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 – Pe)
Where
Y = actual level of output
Y = full-employment level of output
P = actual price level
Pe = expected price level

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

4. Sticky Wage Model
Nominal wages are sticky downward. They adjust to price changes slowly.
Demand for Labor: Ld = 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 Y Short-run AS Real Wage Output Y1 Y2 W/P1 W/P2 Ld
Labor
Labor L1 L2 L1 L2
Price
Short-run AS P2 P1
Output Y1 Y2

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

7. Workers Misperception Model
Real Wage
Price
Ls1
Short-run AS
Ls2 P2
W/P1 P1
W/P2 Ld
Output
Labor L1 L2 Y1 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 PW = price of wheat and P = general price level. With inflation, farmers perceive Pw/P is increased, hence hiring more labor and producing more output

9. Imperfect Information Model
Real Wage
Output Ls Y1 Y Y2
W/P2
W/P1
Ld2
Ld1
Labor
Labor L1 L2 L1 L2
Price
Short-run AS
PW2
PW1
Output Y1 Y2

10. Sticky Price Model Two kinds of firms: p = Pe
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 = Pe

11. P = sPe + (1-s)[P + α (Y – Y)]
Sticky Price Model
The general price level is the “weighted” average price charged by the flexible-price and fixed-price firms
P = sPe + (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 – Pe)
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
Price level
Long-run AS
SRAS2
SRAS1 C P3 P2 B P1 A
AD2
AD1 Y Y1
Output, Income

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
Inflation Rate π2 B P2 π1 A P1 u2 u1
Unemployment Rate