Presentation on theme: "mankiw's macroeconomics modules"— Presentation transcript:
1 mankiw's macroeconomics modules A PowerPointTutorialto Accompany macroeconomics, 5th ed.N. Gregory MankiwMannig J. SimidianCHAPTER THIRTEENAggregate Supply
2 When we introduced the aggregate supply curve of chapter 9, we established that aggregate supply behaves differently in the short runthan in the long run. In the long run, prices are flexible, and theaggregate supply curve is vertical. When the aggregate supply curve isvertical, shifts in the aggregate demand curve affect the price level, butthe output of the economy remains at its natural rate. By contrast, inthe short run, prices are sticky, and the aggregate supply curve is notvertical. In this case, shifts in aggregate demand do cause fluctuationsin output. In chapter 9, we took a simplified view of price stickinessby 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.
3 Three Models of Aggregate Supply Let’s now examine three prominent models of aggregate supply, roughlyin the order of their development. In all the models, some marketimperfection causes the output of the economy to deviate from itsclassical benchmark. As a result, the short-run aggregate supply curveis upward sloping, rather than vertical, and shifts in the aggregatedemand curve cause the level of output to deviate temporarily fromthe natural rate. These temporary deviations represent the booms andbusts of the business cycle.Although each of the three models takes us down a different theoreticalroute, each route ends up in the same place. That final destination is ashort-run aggregate supply equation of the form…
4 Short-run Aggregate Supply Equation Y = Y + a (P-Pe) where a > 0OutputNaturalrate of outputExpectedprice levelpositive constant:an indicator ofhow muchoutput respondsto unexpectedchanges in theprice level.Actual price levelThis equation states that output deviates from its natural rate when theprice level deviates from the expected price level. The parameter aindicates how much output responds to unexpected changes in the pricelevel, 1/a is the slope of the aggregate supply curve.
5 The Sticky-Wage ModelThe sticky-wage model shows what a sticky nominal wage implies foraggregate supply. To preview the model, consider what happens to theamount of output produced when the price level rises:1) When the nominal wage is stuck, a rise in the price level lowers thereal 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 ofoutput means the aggregate supply curve slopes upward during the timewhen the nominal wage cannot adjust.The workers and firms set the nominal wage W based on the target realwage w and on their expectation of the price level Pe. The nominal wagethey set is:W = PeNominal Wage = Target Real Wage Expected Price Level
6 W/P = (Pe/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 = Ld (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).
7 The Production Function Labor, LY = F(L)Income, Output, YL = Ld (W/P)Y=Y+a(P-Pe)The Production FunctionAggregate SupplyLabor Demandreal wage, W/PPrice level, PThe Sticky-Wage ModelAn increase in the price level,reduces the real wage for a givennominal wage, which raisesemployment and output and income.
8 Imperfect-Information Model The second explanation for the upward slope of the short-run aggregatesupply curve is called the imperfect-information model. Unlike thesticky-wage model, this model assumes that markets clear-- that is, allwages and prices are free to adjust to balance supply and demand. In thismodel, the short-run and long-run aggregate supply curves differ becauseof temporary misperceptions about prices.The imperfect-information model assumes that each supplier in theeconomy produces a single good and consumes many goods. Because thenumber of goods is so large, suppliers cannot observe all prices at alltimes. They monitor the prices of their own goods but not the prices of allgoods they consume. Due to imperfect information, they sometimesconfuse changes in the overall price level with changes in relative prices.This confusion influences decisions about how much to supply, and itleads to a positive relationship between the price level and output in theshort run.
9 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. Theamount of wheat she chooses to produce depends on the price of wheatrelative to the prices of other goods and services in the economy. If therelative 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 produceless wheat. The problem is that when the farmer makes her productiondecision, she does not know the relative price of wheat. She knows thenominal price of wheat, but not the price of every other good in theeconomy. She estimates the relative price of wheat using her expectationsof the overall price level.If there is a sudden increase in the price level, the farmer doesn’t know if itis a change in overall prices or just the price of wheat. Typically, she willassume that it is a relative price increase and will therefore increase theproduction of wheat. Most suppliers will tend to make this mistake.To sum up, the notion that output deviates from the natural rate when theprice level deviates from the expected price level is captured by:Y = Y + a(P-Pe)
10 The Sticky-Price Model A third explanation for the upward-sloping short-run aggregate supplycurve is called the sticky-price model. This model emphasizes that firmsdo not instantly adjust the prices they charge in response to changes indemand. Sometimes prices are set by long-term contracts between firmsand consumers.To see how sticky prices can help explain an upward-sloping aggregatesupply curve, first consider the pricing decisions of individual firmsand then aggregate the decisions of many firms to explain the economyas a whole. We will have to relax the assumption of perfect competitionwhereby firms are price takers. Now they will be price setters.
11 Consider the pricing decision faced by a typical firm 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.
12 Now assume that there are two types of firms Now assume that there are two types of firms. Some have flexible prices:they always set their prices according to this equation. Others have stickyprices: they announce their prices in advance based on what they expecteconomic conditions to be. Firms with sticky prices set prices according top = Pe + a(Ye - Ye),where the superscript ‘e’ represents the expected value of a variable. Forsimplicity, assume these firms expect output to be at its natural rate sothat the last term a(Ye - Ye), drops out. Then these firms set price sothat p = Pe. That is, firms with sticky prices set their prices based on whatthey expect other firms to charge.We can use the pricing rules of the two groups of firms to derive theaggregate supply equation. To do this, we find the overall price level in theeconomy as the weighted average of the prices set by the two groups.After some manipulation, the overall price level is:P = Pe + [(1-s)a/s](Y-Y)]
13 P = Pe + [(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. Thosefirms that fix prices in advance set their prices high. These high pricescause the other firms to set high prices also. Hence, a high expected pricelevel Pe leads to a high actual price level P.2) When output is high, the demand for goods is high. Those firmswith 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 firmswith flexible prices. Hence, the overall price level depends on theexpected price level and on the level of output. Algebraic rearrangementputs this aggregate pricing equation into a more familiar form:where a = s/[(1-s)a]. Like the other models, the sticky-price model saysthat the deviation of output from the natural rate is positively associatedwith the deviation of the price level from the expected price level.Y = Y + a(P-Pe)
14 Short-run Aggregate Supply Curve in ACTION Y = Y + a (P-Pe)SRAS (Pe=P2)BP2A'Y'SRAS (Pe=P0)POutputAP0LRAS*YADAD'P1Start at point A; the economy is at full employment Y and the actual price level is P0. Here the actual price level equals the expected price level. Now let’s suppose we increase the price level to P1.Since P (the actual price level) is now greater than Pe (the expected price level) Y will rise above the natural rate, and we slide along the SRAS (Pe=P0) curve to A' .Remember that our new SRAS (Pe=P0) curve is defined by the presence of fixed expectations (in this case at P0). So in terms of the SRAS equation, when P rises to P1, holding Pe constant at P0, Y must rise.Y = Y + a (P-Pe)The “long-run” will be defined when the expected price level equals the actual price level. So, as price level expectations adjust, PeP2, we’ll end up on a new short-run aggregate supply curve, SRAS (Pe=P2) at point B.Hooray! We made it back to LRAS, a situation characterized by perfect information where the actual price level (now P2) equals the expected price level (also, P2).In terms of the SRAS equation, we can see that as Pe 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.Y = Y + a (P-Pe)
15 Deriving the Phillips Curve From the Aggregate Supply Curve The Phillips curve in its modern form states that the inflation ratedepends on three forces:1) Expected inflation2) The deviation of unemployment from the natural rate, calledcyclical unemployment3) Supply shocksThese three forces are expressed in the following equation:p = pe - b(m-mn) + nExpectedInflationSupplyShockInflationb CyclicalUnemployment
16 The Phillips-curve equation and the short-run aggregate supply equation represent essentially the same macroeconomic ideas. Both equationsshow a link between real and nominal variables that causes theclassical dichotomy (the theoretical separation of real and nominalvariables) to break down in the short run.The Phillips curve and the aggregate supply curve are two sides of thesame coin. The aggregate supply curve is more convenient whenstudying output and the price level, whereas the Phillips curveis more convenient when studying unemployment and inflation.
17 To make the Phillips curve useful for analyzing the choices facing policymakers, we need to say what determines expected inflation. Asimple often plausible assumption is that people form their expectationsof inflation based on recently observed inflation. This assumption iscalled adaptive expectations. So, expected inflation pe equals last year’sinflation p-1. In this case, we can write the Phillips curve as:which states that inflation depends on past inflation, cyclicalunemployment, and a supply shock. When the Phillips curve is written inthis form, it is sometimes called the Non-Accelerating Inflation Rate ofUnemployment, or NAIRU.The term p-1 implies that inflation has inertia-- meaning that it keeps goinguntil something acts to stop it. In the model of AD/AS, inflation inertiais interpreted as persistent upward shifts in both the aggregate supplycurve and aggregate demand curve. Because the position of the SRASwill shift upwards overtime, it will continue to shift upward untilsomething changes inflation expectations.p = p-1 - b(m-mn) + n
18 Two Causes of Rising and Falling Inflation The second and third terms in the Phillips-curve equation show the twoforces that can change the rate of inflation. The second term, b(u-un),shows that cyclical unemployment exerts downward pressure on inflation.Low unemployment pulls the inflation rate up. This is calleddemand-pull inflation because high aggregate demand is responsible forthis type of inflation. High unemployment pulls the inflation rate down.The parameter b measures how responsive inflation is to cyclicalunemployment. The third term, n shows that inflation also rises and fallsbecause of supply shocks. An adverse supply shock, such as the rise inworld oil prices in the 70’s, implies a positive value of n and causesinflation to rise.This is called cost-push inflation because adverse supply shocks aretypically events that push up the costs of production. A beneficialsupply shock, such as the oil glut that led to a fall in oil prices in the80’s, makes n negative and causes inflation to fall.
19 The Short-Run Tradeoff Between Inflation and Unemployment In the short run, inflation and unemploymentare negatively related. At any point in time, apolicymaker who controls aggregate demandcan choose a combination of inflation andunemployment on this short-run Phillipscurve.ppe + nunUnemployment, u
20 The Phillips Curve in ACTION Let’s start at point A, a point of price stability (=0%) and full employment (u=un).Remember, each short-run Phillips curve is defined by the presence of fixed expectations.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 – b(u-un) + 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.As long as this inflation misperception exists, the economy willremain below its natural rate un at u'.unUnemployment, uLRPC (u=un)5%10%SRPC (e=0%)SRPC (e=10%)SRPC (e=5%)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%).DEIf 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%.BCu'When expectations adjust, the economy will land on a new SRPC, at point E, where both and e equal 10%.A
21 Rational Expectations and the Possibility of Painless Disinflation Rational expectations make the assumption that people optimally use allthe available information about current government policies, to forecastthe future. According to this theory, a change in monetary or fiscalpolicy will change expectations, and an evaluation of any policy changemust incorporate this effect on expectations. If people do form theirexpectations rationally, then inflation may have less inertia than it firstappears.Proponents of rational expectations argue that the short-run Phillipscurve does not accurately represent the options that policymakers haveavailable. They believe that if policy makers are credibly committed toreducing inflation, rational people will understand the commitment andlower their expectations of inflation. Inflation can then come downwithout a rise in unemployment and fall in output.
22 Hysteresis and the Challenge to the Natural-Rate Hypothesis 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 onlyin the short run. In the long run, the economy returns to the levels ofoutput,employment, and unemployment described by the classical model.Recently, some economists have challenged the natural-rate hypothesisby suggesting that aggregate demand may affect output and employmenteven in the long run. They have pointed out a number of mechanismsthrough which recessions might leave permanent scars on the economyby altering the natural rate of unemployment. Hyteresis is the termused to describe the long-lasting influence of history on the naturalrate.
23 Key Concepts of Ch. 13 Sticky-wage model Imperfect-information model Sticky-price modelPhillips curveAdaptive expectationsDemand-pull inflationCost-push inflationSacrifice ratioRational expectationsNatural-rate hypothesisHyteresis