Chapter 13 Short Run Aggregate Supply CurveIntroductionIntroductionThe sticky-price modelThe sticky-price modelThe sticky-price modelThe sticky-price modelThe sticky-price modelThe sticky-price modelThe imperfect-information modelThe imperfect-information modelEmpirical EvidenceSummary & implicationsSummary & implicationsInflation, Unemployment, and the Phillips CurveComparing SRAS and the Phillips CurveAdaptive and Rational expectations Adaptive expectationsInflation inertiaTwo causes of rising & falling inflationGraphing the Phillips curveShifting the Phillips curveSlide Number 23The sacrifice ratioThe sacrifice ratioRational expectations Painless disinflation?Calculating the sacrifice ratio for the Volcker disinflationCalculating the sacrifice ratio for the Volcker disinflationThe natural rate hypothesisAn alternative hypothesis: HysteresisHysteresis: Why negative shocks may increase the natural rateChapter SummaryChapter SummaryChapter SummaryChapter SummaryChapter 13 Short Run Aggregate Supply Curve  two models of aggregate supply in which output depends positively on the price level in the short run  about the short-run tradeoff between inflation and unemployment known as the Phillips curve1 CHAPTER 13 Aggregate Supply Introduction  In previous chapters, we assumed the price level P was “stuck” in the short run.  This implies a horizontal SRAS curve.  Now, we consider two prominent models of aggregate supply in the short run:  Sticky-price model (Markets not clear)  Imperfect-information model (Markets clear)2 CHAPTER 13 Aggregate Supply Introduction  Both models imply: ()Y Y P EPα=+−natural rate of output a positive parameter expected price level actual price level agg. output  Other things equal, Y and P are positively related, so the SRAS curve is upward-sloping. (intersection with Y-axis)3 CHAPTER 13 Aggregate Supply 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:  Firms set their own prices (e.g., as in monopolistic competition).4 CHAPTER 13 Aggregate Supply The 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 PaYY=+−()=p EP5 CHAPTER 13 Aggregate Supply 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…6 CHAPTER 13 Aggregate Supply The sticky-price model  Subtract (1−s)P from both sides: price set by flexible price firms price set by sticky price firms  Divide both sides by s : 1= +− + −[ ] ( )[ ( )]P sEP sPaYY1= +− −[ ] ( )[ ( )]sP s EP s a Y Y1−=+−()()saP EP Y Ys7 CHAPTER 13 Aggregate Supply The sticky-price model  High EP leads to High P If firms expect high prices, then firms that must set prices in advance will set them high. Other firms respond by setting high prices.  High Y leads to 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 deviation of Y on P. 1−=+−()()saP EP Y Ys8 CHAPTER 13 Aggregate Supply The sticky-price model  Finally, derive AS equation by solving for Y : ( ),Y Y P EPα=+−01= >−ssawhere ()α1−=+−()()saP EP Y Ys9 CHAPTER 13 Aggregate Supply The imperfect-information model Assumptions:  All wages and prices are perfectly flexible, all markets are 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.10 CHAPTER 13 Aggregate Supply The 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 does not know price level at the time she makes her production decision, so uses EP.  Suppose P rises but EP does not.  Supplier thinks her relative price has risen, so she produces more.  With many producers thinking this way, Y will rise whenever P rises above EP.11 CHAPTER 13 Aggregate Supply Empirical Evidence  Imperfect information model predicts Changes in aggregate demand have the biggest effect on output in those countries where aggregate demand and prices are most stable (Only surprises work!)  Sticky price model predicts A high rate of inflation should make the short-run aggregate supply curve steeper.12 CHAPTER 13 Aggregate Supply Summary & implications Both models of agg. supply imply the relationship summarized by the SRAS curve & equation. Y P LRAS YSRAS ()Y Y P EPα=+−P EP=P EP>P EP<13 CHAPTER 13 Aggregate Supply Summary & implications Suppose a positive AD shock moves output above its natural rate and P above the level people had expected. Y P LRAS SRAS1 SRAS equation: ()Y Y P EPα=+−11P EP=AD1 AD2 2EP =2P33P EP=Over time, EP rises, SRAS shifts up, and output returns to its natural rate. 1YY=2Y3Y =SRAS214 CHAPTER 13 Aggregate Supply Inflation, Unemployment, and the Phillips Curve The Phillips curve states that π depends on  expected inflation, Eπ.  cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate  supply shocks, ν (Greek letter “nu”). ()nE uuπ πβ ν= − −+where β > 0 is an exogenous constant.15 CHAPTER 13 Aggregate Supply Comparing SRAS and the Phillips Curve  SRAS curve: Output is related to unexpected movements in the price level.  Phillips curve: Unemployment is related to unexpected movements in the inflation rate. Y Y P EPα=+−SRAS: ( )()nE uuπ πβ ν= − −+Phillips curve:16 CHAPTER 13 Aggregate Supply Adaptive and Rational expectations Ways of modeling the formation of expectations affect the slope of the Phillips curve:  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.17 CHAPTER 13 Aggregate