Copyright 1998, R. H. Rasche Macroeconomic Models II: Supply Side

Copyright 1998, R. H. Rasche Macroeconomy - Supply Side u Supply side of Macroeconomy consists of: – Aggregate Production function relating output produced to inputs of labor and capital (machines and equipment) – Supply and demand curves in Labor Market – Labor Market equilibrium condition u Short-cut to summarize all these pieces: – Expectations Augmented Phillips Curve

Copyright 1998, R. H. Rasche Expectations Augmented Phillips Curve u Phillips thought there was a single, fixed relationship between the unemployment rate and inflation… but... u The relationship between Inflation and Unemployment is not stable! It shifts up and down as expected rate of inflation changes u p t = t-1 p t + g(U t - U Nt ) »p t = Actual Inflation » t-1 p t = Current Expected Inflation Rate »U Nt = “natural unemployment rate”

Copyright 1998, R. H. Rasche Expectations Augmented Phillips Curve: Slope u In expectational equilibrium p t = t-1 p t. Hence U- U N = 0, regardless of the value of the inflation rate. – in expectational equilibrium Phillips curve is vertical. (Long-run Phillips Curve (LP)) u Holding t-1 p t fixed, changes in unemployment rate produce changes in inflation in opposite direction (g < 0) – Short-run Phillips curve (SP) is negatively sloped)

Copyright 1998, R. H. Rasche Long-run -- Short-run Phillips Curves p UUNUN LP SP t-1 p t Long-run and Short-Run Phillips Curves intersect when actual inflation is equal to expected rate of inflation.

Copyright 1998, R. H. Rasche Actual and Forecast (AR[1]) Annual Inflation: Actual and Expected Annual Inflation AR(1),patterns

Copyright 1998, R. H. Rasche Unexpected Inflation vs Unemployment: Annual Unexpected Inflation vs Unemployment

Copyright 1998, R. H. Rasche Long-run & Short-run Phillips Curves in terms of Output (Y) p Y YNYN LP SP t-1 p t p U UNUN LP SP t-1 p t or

Copyright 1998, R. H. Rasche Changes in Expected Inflation Shift SP Curve p YYNYN LP SP t-1 p t ’ Long-run and Short- Run Phillips Curves intersect when actual inflation is equal to expected rate of inflation. When expected rate of inflation changes, the height of the SP curve at Y N is increased or decreased SP’ t-1 p t

Copyright 1998, R. H. Rasche Supply Shocks u Think of changes in Y N as “Supply Shocks” – These can result from anything that changes productivity – Also result from shifts in labor supply function u Shocks to Y n affect both LP and SP curves

Copyright 1998, R. H. Rasche Changes in Y N Shift Both LP and SP Curves p Y t-1 p t With no change in expected inflation, both SP and LP must shift when Y N changes. SP LP YNYN YN’YN’ LP’ SP’