Download Mankiw 5/e Chapter 13: Aggregate Supply

macro
CHAPTER THIRTEEN
Aggregate Supply
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2004 Worth Publishers, all rights reserved
Learning objectives
 three 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
CHAPTER 13
Aggregate Supply
slide 1
Three models of aggregate supply
1. The sticky-wage model
2. The imperfect-information model
3. The sticky-price model
All three models imply:
Y  Y   (P  P )
e
the expected
price level
agg.
output
natural rate
of output
CHAPTER 13
a positive
parameter
Aggregate Supply
the actual
price level
slide 2
Short run aggregate supply
– Short run aggregate supply (SRAS) is
different from long run aggregate supply
(LRAS)
– In general SRAS is upward sloping
CHAPTER 13
Aggregate Supply
slide 3
The sticky-wage model
 S Fisher “Long Term Contracts, Rational Expectations and the Optimal
Money Supply Rule” Journal of Political Economy 85 (February 1977)
– Wages are sticky due to long-term contracts and labor
market imperfections (minimum wages, labor unions, etc)
– Firms and workers negotiate contracts and fix the nominal
wage W before they know what the price level P
– The nominal wage they set is the product of a target real
wage w and the expected price level Pe:
W  ω P
e
Target
real
wage
W
Pe

ω
P
P
CHAPTER 13
Aggregate Supply
slide 4
The sticky-wage model
W
Pe
ω
P
P
If it turns out that
P P
e
P Pe
P P
CHAPTER 13
e
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
Aggregate Supply
slide 5
The sticky-wage model
 Implies that the real wage should be countercyclical , it should move in the opposite direction as
output over the course of business cycles:
– In booms, when Y typically rises, the real wage
should fall.
– In recessions, when Y typically falls, the real
wage should rise.
 Therefore, should expect that corr(W/P,L)<0 and
corr(W/P,Y)<0
 This prediction does not come true in the real
world:
CHAPTER 13
Aggregate Supply
slide 7
Percentage change
in real wage
The cyclical behavior of the real wage
4
1972
3
1998
2
1960
1997
1999
1
1996
1970
0
2000
1984
1993
1992
1982
1991
-1
1965
1990
-2
1975
-3
1979
1974
-4
-5
1980
-3
-2
-1
0
1
2
3
4
5
6
7
8
Percentage change in real GDP
CHAPTER 13
Aggregate Supply
slide 8
Conclusion
 Sticky wage model can not explain some
important regularities of the business cycles
 Extensions of the model include shocks to
the labor demand curve that shifts it during
the business cycles
– Technology shocks
– External shocks
CHAPTER 13
Aggregate Supply
slide 9
The imperfect-information model
R. Lucas “Understanding Business Cycles” Stabilization of the
Domestic and International Economy, vol. 5 of CarnegieRochester Conference on Public Policy (1977)
Assumptions:
 all wages and prices perfectly flexible,
all markets clear
 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
CHAPTER 13
Aggregate Supply
slide 10
The imperfect-information model
Pi
Pi  P  (
)
P
Pi
ln Pi  ln P  ln(
)
P
pi  p  ri
•A firm i should respond to the change in the relative price ri
by increasing output and employment if ri has increased and
do not change anything if all prices have increased
•However, only Pi is observable
CHAPTER 13
Aggregate Supply
slide 11
Imperfect information and aggregate
supply
 When all prices in the economy increase
unexpectedly, it does not change relative
prices but increases the price level P
 Firms, however, observe an increase in Pi,
mistakenly infer that there is a change in the
relative price, and hire more workers to
expand production
 As a result, aggregate supply Y respond to
the change in the price level P
CHAPTER 13
Aggregate Supply
slide 12
The sticky-price model
 Reasons for sticky prices:
– long-term contracts between firms and
customers
– menu costs
– firms do not wish to annoy customers with
frequent price changes
 Assumption:
– Firms set their own prices
(e.g. as in monopolistic competition)
CHAPTER 13
Aggregate Supply
slide 13
The sticky-price model
 An individual firm’s desired price is
p  P  a (Y Y )
where a > 0.
Suppose two types of firms:
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
before they know how P and Y will turn out:
p  P e  a (Y e Y e )
CHAPTER 13
Aggregate Supply
slide 14
The sticky-price model
p  P e  a (Y e Y e )
 Assume sticky price firms expect that output
will equal its natural rate. Then,
p Pe
 To derive the aggregate supply curve, we first
find an expression for the overall price level.
 Let s denote the fraction of firms with sticky
prices. Then, we can write the overall price
level as
CHAPTER 13
Aggregate Supply
slide 15
The sticky-price model
P  s P  (1  s )[P  a(Y Y )]
e
price set by sticky
price firms
price set by flexible
price firms
 Subtract (1s )P from both sides:
sP  s P  (1  s )[a(Y Y )]
e
 Divide both sides by s :
P  P
CHAPTER 13
e
 (1  s ) a 

(Y Y )

s


Aggregate Supply
slide 16
The sticky-price model
P  P
 High P e  High P
e
 (1  s ) a 

(Y Y )

s


If firms expect high prices, then firms who must set
prices in advance will set them high.
Other firms respond by setting high prices.
 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 is the effect
of Y on P.
CHAPTER 13
Aggregate Supply
slide 17
The sticky-price model
P  P
e
 (1  s ) a 

(Y Y )

s


 Finally, derive AS equation by solving for Y :
Y  Y   (P  P ),
e
s
where  
(1  s )a
CHAPTER 13
Aggregate Supply
slide 18
The sticky-price model
In contrast to the sticky-wage model, the stickyprice model implies a pro-cyclical real wage:
Suppose aggregate output/income falls. Then,
 Firms see a fall in demand for their products.
 Firms with sticky prices reduce production,
and hence reduce their demand for labor.
 The leftward shift in labor demand causes
the real wage to fall.
CHAPTER 13
Aggregate Supply
slide 19
Summary & implications
P
LRAS
Y  Y   (P  P e )
P Pe
SRAS
P P
e
P Pe
Y
CHAPTER 13
Aggregate Supply
Y
Each of the
three models of
agg. supply imply
the relationship
summarized by
the SRAS curve
& equation
slide 20
Summary & implications
Suppose a positive
AD shock moves
output above its
natural rate
and P above the
level people
had expected.
SRAS equation: Y  Y   (P  P e )
P
SRAS2
SRAS1
P3  P3e
P2
e
e
Over time,
P

P
P

1
1
2
e
P rises,
SRAS shifts up,
and output returns
to its natural rate.
CHAPTER 13
LRAS
Aggregate Supply
AD2
AD1
Y 3  Y1  Y
Y
Y2
slide 21
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, 
e
n
     (u  u )  
where  > 0 is an exogenous constant.
CHAPTER 13
Aggregate Supply
slide 22
Deriving the Phillips Curve from SRAS
(1)
Y  Y   (P  P e )
(3)
P  P e  (1  )(Y Y )  
(4)
(P  P1 ) /P1  ( P e  P1 ) /P1  (1  )(Y Y ) /P1   /P1
(5)
   e  (1 1 )(Y Y )   1
(6)
(1  1 )(Y Y )    (u  u n )
(7)
   e   (u  u n )   1
CHAPTER 13
Aggregate Supply
slide 23
The Phillips Curve and SRAS
SRAS:
Phillips curve:
Y  Y   (P  P e )
   e   (u  u n )  
 SRAS curve:
output is related to unexpected movements
in the price level
 Phillips curve:
unemployment is related to unexpected
movements in the inflation rate
CHAPTER 13
Aggregate Supply
slide 24
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
 e   1
 Then, the P.C. becomes
n
   1   (u  u )  
CHAPTER 13
Aggregate Supply
slide 25
Inflation inertia
n
   1   (u  u )  
 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.
CHAPTER 13
Aggregate Supply
slide 26
Two causes of rising & falling inflation
   1   (u  u n )  
 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.
CHAPTER 13
Aggregate Supply
slide 27
Graphing the Phillips curve

In the short
run, policymakers
face a trade-off
between  and u.
   e   (u  u n )  

1
The short-run
Phillips Curve
e 
un
CHAPTER 13
Aggregate Supply
u
slide 28
Shifting the Phillips curve
People adjust
their
expectations
over time, so
the tradeoff
only holds in
the short run.

   e   (u  u n )  
 2e  
 1e  
E.g., an increase
in e shifts the
short-run P.C.
upward.
CHAPTER 13
Aggregate Supply
un
u
slide 29
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.
CHAPTER 13
Aggregate Supply
slide 30
Inflation around the world
Consumer prices in Ukraine
Year
Cumulative, 2000=100
Average inflation rate, %
1996
50
80.2
1997
57
15.9
1998
64
10.6
1999
78
22.7
2000
100
28.2
2001
112
12
2002
113
0.8
2003
119
5.2
2004
129
9
2005
147
13.5
2006
160
9
2007 (estimated in 2006)
179
11.5
Aggregate Supply
CHAPTER
13 Fund, World Economic Outlook Database, October 2007
International
Monetary
slide 31
Inflation around the world

“Inflation in Zimbabwe is incalculable” (BBC world
news)
–
–
The chief statistician of the Zimbabwean
Statistical office told the press that inflation in the
country become incalculable because goods
disappeared from the shelves.
According to crude estimates it have reached
8,000% in September and currently is about
15,000%. The IMF had warned that it could
reach 100,000% by the end of the year.
CHAPTER 13
Aggregate Supply
slide 32
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.
CHAPTER 13
Aggregate Supply
slide 33
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.
CHAPTER 13
Aggregate Supply
slide 34
Goodfriend 2007 JEP How the World achieved consensus
on the monetary policy
•In 70’s inflation peaked above 10% twice: 1974 and
1980.
•Okun predicted that to permanently reduce inflation
by 1% it would have taken 10% contraction in output
and employment per year.
•“…Volcker Fed brought the inflation rate down to 4
percent by 1984, although it precipitated recessions in
1980 and 1981–82 to do so.
•Under Alan Greenspan, the Fed gradually worked the
inflation rate down by the early 2000s below 2
percent, a range that Greenspan (2003) dubbed
“effective price stability.” “
CHAPTER 13
Aggregate Supply
slide 35
The sacrifice ratio
for the Volcker disinflation
 1981:  = 9.7%
1985:  = 3.0%
Total disinflation = 6.7%
year
u
un
uu n
1982
9.5%
6.0%
3.5%
1983
9.5
6.0
3.5
1984
7.4
6.0
1.4
1985
7.1
6.0
1.1
Total 9.5%
CHAPTER 13
Aggregate Supply
slide 36
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.
CHAPTER 13
Aggregate Supply
slide 37
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.
CHAPTER 13
Aggregate Supply
slide 38
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.
CHAPTER 13
Aggregate Supply
slide 39
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
CHAPTER 13
Aggregate Supply
slide 40
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
CHAPTER 13
Aggregate Supply
slide 41
CHAPTER 13
Aggregate Supply
slide 42