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 yield Y

3. SRAS P
LRAS
SRAS
P>Pe Y
(1/α)ΔY α
P=Pe ΔY 1
P<Pe P Y
when P=Pe

4. Theory #1: Sticky Price Model
Long term contracts
Fear of annoying customers
Costly to alter prices
Stable 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 equation
will be able to alter their prices as P and Y changes.
These are the flexible price firms. Other firms will set
their prices for a longer period and pick the expected
price when the economy is at long term equilibrium .
Suppose sticky firms are s percent of the economy
and flexible firms are (1-s).
The last equation is the same as
our 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 InformationMC P1 P0
Sticky wages
will keep MC
from shifting
left immediately. Q

10. Theory #2: Imperfect Information
If the prices are greater than expected prices, i.e.
unexpected inflation, producers will mistake the
Price rise in their own markets as higher demand
and produce more.
Again, we have an output response to higher
prices even though all the prices are increasing
because 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 a
supply shock like a change in oil prices
or economy-wide wage negotiation
that affect costs of production.
An increase in costs of production would raise P
at each level of Y: a leftward shift of SRAS. We include
that possibility as v in the
SRAS equation.

12. Phillips Curve
To 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 of
unemployment” (un) the economy is at full-employment and there is no pressure on prices.
The book’s approach (above) is
not as satisfying as the
alternative approach on the right.

13. The Slope of SRAS
If 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? P
Static Expectations
Increase production Y

14. The Slope of SRAS
If 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? P
Adaptive Expectations Y
Keep production the same

15. Phillips Curve What happens when inflationary expectations rise?π
What happens when
inflationary expectations
rise?
πe + v
What happens when there
is a negative supply shock? u un 15

16. Static Expectations You can’t fool every one all the time! IS IS LM r
Fiscal expansion under static
expectations yield higher than
full employment Y indefinitely
because the population does
not adjust its inflationary expectations. π
LRPhC AD π
SRAS
π = πe + v AD
SRPhC un U
You can’t fool every one all the time!

17. Inflation and Unemployment in the United States, 1960–200817

18. Inflation and Unemployment in the United States, 1960–2008π
’80-’83
’76-’79
’86-’93
’01-’08
’61-’69 u 18

19. Adaptive ExpectationsIS IS LM
Fiscal expansion under adaptive
expectations yield higher than
full employment Y initially but as
inflationary expectations rise, SRAS
and LM shift leftward to reach LR
equilibrium eventually. r π
LRPhC AD π
SRAS AD
SRPhC’
π = πe + v
SRPhC U un

20. Shifts in Aggregate Demand
Short run result: point B
Long run: prices rise until
expected price is equal to
the actual price: point C.
Show what happens
when AD falls. 20

21. Rational ExpectationsIS
Fiscal expansion under rational
expectations keeps the economy at
full employment Y because the
population immediately adjusts
inflationary expectations fully. IS LM r π
LRPhC AD π
SRAS AD
SRPhC
π = πe + v U un
Pangloss Solution

22. Test Question
Show static, adaptive, and rational expectations when the Central Bank increases the money supply.

23. Sacrifice Ratio
Using Okun’s Law of each one percentage point in unemployment will decrease
GDP by two percent implies that in four years US lost one-fifth of its income to
bring 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 deviation
of inflation from the target level of inflation + response
of the Fed to the GDP gap