# ch13 Aggregate supply

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### Slide1:

CHAPTER THIRTEEN Aggregate Supply

### Learning objectives:

Learning objectives The model 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

### Content:

Content 1. Short-run Aggregate supply curve 2. Keynes AS vs. classical AS 3. The Phillips curve 4. Three causes of changing inflation 5. Disinflation and the sacrifice ratio 6. Hysteresis hypothesis 7. Chapter summary

### Three models of aggregate supply:

Three models of aggregate supply The sticky-wage model The imperfect-information model The sticky-price model All three models imply: 1

### The sticky-wage model:

The sticky-wage model Assumes that firms and workers negotiate contracts and fix the nominal wage before they know what the price level will turn out to be. The nominal wage, W, they set is the product of a target real wage, , and the expected price level: 1

### The sticky-wage model:

The sticky-wage model If it turns out that then unemployment and output are at their natural rates Real wage is less than its target, so firms hire more workers and output rises above its natural rate Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate 1

1

### Summary & implications:

Summary & implications Each of the three models of agg. supply imply the relationship summarized by the SRAS curve & equation 1

### Summary & implications:

Summary & implications Suppose a positive AD shock moves output above its natural rate and P above the level people had expected. Over time, P e rises, SRAS shifts up, and output returns to its natural rate. 1 Return

### Policy implication of Keynes AS-AD:

Policy implication of Keynes AS-AD 由于AS曲线向上倾斜 市场经济可能出现非充分就业均衡，即有效需求不足。 市场机制不能自动地解决有效需求不足问题。 2

### Policy implication of Keynes AS-AD:

Policy implication of Keynes AS-AD 2 Return

### The Phillips Curve:

With a given expected inflation rate an natural rate of unemployment, there is an inverse relationship between the inflation rate and the unemployment rate. The Phillips Curve 3

### The Phillips Curve:

The Phillips Curve 3

### Slide17:

Slide 8 Mankiw:Macroeconomics, 4/e © by Worth Publishers, Inc. The Phillips Curve of U.S. 3

The Canadian Phillips Curve Each dot shows inflation and unemployment in a year. 3

### Inflation, Unemployment, and the Phillips Curve:

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,  where  > 0 is an exogenous constant. 3

### Deriving the Phillips Curve from SRAS:

Deriving the Phillips Curve from SRAS 3

### The Phillips Curve and SRAS:

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 3

### Graphing the Phillips curve:

Graphing the Phillips curve In the short run, policymakers face a trade-off between  and u. 3 Return

### Three causes of changing inflation:

Three causes of changing inflation Adaptive expectations and inflation inertia Demand-pull inflation Cost-push inflation 4

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 P.C. becomes 4

### Inflation inertia:

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. Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set. 4

### Shifting the Phillips curve:

Shifting the Phillips curve People adjust their expectations over time, so the tradeoff only holds in the short run. E.g., an increase in e shifts the short-run P.C. upward. 4

### Second cause of changing inflation:

Second cause of changing inflation 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. 4

### Third cause of rising & falling inflation:

Third cause 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. 4 Return

### The sacrifice ratio:

The sacrifice ratio To reduce inflation, policymakers can contract agg. demand, causing unemployment to rise above the natural rate. The sacrifice ratio measures the percentage of a year’s real GDP that must be foregone to reduce inflation by 1 percentage point. Estimates vary, but a typical one is 5. 5

### The sacrifice ratio:

The sacrifice ratio Suppose policymakers wish to reduce inflation from 6 to 2 percent. If the sacrifice ratio is 5, then reducing inflation by 4 points requires a loss of 45 = 20 percent of one year’s GDP. This could be achieved several ways, e.g. reduce GDP by 20% for one year reduce GDP by 10% for each of two years reduce GDP by 5% for each of four years The cost of disinflation is lost GDP. One could use Okun’s law to translate this cost into unemployment. 5

### Rational expectations :

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. 5

### Painless disinflation?:

Painless disinflation? Proponents of rational expectations believe that the sacrifice ratio may be very small: Suppose u = u n 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. 5

### The sacrifice ratio for the Volcker disinflation:

The sacrifice ratio for the Volcker disinflation 1981:  = 9.7% 1985:  = 3.0% Total 9.5% Total disinflation = 6.7% 5

### The sacrifice ratio for the Volcker disinflation:

The sacrifice ratio for the Volcker disinflation Previous slide: inflation fell by 6.7% total of 9.5% of cyclical unemployment Okun’s law: each 1 percentage point of unemployment implies lost output of 2 percentage points. So, the 9.5% cyclical unemployment translates to 19.0% of a year’s real GDP. Sacrifice ratio = (lost GDP)/(total disinflation) = 19/6.7 = 2.8 percentage points of GDP were lost for each 1 percentage point reduction in inflation. 5 Return

### The natural rate hypothesis:

The natural rate hypothesis Our 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 (chapters 3-8). 6

### An alternative hypothesis: hysteresis:

An alternative hypothesis: hysteresis Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment. Negative shocks may increase u n , so economy may not fully recover: The skills of cyclically unemployed workers deteriorate while unemployed, and they cannot find a job when the recession ends. Cyclically unemployed workers may lose their influence on wage-setting; insiders (employed workers) may then bargain for higher wages for themselves. Then, the cyclically unemployed “outsiders” may become structurally unemployed when the recession ends. 6 Return

### Chapter summary:

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 falls below the expected price level. 7

### Chapter summary:

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 7

### Chapter summary:

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 7

### Chapter summary:

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 agg. demand can have permanent effects on output and employment 7 End