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Chapter 13: Aggregate Supply. The Model The relationship between production of goods and services and the general price level Y = Y + α (P – P e ) Where.

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Presentation on theme: "Chapter 13: Aggregate Supply. The Model The relationship between production of goods and services and the general price level Y = Y + α (P – P e ) Where."— Presentation transcript:

1 Chapter 13: Aggregate Supply

2 The Model The relationship between production of goods and services and the general price level Y = Y + α (P – P e ) Where –Y = actual level of output –Y = full-employment level of output –P = actual price level –P e = expected price level

3 Aggregate Supply Output, Income Price level Short-run AS where P > or < P e Y Long-run AS where P = P e P

4 Sticky Wage Model Nominal wages are sticky downward. They adjust to price changes slowly. Demand for Labor: L d = L(W/P) Production Function: Y = F(L,K) As price (P) increases, the real wage (W/P) falls, firms respond by hiring more labor (L) and producing more output (Y).

5 Sticky Wage Model W/P 1 W/P2 Labor Real Wage Ld Output Labor L1L1 L1L1 L2L2 L2 Y1Y1 Y2 Output Price Y1Y1 Y2 P1P1 P2 Short-run AS Y

6 Workers Misperception Model Workers confuse nominal “wage” changes with “real” wage changes when the price level changes unexpectedly Demand for Labor: L d = L(W/P) Supply for Labor: L s = L(W/P e ) Write the “expected” real wage as W/P e = W/P * P/P e As P increases, W/P declines but P/P e increases. Workers confuse the real wage decline with a nominal wage increase, hence supplying more labor services

7 Workers Misperception Model Real Wage Labor LdLd W/P1 L1 Ls 1 Ls 2 W/P2 L2 Output Price Short-run AS P1P1 P2P2 Y1Y1 Y2

8 Imperfect Information Model Firms track price changes of their own product more closely than changes of the general price level. Perceptions of an increase in the “relative” price level causes the labor demand, employment, and output to rise. Let P W = price of wheat and P = general price level. With inflation, farmers perceive P w /P is increased, hence hiring more labor and producing more output

9 Imperfect Information Model W/P 1 W/P2 Labor Real Wage Ld1 Output Labor L1L1 L1L1 L2L2 L2 Y1Y1 Y2 Output Price Y1Y1 Y2 P W1 P W2 Short-run AS Y Ld2 Ls

10 Sticky Price Model Two kinds of firms: –Flexible-price firms: those with market power to adjust their prices in response to market changes p = P + α (Y – Y) –Fixed-price firms: those with no market power, hence unable to adjust their prices p = P e

11 Sticky Price Model The general price level is the “weighted” average price charged by the flexible-price and fixed-price firms P = s P e + (1- s )[P + α (Y – Y)] Here s is the market share of the fixed-price firms and ( 1-s ) is the market share of the flexible-price firms

12 Sticky Price Model The aggregate supply curve is: Y = Y + α’ (P – P e ) Where α’ = s / α(1-s)

13 Shift in Aggregate Demand Assume the AD rises due to greater expenditures in the economy, increasing the level of price and output. People adjust their expectations for higher prices. A higher expected price level results in a lower expected real wage. The supply of labor declines, reducing the AS and the level of output. Long-run equilibrium is achieved at the natural level of output, but a higher price level

14 Shift in Aggregate Demand Output, Income Price level Y P1P1 AD 1 AD 2 P2P2 Y1Y1 SRAS 1 SRAS 2 P3P3 Long-run AS A B C

15 The Phillips Curve The relationship between inflation rate and unemployment rate, In the short-run: π = π* - β(u- u*) + v π = actual inflation rate π* = expected inflation rate u = actual unemployment rate u* = natural unemployment rate v = cost-push factor β = the output adjustment factor

16 The Phillips Curve There is a “trade-off” between inflation and unemployment In the long-run, u = u* and v = 0, so π = π*: no trade-off between inflation and unemployment Stagflation is depicted by a shift of the Phillips Curve, resulting in higher unemployment and inflation

17 Shift of the Phillips Curve Unemployment Rate Inflation Rate π2π2 π1π1 u2u2 u1u1 P1P1 P2P2 A B


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