Presentation on theme: "MANKIW'S MACROECONOMICS MODULES"— Presentation transcript:
1MANKIW'S MACROECONOMICS MODULES MANKIW'S MACROECONOMICS MODULESCHAPTER 13Aggregate Supply and the Short-run TradeoffBetween Inflation and UnemploymentA PowerPointTutorialTo AccompanyMACROECONOMICS, 7th. EditionN. Gregory MankiwTutorial written by:Mannig J. SimidianB.A. in Economics with Distinction, Duke UniversityM.P.A., Harvard University Kennedy School of GovernmentM.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
2slope of the Aggregate Supply Curve Important notes on theslope of the Aggregate Supply CurveWhen we introduced the aggregate supply curve of Chapter 9, weestablished 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 tobetter reflect the real world in which some prices are sticky and othersare not.
3A glimpse at the Phillips curve After examining the basic theory of the short-run aggregate supply curve, we establish a key implication. We show that this curve implies a trade-off between two measures of economic performance– inflation and unemployment. This trade-off, called the Phillips curve, tells us that to reduce the rate of inflation policymakers must temporarily raise unemployment, and to reduce unemployment, they must accepthigher inflation. But, this tradeoff ispolicymakers face such a tradeoff in the short run and, why just as importantly, they do not face it in the long run.Inflation, ponly temporary. One goalof this module is to helpexplain how and whyUnemployment, u
4The Basic Theory of Aggregate Supply Let’s now look into a few prominent models of aggregate supply:Sticky-price, which is most widely accepted, and an alternative theoryImperfect-information.In all the models, some market imperfection causes the output of theeconomy to deviate from its natural level. As a result, theshort-run aggregate supply curve is upward sloping, rather thanvertical, and shifts in the aggregate demand curve cause the level ofoutput to deviate temporarily from its natural level. These temporarydeviations represent the booms and busts of the business cycle.Although these 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…
5Short-run Aggregate Supply Equation Y = Y + a(P-EP) 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 level 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.
6The Sticky-Price Model Our first 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.
7Consider 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.
8Now 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 = EP + a(EY - EY)where the capitalized “E” represents the expected value of a variable. Forsimplicity, assume these firms expect output to be at its natural rate, sothe last term a(EY - EY), drops out. Then these firms set price sothat p = EP. 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 = EP + [(1-s)a/s](Y-Y)]
9Imperfect-Information Model The third 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.
10P = EP + [(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 E 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-EP)
11An example of an asparagus farmer Explaining the Short-run Aggregate Supply Equation using Imperfect-Information ModelAn example of an asparagus farmerLet’s consider the decision of a single asparagus farmer, who earns income from selling asparagus and uses this income to buy goods and services. The amount of asparagus she chooses to produce depends on the price of asparagus relative to the prices of other goods and services in the economy. If the relative price of asparagus is high, she works hard and produces more asparagus. If the relative price of asparagus is low, she prefers to work less and produce less asparagus. The problem is that when the farmer makes her production decision, she does not know the relative price of asparagus. She knows thenominal price of asparagus, but not the price of every other good in the economy. She estimates the relative price of asparagus using her expectations of the overall price level. See next slide for the equation.
12If 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 asparagus. Typically, she will assume that it is a relative price increase and will therefore increase the production of asparagus. Most suppliers will tend to make this mistake. To sum up, the notion that output deviates from its natural level when the price level deviates from the expected price level is captured by:Y = Y + a (P - EP), a > 0Expected price levelOutputNatural level of outputPrice level
13Short-run Aggregate Supply Curve in ACTION Y = Y + a (P-EP)SRAS (EP=P2)BP2A'Y'SRAS (EP=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-EP)The “long-run” will be defined when the expected price level equals the actual price level. So, as price level expectations adjust, EPP2, we’ll end up on a new short-run aggregate supply curve, SRAS (EP=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 EP 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-EP)
14Deriving 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 = Ep - b(m-mn) + nExpectedinflationSupplyshocksInflationb Cyclicalunemployment
15The 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.
16To 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 Ep 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—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 upward overtime, it will continue to shift upward untilsomething changes inflation expectations.p = p-1 - b(m-mn) + n
17Two 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 70s, 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 the80s, makes n negative and causes inflation to fall.
18The 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.Inflation, pEp + nunUnemployment, u
19The 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 percent, for example. The economy moves to point D, where actual inflation is 10%, but, E is 5%p.BCu'When expectations adjust, the economy will land on a new SRPC, at point E, where both and E equal 10 percent.A
20Rational 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.
21Hysteresis 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.