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Chapter Thirteen1 A PowerPoint Tutorial to Accompany macroeconomics, 5th ed. N. Gregory Mankiw Mannig J. Simidian ® CHAPTER THIRTEEN Aggregate Supply

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Chapter Thirteen2 When we introduced the aggregate supply curve of chapter 9, we established that aggregate supply behaves differently in the short run than in the long run. In the long run, prices are flexible, and the aggregate supply curve is vertical. When the aggregate supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the output of the economy remains at its natural rate. By contrast, in the short run, prices are sticky, and the aggregate supply curve is not vertical. In this case, shifts in aggregate demand do cause fluctuations in output. In chapter 9, we took a simplified view of price stickiness by drawing the short-run aggregate supply curve as a horizontal line, representing the extreme situation in which all prices are fixed. So, now we’ll refine our understanding of short-run aggregate supply. When we introduced the aggregate supply curve of chapter 9, we established that aggregate supply behaves differently in the short run than in the long run. In the long run, prices are flexible, and the aggregate supply curve is vertical. When the aggregate supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the output of the economy remains at its natural rate. By contrast, in the short run, prices are sticky, and the aggregate supply curve is not vertical. In this case, shifts in aggregate demand do cause fluctuations in output. In chapter 9, we took a simplified view of price stickiness by drawing the short-run aggregate supply curve as a horizontal line, representing the extreme situation in which all prices are fixed. So, now we’ll refine our understanding of short-run aggregate supply.

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Chapter Thirteen3 Let’s now examine three prominent models of aggregate supply, roughly in the order of their development. In all the models, some market imperfection causes the output of the economy to deviate from its classical benchmark. As a result, the short-run aggregate supply curve is upward sloping, rather than vertical, and shifts in the aggregate demand curve cause the level of output to deviate temporarily from the natural rate. These temporary deviations represent the booms and busts of the business cycle. Although each of the three models takes us down a different theoretical route, each route ends up in the same place. That final destination is a short-run aggregate supply equation of the form…

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Chapter Thirteen4 Y = Y + (P-P e ) where Output Actual price level positive constant: an indicator of how much output responds to unexpected changes in the price level. Natural rate of output Expected price level This equation states that output deviates from its natural rate when the price level deviates from the expected price level. The parameter indicates how much output responds to unexpected changes in the price level, 1/ is the slope of the aggregate supply curve.

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Chapter Thirteen5 The sticky-wage model shows what a sticky nominal wage implies for aggregate supply. To preview the model, consider what happens to the amount of output produced when the price level rises: 1) When the nominal wage is stuck, a rise in the price level lowers the real wage, making labor cheaper. 2) The lower real wage induces firms to hire more labor. 3) The additional labor hired produces more output. This positive relationship between the price level and the amount of output means the aggregate supply curve slopes upward during the time when the nominal wage cannot adjust. The workers and firms set the nominal wage W based on the target real wage and on their expectation of the price level P e. The nominal wage they set is: W = P e Nominal Wage = Target Real Wage Expected Price Level

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Chapter Thirteen6 W/P = (P e /P) Real Wage=Target Real Wage (Expected Price Level/Actual Price Level) This equation shows that the real wage deviates from its target if the actual price level differs from the expected price level. When the actual price level is greater than expected, the real wage is less than its target; when the actual price level is less than expected, the real wage is greater than its target. The final assumption of the sticky-wage model is that employment is determined by the quantity of labor that firms demand. In other words, the bargain between the workers and the firms does not determine the level of employment in advance; instead, the workers agree to provide as much labor as the firms wish to buy at the predetermined wage. We describe the firms’ hiring decisions by the labor demand function: L = L d (W/P), which states that the lower the real wage, the more labor firms hire and output is determined by the production function Y = F(L).

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Chapter Thirteen7 Labor, L Y = F(L) Income, Output, Y Labor, L L = L d (W/P) Y=Y+ (P-P e ) real wage, W/P Income, Output, Y Price level, P An increase in the price level, reduces the real wage for a given nominal wage, which raises employment and output and income. An increase in the price level, reduces the real wage for a given nominal wage, which raises employment and output and income.

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Chapter Thirteen8 The second explanation for the upward slope of the short-run aggregate supply curve is called the imperfect-information model. Unlike the sticky-wage model, this model assumes that markets clear-- that is, all wages and prices are free to adjust to balance supply and demand. In this model, the short-run and long-run aggregate supply curves differ because of temporary misperceptions about prices. The imperfect-information model assumes that each supplier in the economy produces a single good and consumes many goods. Because the number of goods is so large, suppliers cannot observe all prices at all times. They monitor the prices of their own goods but not the prices of all goods they consume. Due to imperfect information, they sometimes confuse changes in the overall price level with changes in relative prices. This confusion influences decisions about how much to supply, and it leads to a positive relationship between the price level and output in the short run.

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Chapter Thirteen9 Let’s consider the decision of a single wheat producer, who earns income from selling wheat and uses this income to buy goods and services. The amount of wheat she chooses to produce depends on the price of wheat relative to the prices of other goods and services in the economy. If the relative price of wheat is high, she works hard and produces more wheat. If the relative price of wheat is low, she prefers to work less and produce less wheat. The problem is that when the farmer makes her production decision, she does not know the relative price of wheat. She knows the nominal price of wheat, but not the price of every other good in the economy. She estimates the relative price of wheat using her expectations of the overall price level. If there is a sudden increase in the price level, the farmer doesn’t know if it is a change in overall prices or just the price of wheat. Typically, she will assume that it is a relative price increase and will therefore increase the production of wheat. Most suppliers will tend to make this mistake. To sum up, the notion that output deviates from the natural rate when the price level deviates from the expected price level is captured by: Y = Y + (P-P e )

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Chapter Thirteen10 A third explanation for the upward-sloping short-run aggregate supply curve is called the sticky-price model. This model emphasizes that firms do not instantly adjust the prices they charge in response to changes in demand. Sometimes prices are set by long-term contracts between firms and consumers. To see how sticky prices can help explain an upward-sloping aggregate supply curve, first consider the pricing decisions of individual firms and then aggregate the decisions of many firms to explain the economy as a whole. We will have to relax the assumption of perfect competition whereby firms are price takers. Now they will be price setters.

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Chapter Thirteen11 Consider the pricing decision faced by a typical firm. The firm’s desired price p depends on two macroeconomic variables: 1) The overall level of prices P. A higher price level implies that the firm’s costs are higher. Hence, the higher the overall price level, the more the firm will like to charge for its product. 2) The level of aggregate income Y. A higher level of income raises the demand for the firm’s product. Because marginal cost increases at higher levels of production, the greater the demand, the higher the firm’s desired price. The firm’s desired price is: p = P + a(Y-Y) This equations states that the desired price p depends on the overall level of prices P and on the level of aggregate demand relative to its natural rate Y-Y. The parameter a (which is greater than 0) measures how much the firm’s desired price responds to the level of aggregate output.

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Chapter Thirteen12 Now assume that there are two types of firms. Some have flexible prices: they always set their prices according to this equation. Others have sticky prices: they announce their prices in advance based on what they expect economic conditions to be. Firms with sticky prices set prices according to p = P e + a(Y e - Y e ), where the superscript ‘e’ represents the expected value of a variable. For simplicity, assume these firms expect output to be at its natural rate so that the last term a(Y e - Y e ), drops out. Then these firms set price so that p = P e. That is, firms with sticky prices set their prices based on what they expect other firms to charge. We can use the pricing rules of the two groups of firms to derive the aggregate supply equation. To do this, we find the overall price level in the economy as the weighted average of the prices set by the two groups. After some manipulation, the overall price level is: P = P e + [(1-s)a/s](Y-Y)]

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Chapter Thirteen13 P = P e + [(1-s)a/s](Y-Y)] The two terms in this equation are explained as follows: 1) When firms expect a high price level, they expect high costs. Those firms that fix prices in advance set their prices high. These high prices cause the other firms to set high prices also. Hence, a high expected price level P e leads to a high actual price level P. 2) When output is high, the demand for goods is high. Those firms with flexible prices set their prices high, which leads to a high price level. The effect of output on the price level depends on the proportion of firms with flexible prices. Hence, the overall price level depends on the expected price level and on the level of output. Algebraic rearrangement puts this aggregate pricing equation into a more familiar form: where = s/[(1-s)a]. Like the other models, the sticky-price model says that the deviation of output from the natural rate is positively associated with the deviation of the price level from the expected price level. Y = Y + (P-P e )

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Chapter Thirteen14 Start at point A; the economy is at full employment Y and the actual price level is P 0. Here the actual price level equals the expected price level. Now let’s suppose we increase the price level to P 1. Since P (the actual price level) is now greater than P e (the expected price level) Y will rise above the natural rate, and we slide along the SRAS (P e =P 0 ) curve to A'. Remember that our new SRAS (P e =P 0 ) curve is defined by the presence of fixed expectations (in this case at P 0 ). So in terms of the SRAS equation, when P rises to P 1, holding P e constant at P 0, Y must rise. The “long-run” will be defined when the expected price level equals the actual price level. So, as price level expectations adjust, P e P 2, we’ll end up on a new short-run aggregate supply curve, SRAS (P e =P 2 ) at point B. Hooray! We made it back to LRAS, a situation characterized by perfect information where the actual price level (now P 2 ) equals the expected price level (also, P 2 ). Y = Y + ( P-P e ) Y = Y + (P-P e ) Y = Y + ( P- P e ) In terms of the SRAS equation, we can see that as P e catches up with P, that entire “expectations gap” disappears and we end up on the long run aggregate supply curve at full employment where Y = Y. SRAS (P e =P 2 ) B P2P2 A' Y' SRAS (P e =P 0 ) P Output A P0P0 LRAS* Y AD AD' P1P1

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Chapter Thirteen15 The Phillips curve in its modern form states that the inflation rate depends on three forces: 1) Expected inflation 2) The deviation of unemployment from the natural rate, called cyclical unemployment 3) Supply shocks These three forces are expressed in the following equation: = e n ) + Inflation Cyclical Unemployment Supply Shock Expected Inflation

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Chapter Thirteen16 The Phillips-curve equation and the short-run aggregate supply equation represent essentially the same macroeconomic ideas. Both equations show a link between real and nominal variables that causes the classical dichotomy (the theoretical separation of real and nominal variables) to break down in the short run. The Phillips curve and the aggregate supply curve are two sides of the same coin. The aggregate supply curve is more convenient when studying output and the price level, whereas the Phillips curve is more convenient when studying unemployment and inflation.

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Chapter Thirteen17 To make the Phillips curve useful for analyzing the choices facing policymakers, we need to say what determines expected inflation. A simple often plausible assumption is that people form their expectations of inflation based on recently observed inflation. This assumption is called adaptive expectations. So, expected inflation e equals last year’s inflation -1. In this case, we can write the Phillips curve as: which states that inflation depends on past inflation, cyclical unemployment, and a supply shock. When the Phillips curve is written in this form, it is sometimes called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU. The term -1 implies that inflation has inertia-- meaning that it keeps going until something acts to stop it. In the model of AD/AS, inflation inertia is interpreted as persistent upward shifts in both the aggregate supply curve and aggregate demand curve. Because the position of the SRAS will shift upwards overtime, it will continue to shift upward until something changes inflation expectations. = -1 n ) +

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Chapter Thirteen18 The second and third terms in the Phillips-curve equation show the two forces that can change the rate of inflation. The second term, (u-u n ), shows that cyclical unemployment exerts downward pressure on inflation. Low unemployment pulls the inflation rate up. This is called demand-pull inflation because high aggregate demand is responsible for this type of inflation. High unemployment pulls the inflation rate down. The parameter measures how responsive inflation is to cyclical unemployment. The third term, shows that inflation also rises and falls because of supply shocks. An adverse supply shock, such as the rise in world oil prices in the 70’s, implies a positive value of and causes inflation to rise. This is called cost-push inflation because adverse supply shocks are typically events that push up the costs of production. A beneficial supply shock, such as the oil glut that led to a fall in oil prices in the 80’s, makes negative and causes inflation to fall.

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Chapter Thirteen19 unun Unemployment, u e + In the short run, inflation and unemployment are negatively related. At any point in time, a policymaker who controls aggregate demand can choose a combination of inflation and unemployment on this short-run Phillips curve. In the short run, inflation and unemployment are negatively related. At any point in time, a policymaker who controls aggregate demand can choose a combination of inflation and unemployment on this short-run Phillips curve.

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Chapter Thirteen20 unun Unemployment, u LRPC (u=u n ) 5% 10% SRPC ( e =0%) SRPC ( e =10%) SRPC ( e =5%) D B C E Suppose there is an increase in the rate of growth of the money supply causing LM and AD to shift out resulting in an unexpected increase in inflation. The Phillips curve equation = e – (u-u n ) + v implies that the change in inflation misperceptions causes unemployment to decline. So, the economy moves to a point above full employment at point B. A As long as this inflation misperception exists, the economy will remain below its natural rate u n at u'. Let’s start at point A, a point of price stability ( =0%) and full employment (u=u n ). When the economic agents realize the new level of inflation, they will end up on a new short-run Phillips curve where expected inflation equals the new rate of inflation (5%) at point C, where actual inflation (5%) equals expected inflation (5%). Remember, each short-run Phillips curve is defined by the presence of fixed expectations. If the monetary authorities opt to obtain a lower u again, then they will increase the money supply such that is 10%, for example. The economy moves to point D, where actual inflation is 10% but, e is 5%. When expectations adjust, the economy will land on a new SRPC, at point E, where both and e equal 10%. u'u'

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Chapter Thirteen21 Rational expectations make the assumption that people optimally use all the available information about current government policies, to forecast the future. According to this theory, a change in monetary or fiscal policy will change expectations, and an evaluation of any policy change must incorporate this effect on expectations. If people do form their expectations rationally, then inflation may have less inertia than it first appears. Proponents of rational expectations argue that the short-run Phillips curve does not accurately represent the options that policymakers have available. They believe that if policy makers are credibly committed to reducing inflation, rational people will understand the commitment and lower their expectations of inflation. Inflation can then come down without a rise in unemployment and fall in output.

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Chapter Thirteen22 Our entire discussion has been based on the natural rate hypothesis. The hypothesis is summarized in the following statement: Fluctuations 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. Recently, some economists have challenged the natural-rate hypothesis by suggesting that aggregate demand may affect output and employment even in the long run. They have pointed out a number of mechanisms through which recessions might leave permanent scars on the economy by altering the natural rate of unemployment. Hyteresis is the term used to describe the long-lasting influence of history on the natural rate.

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Chapter Thirteen23 Sticky-wage model Imperfect-information model Sticky-price model Phillips curve Adaptive expectations Demand-pull inflation Cost-push inflation Sacrifice ratio Rational expectations Natural-rate hypothesis Hyteresis Sticky-wage model Imperfect-information model Sticky-price model Phillips curve Adaptive expectations Demand-pull inflation Cost-push inflation Sacrifice ratio Rational expectations Natural-rate hypothesis Hyteresis

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