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Chapter 13-7th and 14-8th edition
Aggregate Supply and the Short-run
Tradeoff Between Inflation and
Unemployment
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
Three models of aggregate supply
1. The sticky-price model
2. The imperfect-information model
3. The sticky-wage model (not in the book)
All three models imply:
Y  Y   (P  P )
e
the expected
price level
agg.
output
natural rate
of output
a positive
parameter
the actual
price level
Summary & implications
P
LRAS
Y  Y   (P  P e )
P Pe
P P
SRAS
e
P Pe
Y
Y
Y is Full Employment output from chapter 3 assuming
perfect competition and flexible wages and prices.
Summary & implications
P
P P
LRAS
Y  Y   (P  P e )
SRAS
e
Y
VSRAS
Y
Note: curvature matters and slope!
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.
The sticky-price model:
 An individual firm’s desired price (p) is:
p  P  a(Y  Y )
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.
The sticky-price model:
Suppose two types of firms:
• firms with flexible prices, set prices as above:
p  P  a(Y  Y )
• firms with sticky prices that must set their price before
they know how P and Y will turn out:
p  EP  a( EY  EY )
• Assume sticky-price firms expect that output will equal
its natural rate. Then,
p  EP
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…
The sticky-price model
P  s[ EP ]  (1  s )[ P  a(Y  Y )]
price set by
sticky-price firms
price set by
flexible-price firms
 Solve for P:
sP  s[ EP ]  (1  s )[a(Y  Y )]
 Divide both sides by s:
(1 s )a
P  EP 
(Y  Y )
s
The sticky-price model
(1 s )a
P  EP 
(Y  Y )
s
• 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.
The sticky-price model
(1 s )a
P  EP 
(Y  Y )
s
 Finally, derive AS equation by solving for Y :
Y  Y   (P  EP ),
s
where  
 0
(1  s ) a
 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 Y
 Would also be case in “short run" if α = 0
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.
The imperfect-information model, also
called the Misperceptions Theory

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
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
What shifts the curves?
Y  Y   (P  P )
e
Y  Y   (P  P )
e
 Change in Pe
 Change in Y-bar
Summary & implications
SRAS equation: Y  Y   (P  P e )
Suppose a positive
AD shock moves
P
output above its
natural rate (to Y2)
and P above the
level people had
P3  P3e
expected (to P2)
P2
Over time,
e
e
P
e
2  P1  P1
P rises,
SRAS shifts up,
and output returns
to its natural rate.
LRAS
SRAS2
SRAS1
AD2
AD1
Y 3  Y1  Y
Y2
Y
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.
An unanticipated increase in the money
supply (same as 2 slides prior)
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
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
An anticipated increase in the money supply – go
directly from P1 to P3 - directly from point E to H.
Inflation, Unemployment, and the Phillips
Curve
5½ % = zero inflation
24
5½ %
25
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
Inflation and unemployment in the United
States, 1970-2005
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”).
e
n
     (u  u )  
where  > 0 is an exogenous constant.
The Phillips Curve is derived from the SRAS
(1)
Y  Y   (P  P e )
(2)
P  P e  (1  )(Y Y )
(3)
P  P e  (1  )(Y Y )  
(4)
(P  P1 )  ( P e  P1 )  (1  ) (Y Y )  
(5)
   e  (1  )(Y Y )  
(6)
(1  )(Y Y )    (u  u n )
(7)
   e   (u  u n )  
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.
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
 e   1
 Then, the Phillips Curve becomes
n
   1   (u  u )  
Inflation inertia
   1   (u  u n )  
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.
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.
Graphing the Phillips curve
In the short
run, policymakers
face a tradeoff
between  and u.

   e   (u  u n )  

1
The short-run
Phillips curve
e 
un
u
Here, the “short run” is the period until people adjust their expectations of
inflation
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 Phillips
Curve upward.

   e   (u  u n )  
 2e  
 1e  
un
u
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.
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.
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.
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.
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).
The Volcker Disinflation: 1979 - 1987
Inflation Rate
(percent per year)
10
1980 1981
A
1979
8
1982
6
1984
4
B
1983
1987
1985
C
1986
2
0
1
2
3
4
5
6
7
8
9
10 Unemployment
Rate (percent)
Copyright © 2004 South-Western
The Volcker Disinflation
Inflation Rate
(percent per year)
10
1980 1981
A
1979
8
1982
6
SRPC1
1984
4
B
1983
1987
SRPC2
1985
C
1986
2
SRPC3
SRPC4
0
1
2
3
4
5
6
7
8
9
10 Unemployment
Rate (percent)
Copyright © 2004 South-Western
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.
The Greenspan Era
Inflation Rate
(percent per year)
10
8
6
1990
1991
1989
1984
1988
1985
1987
2001
1995
1992
2000
1986
1997
1994
1993
1999
2002
1998 1996
4
2
0
1
2
3
4
5
6
7
8
9
10 Unemployment
Rate (percent)
Copyright © 2004 South-Western
 Expected
explains
why there
is a
Rationalinflation
Expectations
and the Possibility
of Costless
Disinflation
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.
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.
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.
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 1981-82.
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-topopulation ratio suggest. Policy makers at the Fed may have to accept
that lower employment is the new normal.”
http://research.stlouisfed.org/fred2/series/LNU03008275
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.
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.
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 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 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