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Lecture XII
Aggregate supply, inflation and Phillips
curve
XII.1. Short- and long-term
Lecture II – VIII: long-term static model
• All assumptions of a general equilibrium model
fulfilled: flexible prices (and wages), full
information, etc.
• Long-term enough for prices to adjust and markets
to clear
• Aggregate supply vertical, level of (potential)
product determined by production function
• Aggregate demand is a decreasing function of price
• Say`s law ensures that AD equals AS
• Classical dichotomy – amount of money determines
prices (and all other nominal values), but not real
variables
Lecture X: Keynesian model
•
•
•
•
•
Assumptions of general equilibrium model not fulfilled
Depression: free resources (labor)  prices constant
Aggregate demand - decreasing function of the price
Aggregate supply - at constant prices - is horizontal
Adjustment towards equilibrium – quantity (not price)
adjustment, and aggregate supply adjusts to aggregate
demand (opposite to classical, long-term model)
• Money is not neutral, amount of money in the economy
has an impact on aggregate demand
• Aggregate demand can be influenced by policies to
adjust to aggregate supply
Real world
• In the long-term, the prices do adjust and markets do clear,
indeed
• When capital fixed, then product is determined by
employment and after full adjustment, labor market is in
equilibrium as well and this equilibrium generates full
employment and potential product
• In the long-term AS is vertical (classical)
• In the short-term: price and wages are not very flexible, for
several reasons
– Low and/or slowly spreading information, slow reaction of
firms (they do not change wages and prices immediately),
etc.
– This applies in every moment of economic cycle, not only
in depression
• In the short-term, AS is horizontal (Keynesian)
XII.2 AD x AS model
• Aggregate demand: both in short- and long-run
decreasing function of price
• Aggregate supply
– In the long-run: vertical at potential product, long-run
aggregate supply (LRAS)
– In very short-run (ISLM): horizontal at fixed price, shortrun aggregate supply (SRAS)
– In medium term: positively sloped AS (see bellow)
• Shifts in AD
– In the long-run, do not change product, but over-all price
level – consistent with classical model
– In very short-run, do change the level of product (and
employment), but price is fixed – consistent with original
version of Keynesian model


Long-run shifts of AD
permanent change that contracts AD
LRAS
P
P1
E1
P2
E2


Yf

AD1
AD2
Y
Short-run shift of AD
(external shock that contracts AD)
P
E2
P1
E1
SRAS
AD1


Y2
AD2
Y1

Y
From short- to long-run (1)
• Short-run equilibrium:
– AD equals AS, adjustment through quantities  AS adjusts to
AD
– Price fixed, equilibrium as state of rest, there can be excess
supply on labor market (involuntary unemployment)
– Actual product can be lower/higher than potential one
• Long-run equilibrium:
– AD equals AS
– Simultaneous adjustment of all prices generates equilibrium on
all markets
– Actual product equal to potential one
Long-run equilibrium
P
LRAS
E
SRAS
AD
Yf
Y
From short- to long-run (2)
Intuitive interpretation:
• Fixed price corresponds either to the depression
(Keynes) or to very short-run, when prices (and wages)
are fixed in all economies and at (almost) all situations
(exceptions – e.g. hyperinflations)
• Long-run equilibrium – prices and wages had to react
to changes in demand/supplies on all markets
(including labor) and their adjustment cleared all
markets simultaneously
Adjustment in the long-run
P
P1
LRAS
E1
SRAS1
A
AD1
E2
P2

YA

SRAS2
AD2
Yf

Y
Adjustment - summary
• Aggregate demand: both in short- and long-run
decreasing function of price
• Aggregate supply
– In the long-run: vertical at potential product, long-run
aggregate supply (LRAS)
– In very short-run (ISLM): horizontal at fixed price, shortrun aggregate supply (SRAS)
– In medium term: positively sloped AS
• Shifts in AD
– In the long-run, do not change product, but over-all price
level – consistent with classical model
– In very short-run, do change the level of product (and
employment), but price is fixed – consistent with original
version of Keynesian model
XII.3 Short-term aggregate supply
• Adjustment process (from short- to longterm) might take long time  an obvious
question:
– how does the aggregate supply look like in
this adjustment period?  increasing
function of price
• Model?
– No unified theory till today
– 3 plausible models, all taking into account
that prices do adjust, but with time lag,
slowly (“sticky” prices)
XII.3.1 Wage rigidity –sticky
wages
• Originally: F.Modigliani (1944) – downward
wage rigidity
• In general: wages rigid in both directions,
reasons:
– Long term wage contracts, eventually
implicit contracts, power of the unions
• Intuitively: if wages rigid, then price increase
lowers real wage  firms increase employment
 product increases and supply increasing
function of the price
Model (1)
• Model only for the situation, when product smaller
or equal to potential product
• Labor market
– Either in equilibrium – natural unemployment
(employment, product)
– Or product smaller than potential,
unemployment higher than natural, supply of
labor higher than demand and unemployment
determined by demand (when DS, amount
realized on the market always given by min
(D,S))
Model (2)
Wage negotiations:
• Nominal wage always negotiated at the expected price Pe , so
both firms and workers have in mind targeted real wage, so
wT a W = wT . Pe
• Employment given by demand  firms then decide according
price P
- (W/P) = wT . (Pe /P)
– if P = Pe , then (W/P) = wT
– if P > Pe , then (W/P) < wT
– if P < Pe , then (W/P) > wT
– Unexpected growth of price means fall of real wage 
higher employment  higher product; conversely, fall of
price  lower product
Higher price  higher AS (and vice versa)
NS
W/P
W1
P2
W1
P1
Y
P

E
N2
Nf
ND
N
P1
P2
E
 

Yf
Y2
 
AS
Y  F K,N


Y2 Yf

N2
Nf
 
N
Y
Model (3)
• Difference between actual and expected
price reflects price movements
– One possible interpretation – in moment t
expectation equals price
– real price, determining real wage, is price in
moment t+1
• Generalization:
Y  Yf  P  P  ,   0
e
Wage rigidity – weaknesses of the
model
• Model with rigid wages explains the
relation between price movements and
aggregate supply in the situation, when
product is lower or equal to potential one
• Does not cover situations, when product
increases over potential level
– compare impact of wage growth when
initially product is on potential level
• Real wages move against the cycle
XIII.3.2 Wrong perception of price
level by workers
Starting assumption – firms always know
prices, workers only expect them and will
know real price only with a time lag
• Demand for labor ND  ND W P
• Supply of labor NS  NS W P e 
W W P
• Always P e  P . P e and ratio P P e reflects
a degree ofwrong perception of price
level by workers



Model (1)
• Demand for labor: decreasing function of real
wage
• Supply of labor: increasing function of expected
real wage, can be written as
N  N W P  N
S
S
e
S
W P.P P 
e
– Labor supply curve shifts according the ratio P/Pe
• Model explains the relation between price and AS
even when product is higher than a potential one
 • Model assumes simultaneous clearing of all
markets
Wrong price perception: price
increase • Demand – decreasing
N1S
W/P

W P1
N
function of real wage
• Supply – increasing function
e
of W P.P P 
S
• N1 initial supply
• Unexpected price increase
  labor supply shifts to the

right  real wage fall 
new equilibrium with higher
employment
S
2

W P2
ND  ND W P
N1 N 2

N
Model (2)
• Price increase  employment increase
• AD – increasing function of price
• In general again Y  Yf  P  Pe  ,   0
AS
P

Yf
Y
XIII.3.3 Incomplete price
information
Assumptions:
• No difference between firms and workers
• On the markets, agents know
– Quite well the price of goods they produce
– not so well the price of most other goods
• Agents produce one good and consume
many goods
Model
• Unexpected increase of overall price level, then
each agent
– as producer perceives the increase of the price of
“its” product and feel incentives to increase
production
– as a consumer doesn’t perceive the price increase as
an overall one, as he doesn’t know all other prices
• Main idea – at change of absolute price level,
agent wrongly assumes the change of only
relative prices (of “his” product)  increases
supply because of increase of price
• Formally again
Y  Yf  P  P  ,   0
e
XII.3.4 Summary
• Particular models of short term
aggregate supply differ, but do not
exclude each other exclusively
• All models generate AS that – in the short
run – is increasing function of price
Y  Yf  P  P  ,   0
e
Interpretation
• Variations from potential (natural) product are
proportional to variations of actual price from
expected one
• Actual price higher than expected  product
higher than potential; and vice versa
• In graphical terms: short term AS is increasing,
slope 1/
• Expected price becomes a model parameter
– When actual and expected price equal, product
on potential level
– Change of expected price shifts AS curve
• Dynamics
AS in long and short term
P
LRAS
AS
Pe
Yf
Y
XII.4 Model AD-AS
Equilibrium
• Juxtaposing AD and AS
– AD  static model
– AS  dynamics, expected price
• Equilibrium in AD-AS model:
– Mathematically – solution of system of equations
– Graph – intersection of AD and AS curves
– Economic interpretation:
• AD: at given price, other variables adjust to keep
markets of both goods and money in equilibrium
• AS: equation to determine price, initial condition –
expected price Pe
Medium term adjustment (1)
Impacts of exogenous changes of either fiscal or
monetary origin
• Initial situation: long term equilibrium, i.e. product,
employment and unemployment at natural values
• Initial condition for AS: expected price Pe
• Exogenous change shifts AD
– If AS was horizontal (depression), then change of
equilibrium given by one of short term
multipliers and price remains constant
– Positively sloped AS: new equilibrium, when
product higher than potential and price higher as
well
• New short term equilibrium
Medium term adjustment (2)
• In medium term, people start to correct their
expectations, the adjustment continues
• Expected price continues to increase and – with
delay – continues to do so till expected price
differs from an actual one
• However, this is possible only at long term
equilibrium, at vertical AS and natural product
• Stimulation of AD ends up by adjustment back
to potential product, but with higher price
Medium term adjustment (3)
P
LRAS
AS 3
AS1
P3e =
P3
P2
e
2
e
1
P = P = P1
C
B
A
AD 2
AD1
Y3 = Y1
Y2
Y
Conclusions
• Closer to the real world
• Short run – product differs from
potential one, money is not neutral
• Long run – product equal to potential
(variables on natural levels), money is
neutral
• What is short run, how to control
adjustment to natural values?
• … and mainly: according which criteria?
XII.5. Phillips curve
• Original version: A.W.Phillips, 1958
• Assumption of inverse relationship between
growth of wages and unemployment
W  W1
 .u,  > 0
W1
• respectively, between growth of prices (inflation)
and unemployment
P  P1
 .u

P1
• At the beginning of 1960s, it seemed - statistically the data confirm this assumption

Inflation and unemployment
USA, 1950-1969
9
8
Inflation (%)
7
6
5
4
3
2
1
0
-1
3
4
5
Unemployment (%)
6
7
XII.5.1. Theory (1)
• Phillips – empirically observed reality
• 1960: Samuelson a Sollow – theory
– Increasing AS  relation between change of
product and change of price level
– Inverse relation between the difference of
product from potential one and difference of
unemployment from natural one
– Okun`s law
  

u* -u = Y-Y* ,  >0
Theory (2)
• Product higher than potential one suppresses
unemployment bellow natural rate  increase
of wages and (under the assumption of no labor
productivity growth) of prices
• Phillips` empirical observation can be written
as
P-P-1
*
    . u  u , kde  
P-1
• Inflation is negatively related to the difference
between actual and natural rate of
unemployment


Inflation
• L V – inflation defined as a monetary
phenomenon
• Here – theory, based on an empirically
observed Phillips` curve
• Original version of Phillips curve – theory of
demand-pull inflation, i.e. inflation, generated
by the increase of aggregate demand, that
decreases unemployment bellow a natural level,
with subsequent increase of nominal wages and
price
Conclusions for economic policies
• Phillips curve implies that high inflation (that usually
accompanies economic growth) means lower
unemployment and vice versa
• If this is a theoretically proved truth, then - consistently
with Keynesian policy recommendation (fiscal and
monetary policies) - a famous policy trade-off was
formulated:
– If a country is ready to tolerate higher inflation, then
aggregate demand can be stimulated consistently
towards potential product and keep unemployment low
all the time
– On the contrary, if there is a danger of economic overheating (too high inflation and product above potential
level), the the economy might be slowed-down and
inflation (and growth) lowered at the costs of higher
unemployment
XII.5.2. Empirical problems and
inflationary expectations
Inflation and unemployment
USA, 1970-2000
14
Inflation (%)
12
10
8
6
4
2
0
4
5
6
7
8
Unemployment (%)
9
10
Data after 1970
• After 1970, the data in developed economies
contradicted both Phillips curve and the theory
of demand pull inflation (see previous slide)
• Inflation was high even at low growth and and
high unemployment
– A specific name: stagflation
• Problem: quickly it was clear that Phillips
curve is not a representation of a theoretical
truth (at least not in its original version)
• Consequently: policy recommendations, based
of inflation - unemployment trade-off, are not
generally valid
Phillips curve - a wrong concept? (1)
Two 1968 contributions:
• M.Friedman: The Role of Monetary Policy
• E.Phelps: Money-Wage Dynamics and LaborMarket Equilibrium
Original Phillips curve:
• For a period, when long-term average inflation
is zero and workers expect the next year’s
inflation zero as well. This was true until
1960’s.
• Inflation/unemployment trade-off: not a longterm concept, as there is always some level of
unemployment – a natural rate (see L VI)
Phillips curve - a wrong concept? (2)
Original Phillips curve: wage negotiations,
when with high unemployment and
expectation of zero inflation, firms easily
find workers, ready to take a low wage.
Positive inflation expectation: workers
negotiate much harder for higher
nominal wages to keep real wages
unchanged.
Phillips curve - a wrong concept? (3)
Define expected price as Pe and expected inflation
as
e
P  P1
 
P1
e
and original Phillips curve can be expressed

    .u, with   0
e
e
However, whenever  e  0 , than inflation might
rise, even with high unemployment
→ no unemployment x inflation trade-off

Phillips curve - a wrong concept? (4)
No permanent inflation/unemployment trade-off;
consequences:
• Permanent positive inflation, which generates
an expectation about a positive inflation
further on;
• Unemployment can not – for a longer period of
time – be kept bellow a certain level (natural
rate, consistent with full employment output)
Over time, Phillips curve trade-off disappears
Expectations-augmented Phillips curve
Suppose that   0 and, say,  e   1
than
   1  .u
This fits the data for the period even beyond 1970
 well.
rather
Back to 
more usual notation: u *  0
than
  u  u   -1
*
↔ expectations-augmented Phillips curve

Change of inflation and
unemployment
Change of inflation
(%)
USA, 1970-2000
5
4
3
2
1
0
-1
-2
-3
-4
-5
4
5
6
7
8
Unemployment (%)
9
10
XII.5.3. Cost-push inflation
• Even without demand pressures, economy
might suffer from even higher inflation because
of increase of costs
• Usually as a consequence of exogenous shocks
– Oil socks in 1970s
• Consequences for economic policies, dilemma
– Either prevent higher inflationary expectations, but
at the cost of temporary slow-down in economic
growth and increase of unemployment
– Or stimulate aggregate demand, overcome
stagnation, but inflation will not only be higher, but
higher inflationary expectations will be generated
Literature to L XII
• Mankiw, Ch. 9
• Holman, Ch. 10