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Chapter Thirteen1 CHAPTER 13 Aggregate Supply and the Short-run Tradeoff Between Inflation and Unemployment ® A PowerPoint Tutorial To Accompany MACROECONOMICS, 7th. Edition N. Gregory Mankiw Tutorial written by: Mannig J. Simidian B.A. in Economics with Distinction, Duke University M.P.A., Harvard University Kennedy School of Government M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management

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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 to better reflect the real world in which some prices are sticky and others are not. 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 to better reflect the real world in which some prices are sticky and others are not.

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Chapter Thirteen3 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 accept higher inflation. But, this tradeoff is policymakers face such a tradeoff in the short run and, why just as importantly, they do not face it in the long run. Inflation, Unemployment, u only temporary. One goal of this module is to help explain how and why

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Chapter Thirteen4 Let’s now look into a few prominent models of aggregate supply: Sticky-price, which is most widely accepted, and an alternative theory Imperfect-information. In all the models, some market imperfection causes the output of the economy to deviate from its natural level. 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 its natural level. These temporary deviations represent the booms and busts of the business cycle. Although these 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 Thirteen5 Y = Y + (P-EP) 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 level 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 Thirteen6 Our first 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 Thirteen7 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 Thirteen8 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 = EP + a(EY - EY) where the capitalized “E” represents the expected value of a variable. For simplicity, assume these firms expect output to be at its natural rate, so the last term a(EY - EY), drops out. Then these firms set price so that p = EP. 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 = EP + [(1-s)a/s](Y-Y)]

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Chapter Thirteen9 The third 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 Thirteen10 P = 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. 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 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-EP)

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Chapter Thirteen11 Let’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 the nominal 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.

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Chapter Thirteen12 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 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 + (P - EP), a > 0 OutputNatural level of outputPrice level Expected price level

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Chapter Thirteen13 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, EP P 2, we’ll end up on a new short-run aggregate supply curve, SRAS (EP=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-EP) Y = Y + (P-EP) Y = Y + ( P- EP) 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. SRAS (EP=P 2 ) B P2P2 A' Y'Y' SRAS (EP=P 0 ) P Output A P0P0 LRAS* Y AD AD' P1P1

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Chapter Thirteen14 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 shocks Expected inflation

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Chapter Thirteen15 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 Thirteen16 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—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 upward overtime, it will continue to shift upward until something changes inflation expectations. = -1 n ) +

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Chapter Thirteen17 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 70s, 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 80s, makes negative and causes inflation to fall.

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Chapter Thirteen18 unun Inflation, Unemployment, u + 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 Thirteen19 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 percent, for example. The economy moves to point D, where actual inflation is 10%, but, E is 5%p. When expectations adjust, the economy will land on a new SRPC, at point E, where both and E equal 10 percent. u'u'

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Chapter Thirteen20 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 Thirteen21 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 Thirteen22 Sticky-price model Sticky-wage model Imperfect-information model Phillips curve Adaptive expectations Demand-pull inflation Cost-push inflation Sacrifice ratio Rational expectations Natural-rate hypothesis Hyteresis Sticky-price model Sticky-wage model Imperfect-information model Phillips curve Adaptive expectations Demand-pull inflation Cost-push inflation Sacrifice ratio Rational expectations Natural-rate hypothesis Hyteresis

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