Download Chapter 9: Introduction to Economic Fluctuations

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
Real Wage
Y1 Output
Y
Y2
W/P1
W/P2
Ld
L1 L2 Labor
L1 L2
Price
P2
P1
Labor
Short-run AS
Y1 Y2
Output
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
L1 L2
Labor
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
Ls
Y1 Output
Y
Y2
W/P2
W/P1
Ld2
Ld1
L1 L2 Labor
Price
L1 L2
Labor
Short-run AS
PW2
PW1
Y1 Y2
Output
Sticky Price Model
Two kinds of firms:
– 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
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
C
P3
P2
SRAS2
SRAS1
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
π1
B
P2
A
u1
P1
u2
Unemployment Rate