Aggregate supply Eva Hromádková, 3.5 2010 0VS452 + 5EN253 Lecture 11 Slides by: Ron Cronovich Aggregate supply Eva Hromádková, 3.5 2010

Learning objectives three models of aggregate supply in which output depends positively on the price level in the short run Implication of SRAS curve: the short-run tradeoff between inflation and unemployment known as the Phillips curve

A new and improved short run AS curve Y P By now – difference between behavior of aggregate supply in the short run (price fixed) and long run (output fixed – classical theory) – 2 versions of AS curve Now – look at more “realistic” aggregate function in the short run – positive dependence on price Interpretation: a rise in price is associated with a rise in output (like in a firm) + can be explained as medium term AS – until the shock adjusts Consider a more realistic case, in between the two extreme assumptions we considered before.

Three models of aggregate supply Consider 3 stories that could give us this SRAS: 1. The sticky-wage model 2. The imperfect-information model 3. The sticky-price model agg. output natural rate of output a positive parameter the actual price level the expected price level 3 stories that would explain why higher output is associated with higher price level. Basic intuition: when price rises above what people expected, they can be induced into producing more => only unexpected movements in price cause deviations in the real economy

1. The sticky-wage model Main idea Assumes that firms and workers negotiate contracts and fix the nominal wage before they know what the price level will turn out to be. The nominal wage, W, they set is the product of a target real wage, , and the expected price level: Main idea: When nominal wage (W) is sticky, rise in price level lowers the real wage (W/P). Labor is cheaper so firms hire more and produce more. W – real wage Can be the equilibrium real wage Can be higher (due to unions, efficiency wages, etc.) Real wage = W/P is different from target real wage (w) if realized price level is different from the expected price level. Reference: Gray, J.A. (1976) – JME Fischer, S. (1977) - JPE

Other strong assumption = employment is determined by the quantity of labor that firms demand – no say from workers

1. The sticky-wage model Intuition If it turns out that then unemployment and output are at their natural rates Real wage is less than its target, so firms hire more workers and output rises above its natural rate Summary of outcomes Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate

1. The sticky-wage model Problem Implies that the real wage should be counter-cyclical , it should move in the opposite direction as output over the course of business cycles: In booms, when P typically rises, the real wage should fall. In recessions, when P typically falls, the real wage should rise. This prediction does not come true in the real world: This was initially noted by Keynes – first point of attack.

The cyclical behavior of the real wage Real world data Percentage change in real 4 1972 wage 3 1998 1965 2 1960 1997 1999 1 1996 2000 1970 1984 1982 1993 1991 1992 -1 Relation is more or less positive – think about the recent booms and behavior of wages. If real wage is cyclical, it is slightly procyclical. Main problem – unchanging labor demand curve over booms and recessions. 1990 -2 1975 -3 1979 1974 -4 1980 -5 -3 -2 -1 1 2 3 4 5 6 7 8 Percentage change in real GDP

2. The imperfect-information model Assumptions all wages and prices perfectly flexible, all markets clear each supplier produces one good, consumes many goods each supplier knows the nominal price of the good she produces, but does not know the overall price level No price or wage rigidities. Main idea: misperception about prices – consumers closely monitor price of good he produces + vaguely infers about the overall price level Misperception: change in relative prices x changes in price level

2. The imperfect-information model Main idea Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level. Supplier doesn’t know price level at the time she makes her production decision, so uses the expected price level, P e. Suppose P rises but P e does not. Then supplier thinks her relative price has risen, so she produces more. With many producers thinking this way, Y will rise whenever P rises above P e. Interesting study on the validity of this model by its inventor – Robert Lucas: comparison of countries with big volatility of aggregate demand (=> big price aggregate level price movement => consumers should have learned that =>should not respond by changes aggregate supply) and small volatility (here, the changes are mostly implied by the changes in relative prices => should generate response by changed volume of production.

3. The sticky-price model Assumptions Reasons for sticky prices: long-term contracts between firms and customers menu costs firms do not wish to annoy customers with frequent price changes Assumption: Firms set their own prices (e.g. as in monopolistic competition – firms have some power on the market) Firms do not instantly adjust prices in response to changes in demand. Assumption of price setting – departure from assumption of perfect competition.

The sticky-price model Model An individual firm’s desired price is where a > 0. Suppose two types of firms: firms with flexible prices, set prices as above firms with sticky prices must set their price before they know how P and Y will turn out: Pricing decision of individual firm: price depends on Overall level of prices P – it measures level of their costs Aggregate income: higher income => higher demand for firm’s product

The sticky-price model Model II Assume firms w/ sticky prices expect that output will equal its natural rate. Then, To derive the aggregate supply curve, we first find an expression for the overall price level. Let s denote the fraction of firms with sticky prices. Then, we can write the overall price level as S => fraction of firms with sticky prices 1-s => fraction of firms with flexible prices

The sticky-price model Model III price set by sticky price firms price set by flexible price firms Subtract (1s )P from both sides: General price level Divide both sides by s :

The sticky-price model Implications High P e  High P If firms expect high prices, then firms who must set prices in advance will set them high. Other firms respond by setting high prices. High Y  High P When income is high, the demand for goods is high. Firms with flexible prices set high prices. The greater the fraction of flexible price firms, the smaller is s and the bigger is the effect of Y on P. Effect of income on the price level is based on the existence of flexible –pricing firms. BUT we need sticky pricing firms in order to build expectation of price different than real one.

The sticky-price model AS curve Finally, derive AS equation by solving for Y :

The sticky-price model Implications In contrast to the sticky-wage model, the sticky-price model implies a procyclical real wage: Suppose aggregate output/income falls. Then, Firms see a fall in demand for their products. Firms with sticky prices reduce production, and hence reduce their demand for labor. The leftward shift in labor demand causes the real wage to fall. What happens on the labor market: Suppose recession => falling demand

Summary & implications LRAS SRAS Each of the three models of agg. supply imply the relationship summarized by the SRAS curve & equation

Summary & implications Suppose a positive AD shock moves output above its natural rate and P above the level people had expected. SRAS2 Y P LRAS AD2 SRAS1 AD1 This graph has two lessons for students: First, changes in the expected price level shift the SRAS curve (this should be clear from the equation, as should the fact that a change in the natural rate of output will shift the SRAS curve). The second lesson concerns the adjustment of the economy back to full-employment output. Over time, P e rises, SRAS shifts up, and output returns to its natural rate.

Aggregate Supply The Inflation-Unemployment Tradeoff Increases in aggregate demand causes . . . . . A trade-off between unemployment and inflation. REAL OUTPUT PRICE LEVEL UNEMPLOYMENT RATE INFLATION RATE Phillips curve Aggregate supply c C b B AD3 a A AD2 AD1 LO2

Aggregate Supply The Phillips Curve The Phillips curve = historical inverse relationship (tradeoff) between the rate of unemployment and the rate of inflation. A. W. Phillips: UK, years 1826-1957 Samuelson and Solow: USA, years 1900-1960 Now, more of a theoretical concept that captures relationship between unemployment and inflation

Phillips curve UK The Phillips curve in the UK, 1861 - 1913

Phillips curve? US

Phillips curve Theoretical introduction The Phillips curve states that  depends on expected inflation, e cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate supply shocks,  Story with AD movements – unemployment X price tradeoff - stagflation – movements of AS curve - how the Phillips curve was developed – first clear relation + then expectation and uncertainty  measures the responsiveness of inflation to cyclical unemployment. where  > 0 is an exogenous constant.

Phillips curve How to derive the Phillips Curve from SRAS Equation (1) is the SRAS equation. Solve (1) for P to get (2). To get (3), add the supply shock term to (2). To get (4), subtract last year’s price level (P-1) from both sides. To get (5), write  in place of (P- P-1) and e in place of (Pe- P-1). Note that the change in the price level is not exactly the inflation rate, unless we interpret P as the natural log of the price level. Equation (6) captures the relationship between output and unemployment from Okun’s law (chapter 2): the deviation of output from its natural rate is inversely related to cyclical unemployment. Substituting (6) into (5) gives (7), the Phillips curve equation introduced on the preceding slide.

Phillips curve The Phillips Curve and SRAS SRAS curve: output is related to unexpected movements in the price level Phillips curve: unemployment is related to unexpected movements in the inflation rate Both equations show a link between real and nominal variables that causes the classical dichotomy to break down in the short run.

Phillips curve Adaptive expectations Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation. A simple example: Expected inflation = last year’s actual inflation What determines expected inflation – how can policymakers affect it? Then, the P.C. becomes

Phillips curve Inflation inertia In this form, the Phillips curve implies that inflation has inertia: In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate. Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set. Existence of NAIRU – Non-Accelerating Inflation rate of unemployment Un – NAIRU – Non-Accelerating Inflation Rate of Unemployment Adaptive expectations No supply shocks – v No cyclical unemployment (even without external factors existence of continuous inflation => Self-fulfilling “prophecies” of inflation)

Phillips curve Two causes of rising & falling inflation demand-pull inflation: inflation resulting from demand shocks. Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up. cost-push inflation: inflation resulting from supply shocks. Adverse supply shocks typically raise production costs and induce firms to raise prices, “pushing” inflation up. Demand – pull inflation – operates through labor market = unemployment rate

Graphing the Phillips curve In the short run, policymakers face a trade-off between  and u. u  The short-run Phillips Curve Here, the “short run” is the period until people adjust their expectations of inflation. Policymaker cannot affect pi and mu

Shifting the Phillips curve People adjust their expectations over time, so the tradeoff only holds in the short run. u  E.g., an increase in e shifts the short-run P.C. upward.

Phillips curve The sacrifice ratio To reduce inflation, policymakers can contract agg. demand, causing unemployment to rise above the natural rate. The sacrifice ratio measures the percentage of a year’s real GDP that must be foregone to reduce inflation by 1 percentage point. Estimates vary, but a typical one is 5. Contraction of aggregate demand => Lower output (and GDP)

Phillips curve The sacrifice ratio II Suppose policymakers wish to reduce inflation from 6 to 2 percent. If the sacrifice ratio is 5, then reducing inflation by 4 points requires a loss of 45 = 20 percent of one year’s GDP. This could be achieved several ways, e.g. reduce GDP by 20% for one year reduce GDP by 10% for each of two years reduce GDP by 5% for each of four years The cost of disinflation is lost GDP. One could use Okun’s law to translate this cost into unemployment. Do example: Suppose Phillips curve is: pi = pie – 0.4 (u -un ) Where pie = pi(-1) and un=0.05 If want to reduce inflation from 0.06 to 0.02: 0.02 = 0.06 – 0.4(u - 0.06) so -0.04 = -0.4(u - 0.06) so 0.10 = u – 0.06 So u = 0.16 (so have to raise u by 10 %pts) Next year: pi(-1) = 0.02 0.02 = 0.02 – 0.4(u -0.06) So u = 0.06 (no need for extra unemployment)

Phillips curve Rational expectations Ways of modeling the formation of expectations: adaptive expectations: People base their expectations of future inflation on recently observed inflation. rational expectations: People base their expectations on all available information, including information about current and prospective future policies. A good example to illustrate the difference between adaptive and rational expectations. Suppose the Fed announces a shift in priorities, from maintaining low inflation to maintaining low unemployment w/o regard to inflation; this shift will start affecting policy next week. If expectations are adaptive, then expected inflation will not change, because it is based on past inflation. The Fed’s announcement pertains to the future, and has no impact on past inflation. If expectations are rational, then expected inflation will increase right away, as people factor this announcement into their forecasts.

Phillips curve Painless disinflation? Proponents of rational expectations believe that the sacrifice ratio may be very small: Suppose u = u n and  = e = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible. If the announcement is credible, then e will fall, perhaps by the full 4 points. Then,  can fall without an increase in u.

CASE STUDY The sacrifice ratio for the Volcker disinflation 1981:  = 9.7% 1985:  = 3.0% Total disinflation = 6.7% year u u n uu n 1982 9.5% 6.0% 3.5% 1983 9.5 6.0 3.5 1984 7.4 1.4 1985 7.1 1.1 Beginning of 80’s – very high inflation levels Tight monetary policy => lower aggregate demand => lower unemployment => lower inflation The natural rate of unemployment is assumed to be 6.0% during the early 1980s. Total 9.5%

CASE STUDY The sacrifice ratio for the Volcker disinflation Previous slide: inflation fell by 6.7% total of 9.5% of cyclical unemployment Okun’s law: each 1 percentage point of unemployment implies lost output of 2 percentage points. So, the 9.5% cyclical unemployment translates to 19.0% of a year’s real GDP. Sacrifice ratio = (lost GDP)/(total disinflation) = 19/6.7 = 2.8 percentage points of GDP were lost for each 1 percentage point reduction in inflation.

The natural rate hypothesis Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis: Changes 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. The natural rate hypothesis allows us to study the long run separately from the short run. Challenge = hysteresis = long-lasting effect of irregularities in AD on natural rate of unemployment Loss of skills of workers Attitudes towards work Wage-setting process : shift of market power

Chapter summary 1. Three models of aggregate supply in the short run: sticky-wage model imperfect-information model sticky-price model All three models imply that output rises above its natural rate when the price level rises above the expected price level.

Chapter summary 2. Phillips curve derived from the SRAS curve states that inflation depends on expected inflation cyclical unemployment supply shocks presents policymakers with a short-run tradeoff between inflation and unemployment