Presentation on theme: "MACROECONOMICS Chapter 13"— Presentation transcript:
1 MACROECONOMICS Chapter 13 Aggregate Supply and the Short Run Tradeoff Between Inflation and Unemployment
2 Short-Run Aggregate Supply We assumed all prices were sticky together and they all moved together for long-run adjustment.Now we will entertain two theories to modify the SRAS curves.Both will yieldY
4 Theory #1: Sticky Price Model Long term contractsFear of annoying customersCostly to alter pricesStable wages (stable costs of production)
5 Theory #1: Sticky Price Model Monopolistic competition models have price determination for firms as MC + premium where the more elastic is the demand curve for the firm, the lower is the premium.If MC responds to the overall price level P and premium responds to higher GDP (more GDP, more demand), then the firm will determine its price, p, according to
6 Theory #1: Sticky Price Model Those firms that will follow the equationwill be able to alter their prices as P and Y changes.These are the flexible price firms. Other firms will settheir prices for a longer period and pick the expectedprice when the economy is at long term equilibrium .Suppose sticky firms are s percent of the economyand flexible firms are (1-s).The last equation is the same asour new SRAS curve.
7 Theory #2: Imperfect Information No need to assume monopolistic competition.Markets clear but temporary misperceptions about prices in other markets than their own separate LRAS and SRAS.They know their own costs. They know their own market with their competitors.They do not know if the price increases in their market are because of inflation or demand increase.
8 Theory #2: Imperfect Information If you see prices for your product is increasing, you better increase production even if MC is rising because it will yield higher profits.More work, more output, more GDP!If the price rise was because of inflation and you increased production, eventually you will realize that there is no extra demand and you will come back to original output.This is true for every producer.
9 Theory #2: Imperfect Information MCP1P0Sticky wageswill keep MCfrom shiftingleft immediately.Q
10 Theory #2: Imperfect Information If the prices are greater than expected prices, i.e.unexpected inflation, producers will mistake thePrice rise in their own markets as higher demandand produce more.Again, we have an output response to higherprices even though all the prices are increasingbecause people do not have perfect information.
11 Supply Shock This specification came from tracing the impact of AD shift on Y and P.What if Y and P were to respond to asupply shock like a change in oil pricesor economy-wide wage negotiationthat affect costs of production.An increase in costs of production would raise Pat each level of Y: a leftward shift of SRAS. We includethat possibility as v in theSRAS equation.
12 Phillips CurveTo go from GDP to unemployment rate, we can use the Okun approach:a two percentage deviation of GDP from full-employment Y will affect the cyclical unemployment rate by one percentage point. At “natural rate ofunemployment” (un) the economy is at full-employment and there is no pressure on prices.The book’s approach (above) isnot as satisfying as thealternative approach on the right.
13 The Slope of SRASIf one lived in a society where inflation was rare, and one saw an increase in the price of her market, what would be her reaction?Increase production;Keep production the same?PStatic ExpectationsIncrease productionY
14 The Slope of SRASIf one lived in a society where inflation was a common occurrence, and one saw an increase in the price of the product one was supplying, what would be the reaction?Increase production;Keep production the same?PAdaptive ExpectationsYKeep production the same
15 Phillips Curve What happens when inflationary expectations rise? πWhat happens wheninflationary expectationsrise?πe + vWhat happens when thereis a negative supply shock?uun15
16 Static Expectations You can’t fool every one all the time! IS IS LM r Fiscal expansion under staticexpectations yield higher thanfull employment Y indefinitelybecause the population doesnot adjust its inflationary expectations.πLRPhCADπSRASπ = πe + vADSRPhCunUYou can’t fool every one all the time!
17 Inflation and Unemployment in the United States, 1960–2008 17
18 Inflation and Unemployment in the United States, 1960–2008 π’80-’83’76-’79’86-’93’01-’08’61-’69u18
19 Adaptive Expectations ISISLMFiscal expansion under adaptiveexpectations yield higher thanfull employment Y initially but asinflationary expectations rise, SRASand LM shift leftward to reach LRequilibrium eventually.rπLRPhCADπSRASADSRPhC’π = πe + vSRPhCUun
20 Shifts in Aggregate Demand Short run result: point BLong run: prices rise untilexpected price is equal tothe actual price: point C.Show what happenswhen AD falls.20
21 Rational Expectations ISFiscal expansion under rationalexpectations keeps the economy atfull employment Y because thepopulation immediately adjustsinflationary expectations fully.ISLMrπLRPhCADπSRASADSRPhCπ = πe + vUunPangloss Solution
22 Test QuestionShow static, adaptive, and rational expectations when the Central Bank increases the money supply.
23 Sacrifice RatioUsing Okun’s Law of each one percentage point in unemployment will decreaseGDP by two percent implies that in four years US lost one-fifth of its income tobring inflation down. This may or may not include the lost work skills.23
24 Taylor Rule Nominal federal funds rate = current inflation + “natural” real rate of interest + response of the Fed to the deviationof inflation from the target level of inflation + responseof the Fed to the GDP gap