0. Chapter 13-7th and 14-8th 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.

1. We will cover…
models of aggregate supply in which output depends positively on the price level in the short run
Two models presented in the book
the short-run tradeoff between inflation and unemployment known as the Phillips curve

2. Three models of aggregate supply
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

3. Summary & implications
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.

4. Summary & implications
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
VSRAS
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.
Note: curvature matters and slope!

5. The sticky-price model:
Reasons for sticky prices:
long-term contracts between firms and customers
menu costs
firms not wishing to annoy customers with frequent price changes
Assumption:
monopolistic competition.
Firms have the ability to set their own prices.
If you don’t like the appearance of the term “monopolistic competition” in this slide, just change the parenthetical comment to “(i.e., firms have some market power)” or something to that effect.

6. The sticky-price model:
An individual firm’s desired price (p) is:
Where: P is the overall price level and a > 0.
Higher P means that firm’s costs are likely to be high.
So, higher P means that firm will want to have a higher price itself.
Also, a booming economy raises the demand for firm’s product, marginal cost rises at higher levels of production, so higher demand raises individual firm’s desired price.
Interpretation of the first equation:
If output is at its natural rate, then each firm’s optimal price is the same as the overall price level. When the economy is weak (output below its natural rate), firms set their prices lower, and in a boom when demand is high, firms set their prices higher.
Remind your students that “E” is the expectation operator introduced in Chapter 5.
Hence, EP is the expected price level and (EY – EYbar) is the expected deviation of output from its natural, full-employment level.

7. The sticky-price model:
Suppose two types of firms:
firms with flexible prices, set prices as above:
firms with sticky prices that must set their price before they know how P and Y will turn out:
Assume sticky-price firms expect that output will equal its natural rate. Then,

8. The sticky-price model
To derive the aggregate supply curve, first find an expression for the overall price level.
s = fraction of firms with sticky prices.
Then, we can write the overall price level as…

9. The sticky-price model
price set by sticky-price firms
price set by flexible-price firms
Solve for P:
Divide both sides by s:

10. The sticky-price model
High EP  High P When firms expect high prices, then firms that must set prices in advance will set them high. Other firms respond by setting high prices too.
High Y  High P When income is high, the demand for goods is high. Firms with flexible prices set high prices.
The greater the fraction of flexible-price firms, the smaller is s and the bigger the effect of Y on P.

11. The sticky-price model
Finally, derive AS equation by solving for Y :
Over sufficiently long periods, all firms should be able to adjust their prices
So in long run, s = 0 and should have no relationship between P and Y : LRAS vertical at
Would also be case in “short run" if α = 0

12. 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, consumes many goods.
Each supplier knows the nominal price of the good she produces, but does not know the overall price level.

13. The imperfect-information model, also called the Misperceptions Theory

14. 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

15. 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

16. What shifts the curves?
Change in Pe
Change in Y-bar

17. Summary & implications
Suppose a positive AD shock moves output above its natural rate (to Y2) and P above the level people had expected (to P2)
SRAS equation:
SRAS2 Y P
LRAS
AD2
SRAS1
AD1
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.
Over time, P e rises, SRAS shifts up, and output returns to its natural rate.

18. Monetary policy and the misperceptions theory
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
The previous slide showed the effect of an unanticipated change in the money supply.

19. An unanticipated increase in the money supply (same as 2 slides prior)

20. 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

21. The Misperceptions Theory and the Nonneutrality of Money
Monetary policy and the misperceptions theory
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

22. An anticipated increase in the money supply – go directly from P1 to P3 - directly from point E to H.

23. Inflation, Unemployment, and the Phillips Curve

24. 5½ % = zero inflation

25. 5½ %

26. Unemployment and Inflation: Is There a Trade-off?
Many people 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

27. Inflation and unemployment in the United States, 1970-2005

28. Inflation, Unemployment, and the Phillips Curve
The Phillips curve states that  depends on:
expected inflation,  e.
cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate
supply shocks,  (Greek letter “nu”).
 measures the responsiveness of inflation to cyclical unemployment.
where  > 0 is an exogenous constant.

29. The Phillips Curve is derived from the 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  in place of (P- P-1) and e in place of (Pe- 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 (chapter 2): 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.

30. The Phillips Curve and SRAS
SRAS curve: Output is related to unexpected movements in the price level.
Phillips curve: Unemployment is related to unexpected movements in the inflation rate.

31. How are expectations about inflation formed? Adaptive expectations
Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation.
A simple example: Expected inflation = last year’s actual inflation
Then, the Phillips Curve becomes

32. 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.

33. 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.

34. 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

35. 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 P.C. 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 Phillips Curve upward.

36. THE COST OF REDUCING INFLATION
To reduce inflation, an 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.

37. 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.

38. Example
In this scenario, inflation has no effect on output or employment: Both will be the same as in a noninflationary economy where everyone expects an inflation rate of zero.
In both scenarios inflation has no effect on relative prices. The economy will tend to produce at full employment output and the unemployment rate will gravitate toward the natural rate.
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.

39. Example:
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 13 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.

40. 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).

41. 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

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

43. 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.

44. 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

45. Rational Expectations and the Possibility of Costless Disinflation
Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run.
How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.
The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future. Expectations adjust quickly.

46. 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.

47. An alternative hypothesis: Hysteresis
Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment.
A recession (negative demand shock) may leave permanent scars on the economy increase un, so economy may not fully recover.

48. 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. In other words, after more than four years of recovery, the economy still has an unprecedented number of long-term unemployed.
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.”

50. 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. (increased frictional unemployment)
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.

51. 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.

52. 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

53. 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

54. 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