Both aggregate demand and supply increase
But aggregate supply shifted more
Rapid growth, lower unemployment, and lower inflation

28. Favorable Supply Shock

29. What the Phillips Curve Is and Is Not
Is a statistical relationship between inflation and unemployment
Holds if business cycle fluctuations arise mainly from demand with AS stable
During 1970s, 1980s, AS was not stable.
If AS shifts, the Phillips curve shifts

30. The Phillips Curve is Not Stable
Self-correcting mechanism shifts the AS curve
Refers to the way money wages respond to recessionary or expansionary gaps
Wage changes shift the aggregate supply curve
Effecting equilibrium real GDP and the price level
The Phillips curve shifts

31. Inflation, Unemployment, and the Augmented Phillips curve
The Phillips curve states that π depends on:
expected inflation, Eπ
cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate
supply shocks,  (Greek letter “nu”).
β measures the responsiveness of inflation to cyclical unemployment.
where β > 0 is an exogenous constant.

32. Deriving the Phillips curve from SRAS
Explain each equation briefly before displaying the next. Here are the explanations:
Equation (1) is the SRAS equation.
Solve (1) for P to get (2).
To get (3), add the supply shock term to (2).
To get (4), subtract last year’s price level (P-1) from both sides.
To get (5), write π in place of (P- P-1) and Eπ in place of (EP- P-1). Note that the change in the price level is not exactly the inflation rate, unless we interpret P as the natural log of the price level.
Equation (6) captures the relationship between output and unemployment from Okun’s law: the deviation of output from its natural rate is inversely related to cyclical unemployment.
Substituting (6) into (5) gives (7), the Phillips curve equation introduced on the preceding slide.
Chapter 15 stops at equation (5)
Okun’s Law

33. Comparing SRAS and the Phillips curve
SRAS curve: Output is related to unexpected movements in the price level.
Phillips curve: Unemployment is related to unexpected movements in the inflation rate.

34. Adaptive expectations
Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation.
A simple version: Expected inflation = last year’s actual inflation
Then, Phillips curve equation becomes

35. Inflation inertia
In this form, the Phillips curve implies that inflation has inertia:
In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate: π = π-1
Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set.

36. Two causes of rising & falling inflation
cost-push inflation: inflation resulting from supply shocks
Adverse supply shocks typically raise production costs and induce firms to raise prices, “pushing” inflation up.
demand-pull inflation: inflation resulting from demand shocks
Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up.
Of course, a favorable supply shock that lowers production costs will “push” inflation down, and a negative demand shock which raises cyclical unemployment will “pull” inflation down.

37. Graphing the Phillips curve
In the short run, policymakers face a tradeoff between  and u. u 
The short-run Phillips curve
Here, the “short run” is the period until people adjust their expectations of inflation.
Here, the “short run” is the period until people adjust their expectations of inflation

38. Shifting the Phillips curve
People adjust their expectations over time, so the tradeoff only holds in the short run. u 
After displaying this slide, you might consider giving your students an exercise using the Phillips curve. One possibility would be to ask them to draw a graph of the PC curve, then show what happens to it in the face of an adverse supply shock or an increase in the natural rate of unemployment, giving intuition for each.
The intuition for why an increase in the natural rate shifts the PC upward (or rightward) is as follows:
At any given value of actual unemployment, an increase in the natural rate implies a decrease in cyclical unemployment, which increases inflation by increasing pressures for wages to rise. Thus, each value of unemployment has a higher value of inflation than before.
E.g., an increase in E shifts the short-run P.C. upward.

39. Chapter 15 - The Phillips Curve
current inflation
indicates how much inflation responds when output fluctuates around its natural level
supply shock, random and zero on average
previously expected inflation
Current inflation is affected by three things:
1) the rate of inflation people expected in the previous period, because it figured into their previous wage and price-setting decisions
2) the output gap: when output is above its natural level, firms experience rising marginal costs, so they raise prices faster. When output is below its natural level, marginal costs fall, so firms slow the rate of their price increases.
3) a supply shock (e.g. sharp changes in the price of oil), as discussed in Chapter 14
At full employment, actual inflation = expected.
As Y rises above full employment, inflation rises.
As Y falls below full employment, inflation falls.

40. The Dynamic Aggregate Supply Curve (DAS)
The DAS curve shows a relation between output and inflation that comes from the Phillips Curve and Adaptive Expectations:
(DAS)
This equation comes from using the expectations equation to substitute the expected inflation term out of the Phillips curve equation. See pp for details.

41. The Dynamic Aggregate Supply Curveπ
DAS slopes upward: high levels of output are associated with high inflation – demand pull inflation.
DASt
DAS shifts in response to changes in previous period’s inflation, the natural level of output, and supply shocks.
The intuition for the positive slope of DAS comes from the Phillips Curve:
If output is above its natural rate, unemployment is below the natural rate of unemployment. The labor market is very “tight” and the economy is “overheating,” leading to an increase in inflation.
(Of course, the unemployment rate is not explicitly included in this model, but students know from Okun’s Law that it is very tightly linked to output.)
Students may find it odd to say “DAS shifts in response to changes in previous inflation,” thinking that previous inflation is fixed because the past is unchangeable. However, a change in current period inflation will become a change in next period’s previous inflation, and thus will shift next period’s DAS curve.

42. The Dynamic Aggregate Supply Curveπ Yt
DASt A
πt = t-1
The vertical line drawn at Ybar is shown for reference: it allows us to see the gap between current output and its natural level, which, in turn, influences how the economy will evolve over subsequent periods.
Yt = 𝒀

43. THE COST OF REDUCING INFLATION
To reduce inflation, policy makers can contract aggregate demand, causing unemployment to rise above the natural level.
The economy must endure a period of high unemployment and low output.
When the Fed combats inflation, the economy moves down the short-run Phillips curve.
The economy experiences lower inflation but at the cost of higher unemployment.

44. Example:
Consider an economy in which inflation has been steady at 13 percent per year for several years.
Assume firms and households form their expectations on the basis of past experience (adaptive or backward-looking expectations)
everyone will expect inflation for the coming year to be 13 percent.
Thus, labor negotiations will ensure a 13 percent rise in wages. Firms expect their input costs to rise by 13 percent so they will raise their prices by 13 percent as well.
The Fed must be increasing the money supply 13 percent per year as well.

45. Example In this scenario, at full employment with 13% inflation.
Now, suppose the Fed wishes to break this cost-price spiral and bring down the rate of inflation.
The only way to induce firms to raise prices by less than 13 percent is to create a situation where they are unable to sell their output at currently planned prices.

46. Example: Create a recession!!!
Similarly, the only way to induce workers to accept less than a 13 percent rise in their wages is to create excess supply in the labor market, so that competition for scarce jobs will lead to a slower rate of wage growth.
Create a recession!!!
To create the recession, the Fed simply needs to cut the growth rate of the money supply below __ percent. Initially, with prices still rising at 13 percent, the demand for money will be rising faster than the supply of money causing the interest rate to rise and investment to fall.
The result is a decline in aggregate expenditure and a decline in output, together with a slowing down of wage and price increases.

47. The Volcker Disinflation
When Paul Volcker became Fed chairman in 1979, inflation was widely viewed as one of the nation’s foremost problems.
Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high employment (about 10 percent in 1983).

48. U.S. Inflation Rate

49. The Volcker Disinflation: 1979 - 1987
Inflation Rate
(percent per year) 10
1980
1981
1979 A 8
1982 6
1984
1983 B 4
1987 C
1985
1986 2 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)
Copyright © South-Western

50. The Volcker Disinflation
Inflation Rate
(percent per year)
LRPC 10
1980
1981
1979 A 8
1982 6
SRPC1
1984
1983 B 4
1987 C
SRPC2
1985
1986
SRPC3 2
SRPC4 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)
Copyright © South-Western

51. The Greenspan Era
Alan Greenspan’s term as Fed chairman (1987) began with a favorable supply shock.
In 1986, OPEC members abandoned their agreement to restrict supply.
This led to falling inflation and falling unemployment.

52. The Greenspan Era 10 8 6 4 2 1 2 3 4 5 6 7 8 9 10 Inflation Rate
(percent per year) 10 8 6
1990 4
1991
1989
1984
1988
1985
1987
2001
1995
2000
1992
1993 2
1994
1986
1997
1996
1999
1998
2002 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)
Copyright © South-Western

53. Rational expectations
Ways of modeling the formation of expectations:
adaptive expectations: People base their expectations of future inflation on recently observed inflation.
rational expectations: People base their expectations on all available information, including information about current and prospective future policies. Expectations adjust quickly.
The trade-off between inflation and unemployment disappears quickly.
Here’s a good example to illustrate the difference between adaptive and rational expectations.
Suppose the Fed announces a shift in priorities, from maintaining low inflation to maintaining low unemployment w/o regard to inflation; this shift will start affecting policy next week.
If expectations are adaptive, then expected inflation will not change, because it is based on past inflation. The Fed’s announcement pertains to the future, and has no impact on past inflation.
If expectations are rational, then expected inflation will increase right away, as people factor this announcement into their forecasts.

54. Painless disinflation?
Proponents of rational expectations believe that the cost of reducing inflation may be very small:
Suppose u = un and  = e = 6%,
and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible.
If the announcement is credible, then e will fall, perhaps by the full 4 points.
Then,  can fall without an increase in u.
Here’s an interesting and important implication:
Central banks that are politically independent are typically more credible than those that are puppets of elected officials. Hence, in countries with central banks that are NOT politically independent, it is usually far costlier to reduce inflation. A very worthwhile reform, therefore, would be for governments to give their central banks independence.

55. The natural rate hypothesis
The analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis:
Changes in aggregate demand affect output and employment only in the short run.
In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model (Chap. 3).
Allows economist to study SR and LR separately.
The natural rate hypothesis allows us to study the long run separately from the short run.

56. An alternative hypothesis: Hysteresis Read the first or 5 pages of the Yellen Presentation
Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment.
A recession (negative demand shock) may increase un, so economy may not fully recover.

57. Hysteresis: Why negative shocks may increase the natural rate
The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends.
Cyclically unemployed workers may lose their influence on wage-setting; then, insiders (employed workers) may bargain for higher wages for themselves.
Result: The cyclically unemployed “outsiders” may become structurally unemployed when the recession ends.

58. Mankiw NYT Article 11/23/13
“The most arresting piece of economic data is in the number of weeks the average unemployed person has been looking for work — statistics that have been compiled since 1948.
Until recently, the largest such figure was 22 weeks, in the aftermath of the deep recession of
In the most recent recession, however, the average reached about 41 weeks, and it still stands at more than 36 weeks (Oct 2014 at 32.7; Oct 2015 at 28.9). In other words, after more than four years of recovery, the economy still has an unprecedented number of long-term unemployed.

59. Mankiw NYT Article 11/23/13
Some economists believe that long-term unemployment leaves permanent scars on the economy — a theory called hysteresis.
One possible reason for hysteresis is that the long-term unemployed lose valuable job skills and, over time, become less committed to the labor market. In some ways, perhaps, they should be thought of as effectively out of the labor force.
If this theory is right, the labor market today may have less slack than the unemployment rate and the employment-to-population ratio suggest. Policy makers at the Fed may have to accept that lower employment is the new normal.” higher unemployment is the new normal.

61. Chapter Summary 1. Three models of aggregate supply in the short run:
sticky-wage model
imperfect-information model
sticky-price model
All three models imply that output rises above its natural rate when the price level rises above the expected price level.

62. Chapter Summary 2. Phillips curve derived from the SRAS curve
states that inflation depends on
expected inflation
cyclical unemployment
supply shocks
presents policymakers with a short-run tradeoff between inflation and unemployment

63. Chapter Summary 3. How people form expectations of inflation
adaptive expectations
based on recently observed inflation
implies “inertia”
rational expectations
based on all available information
implies that disinflation may be painless

64. Chapter Summary 4. The natural rate hypothesis and hysteresis
the natural rate hypotheses
states that changes in aggregate demand can only affect output and employment in the short run
hysteresis
states that aggregate demand can have permanent effects on output and employment