14

Aggregate Supply and the

Short-Run Tradeoff Between
Inflation and Unemployment

MACROECONOMICS
N. Gregory Mankiw
PowerPoint ® Slides by Ron Cronovich
© 2013 Worth Publishers, all rights reserved
 IN THIS CHAPTER, YOU WILL LEARN:

 two models of aggregate supply in which output

depends positively on the price level in the short
run
 about the short-run tradeoff between inflation and
unemployment known as the Phillips curve

1
 Introduction
 In previous chapters, we assumed the price
level P was “stuck” in the short run.
 This implies a horizontal SRAS curve.
 Now, we consider two prominent models of
aggregate supply in the short run:
 Sticky-price model
 Imperfect-information model

CHAPTER 14 Aggregate Supply 2

 Introduction
 Both models imply:
Y  Y   (P  EP )
agg. expected
output price level
a positive
natural rate actual
parameter
of output price level

 Other things equal, Y and P are positively

related, so the SRAS curve is upward sloping.

CHAPTER 14 Aggregate Supply 3

 The sticky-price model
 Reasons for sticky prices:
 long-term contracts between firms and
customers
 menu costs
 firms not wishing to annoy customers with
frequent price changes
 Assumption:
 Firms set their own prices
(e.g., as in monopolistic competition).

CHAPTER 14 Aggregate Supply 4

 The sticky-price model
 An individual firm’s desired price is:
p  P  a (Y  Y )
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:
p  EP  a ( EY  EY )

CHAPTER 14 Aggregate Supply 5

 The sticky-price model
p  EP  a ( EY  EY )
 Assume sticky-price firms expect that output will
equal its natural rate. Then,
p  EP
 To derive the aggregate supply curve,
first find an expression for the overall price level.
s= fraction of firms with sticky prices.
Then, we can write the overall price level as…

CHAPTER 14 Aggregate Supply 6

 The sticky-price model
P  s[ EP ]  (1  s )[ P  a (Y  Y )]

price set by price set by

sticky-price firms flexible-price firms

 Subtract (1s)P from both sides:

sP  s[ EP ]  (1  s )[a (Y  Y )]
 Divide both sides by s:
(1 s )a
P  EP  (Y  Y )
s
CHAPTER 14 Aggregate Supply 7
 The sticky-price model
(1 s )a
P  EP  (Y  Y )
s
 High EP  High P
If firms expect high prices, then firms that 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 the effect of Y on P.

CHAPTER 14 Aggregate Supply 8

 The sticky-price model
(1 s )a
P  EP  (Y  Y )
s
 Finally, derive AS equation by solving for Y :

Y  Y   (P  EP ),
s
where    0
(1  s ) a

CHAPTER 14 Aggregate Supply 9

 The imperfect-information model
Assumptions:
 All wages and prices are perfectly flexible,
all markets are 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.

CHAPTER 14 Aggregate Supply 10

 The imperfect-information model
 Supply of each good depends on its relative
price: the nominal price of the good divided by
the overall price level.
 Supplier does not know price level at the time
she makes her production decision, so uses EP.
 Suppose P rises but EP does not.
 Supplier thinks her relative price has risen,
so she produces more.
 With many producers thinking this way,
Y will rise whenever P rises above EP.
CHAPTER 14 Aggregate Supply 11
 Summary & implications

P LRAS
Y  Y   (P  EP)

P  EP
Both models
SRAS of agg. supply
P  EP
imply the
P  EP relationship
summarized
Y by the SRAS
Y curve &
equation.

CHAPTER 14 Aggregate Supply 12

 Summary & implications

Suppose a positive SRAS equation: Y  Y   (P  EP)

AD shock moves
P SRAS2
output above its LRAS
natural rate and SRAS1
P above the level
people had P3  EP3
expected.
P2
Over time, AD2
EP2  P1  EP1
EP rises,
SRAS shifts up, AD1
and output returns Y
to its natural rate. Y2
Y3  Y1  Y
CHAPTER 14 Aggregate Supply 13
 Inflation, unemployment,
and the Phillips curve
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,  (Greek letter “nu”).

  E   (u  u )  
n

where  > 0 is an exogenous constant.

CHAPTER 14 Aggregate Supply 14

 Deriving the Phillips curve from SRAS
(1) Y  Y   (P  EP )

(2) P  EP  (1  ) (Y  Y )

(3) P  EP  (1  )(Y  Y )  

(4) (P  P1 )  ( EP  P1 )  (1  )(Y  Y )  

(5)   E  (1  ) (Y  Y )  

(6) (1  ) (Y  Y )    (u  u n )

(7)   E   (u  u n )  
CHAPTER 14 Aggregate Supply 15
 Comparing SRAS and the Phillips curve

SRAS: Y  Y   (P  EP )
Phillips curve:   E   (u  u n )  
 SRAS curve:
Output is related to
unexpected movements in the price level.
 Phillips curve:
Unemployment is related to
unexpected movements in the inflation rate.

CHAPTER 14 Aggregate Supply 16

 Adaptive expectations

 Adaptive expectations: an approach that

assumes people form their expectations of future
inflation based on recently observed inflation.
 A simple version:
Expected inflation = last year’s actual inflation
E   1
 Then, P.C. becomes
   1   (u  un )  

CHAPTER 14 Aggregate Supply 17

 Inflation inertia
   1   (u  un )  
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.

CHAPTER 14 Aggregate Supply 18

 Two causes of rising & falling inflation
   1   (u  un )  
 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:
inflation resulting from demand shocks
Positive shocks to aggregate demand cause
unemployment to fall below its natural rate,
which pulls the inflation rate up.
CHAPTER 14 Aggregate Supply 19
 Graphing the Phillips curve

In the short 
  E   (u  u n )  
run, policymakers
face a tradeoff
between  and u. 
1 The short-run
E   Phillips curve

n u
u

CHAPTER 14 Aggregate Supply 20

 Shifting the Phillips curve

People adjust

  E   (u  u n )  
their
expectations
over time,
E 2  
so the tradeoff
only holds in E 1  
the short run.

E.g., an increase
in E shifts the
u
short-run P.C. u n

upward.
CHAPTER 14 Aggregate Supply 21
 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 forgone to reduce inflation
by 1 percentage point.
 A typical estimate of the ratio is 5.

CHAPTER 14 Aggregate Supply 22

 The sacrifice ratio

 Example: To reduce inflation from 6 to 2 percent,

must sacrifice 20 percent of one year’s GDP:
GDP loss = (inflation reduction) × (sacrifice ratio)
= 4 × 5
 This loss could be incurred in one year or spread
over several, e.g., 5% loss for each of four years.
 The cost of disinflation is lost GDP.
One could use Okun’s law to translate this cost
into unemployment.

CHAPTER 14 Aggregate Supply 23

 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.

CHAPTER 14 Aggregate Supply 24

 Painless disinflation?
 Proponents of rational expectations believe
that the sacrifice ratio may be very small:
 Suppose u = un 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.
CHAPTER 14 Aggregate Supply 25
 Calculating the sacrifice ratio
for the Volcker disinflation

 1981:  = 9.7%
Total disinflation = 6.7%
1985:  = 3.0%

year u un uu n
1982 9.5% 6.0% 3.5%
1983 9.5 6.0 3.5
1984 7.4 6.0 1.4
1985 7.1 6.0 1.1

Total 9.5%
CHAPTER 14 Aggregate Supply 26
 Calculating the sacrifice ratio
for the Volcker disinflation

 From previous slide: Inflation fell by 6.7%,

total cyclical unemployment was 9.5%.
 Okun’s law:
1% of unemployment = 2% of lost output.
 Thus, 9.5% cyclical unemployment
= 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.
CHAPTER 14 Aggregate Supply 27
 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 (Chaps. 3–9).

CHAPTER 14 Aggregate Supply 28

 An alternative hypothesis: Hysteresis

 Hysteresis: the long-lasting influence of history

on variables such as the natural rate of
unemployment.
 Negative shocks may increase un,
so economy may not fully recover.

CHAPTER 14 Aggregate Supply 29

 Hysteresis: Why negative shocks
may increase the natural rate
 The skills of cyclically unemployed workers may
deteriorate while unemployed, and they may not
find a job when the recession ends.
 Cyclically unemployed workers may lose
their influence on wage setting;
then, insiders (employed workers)
may bargain for higher wages for themselves.
Result: The cyclically unemployed “outsiders”
may become structurally unemployed when the
recession ends.
CHAPTER 14 Aggregate Supply 30
 CHAPTER SUMMARY

1. Two models of aggregate supply in the short run:

 sticky-price model
 imperfect-information model
Both models imply that output rises above its natural
rate when the price level rises above the expected
price level.

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 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

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 CHAPTER SUMMARY

3. How people form expectations of inflation

 adaptive expectations
 based on recently observed inflation
 implies “inertia”
 rational expectations
 based on all available information
 implies that disinflation may be painless

33
 CHAPTER SUMMARY

4. The natural rate hypothesis and hysteresis

 the natural rate hypotheses
 states that changes in aggregate demand can
affect output and employment only in the short
run
 hysteresis
 states that aggregate demand can have
permanent effects on output and employment

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