Slide 0Learning objectivesA new and improved short run AS curveThree models of aggregate supplyThe sticky-wage modelSlide 6Slide 6Slide 8The cyclical behavior of the real wageThe imperfect-information modelSlide 11The sticky-price modelSlide 13Slide 14Slide 15Slide 16Slide 17Slide 18Summary & implicationsSlide 20Inflation, Unemployment, and the Phillips CurveDeriving the Phillips Curve from SRASThe Phillips Curve and SRASAdaptive expectationsInflation inertiaTwo causes of rising & falling inflationGraphing the Phillips curveShifting the Phillips curveThe sacrifice ratioSlide 30Rational expectationsPainless disinflation?The sacrifice ratio for the Volcker disinflationSlide 34The natural rate hypothesisChapter summarySlide 37macroeconomics fifth editionN. Gregory MankiwPowerPoint® Slides by Ron Cronovichmacro © 2002 Worth Publishers, all rights reservedTopic 11:Aggregate Supply(Chapter 13)CHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 2Learning objectivesLearning 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 curveCHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 3A new and improved short run AS curveA new and improved short run AS curveY P= + =( )Y Y P Pa= LRAS:Y Y= old SRAS:P Pnew SRASConsider a more realistic case, in between the two extreme assumptions we considered before.CHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 4Three models of aggregate supplyThree models of aggregate supplyConsider 3 stories that could give us this SRAS: 1. The sticky-wage model2. The imperfect-information model3. The sticky-price model( )eY Y P P= + -anatural rate of outputa positive parameterthe expected price levelthe actual price levelagg. outputCHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 5The sticky-wage modelThe 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:eWω P= �eW PωP P� = �CHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 6The sticky-wage modelThe sticky-wage modelIf it turns out thateW PωP P= �eP P=eP P>eP P<thenunemployment and output are at their natural ratesReal wage is less than its target, so firms hire more workers and output rises above its natural rateReal wage exceeds its target, so firms hire fewer workers and output falls below its natural rateCHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 7Real wage, W/PIncome, output, YPrice level, PIncome, output, YLabor, L Labor, LW/P1W/P2L 5 Ld(W/P)L2L1Y2Y1Y 5 F(L)L2L1P2P1Y 5 Y 1 a(P 2 P e)Y2Y11. An increase in the price level . .3. ...which raises employment, . .4. ... output, . .5. ... and income.2. .. . reduces the real wage for a given nominal wage, . .6. The aggregatesupply curvesummarizes these changes.(a) Labor Demand (b) Production Function(c) Aggregate SupplyCHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 8The sticky-wage modelThe sticky-wage modelImplies that the real wage should be counter-cyclical , it should move in the opposite direction as output over the course of business cycles:–In booms, when P typically rises, the real wage should fall. –In recessions, when P typically falls, the real wage should rise. This prediction does not come true in the real world:CHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 9The cyclical behavior of the real wageThe cyclical behavior of the real wagePercentage change in realwagePercentage change in real GDP1982197519931992196019961999199719981979197019801991197419901984200019721965-3 -2 -1 0 1 2 3 7 86544 3 2 1 0 -1 -2-3 -4 -5CHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 10The imperfect-information modelThe imperfect-information modelAssumptions: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 levelCHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 11The imperfect-information modelThe imperfect-information modelSupply of each good depends on its relative price: the nominal price of the good divided by the overall price level.Supplier doesn’t know price level at the time she makes her production decision, so uses the expected price level, P e. Suppose P rises but P e does not. Then supplier thinks her relative price has risen, so she produces more. With many producers thinking this way, Y will rise whenever P rises above P e.CHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 12The sticky-price modelThe 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 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 13The sticky-price modelThe sticky-price modelAn individual firm’s desired price is 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 Y Y= + -a( )e e ep P Y Y= + -aCHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 14The sticky-price modelThe sticky-price modelAssume firms w/ sticky prices expect that output will equal its natural rate. Then,( )e e ep P Y Y= + -aep P=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 asCHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 15The sticky-price modelThe sticky-price modelSubtract (1s )P from both sides:(1 )[ ( )]eP s P s P Y Y= + - + -aprice set by flexible price firmsprice set by sticky price firms(1 )[ ( )]esP s P s Y Y= + - -aDivide both sides by s :(1 )( )esP P Y Ys-� �= + -� �� �aCHAPTER 13CHAPTER 13 Aggregate Supply Aggregate Supplyslide 16The sticky-price modelThe sticky-price modelHigh P e  High PIf firms expect high prices, then firms who must set prices in advance will set