Applied Macroeconomics
Aggregate Supply and the Phillips
Curve
Eric Amoo Bondzie
In this lecture, you will learn…
Aggregate Supply and the Phillips curve
Three models of aggregate supply in which
output
depends positively on the price level in the
short run
Short-run tradeoff between inflation and
unemployment known as the Phillips curve
Practice with maths for section A in the
exam
Three models of aggregate supply
[Link] sticky-wage model
2. The imperfect-information model
[Link] sticky-price model
All three models imply:
Y Y
agg. the expected
output (P P e ) price level
a positive
natural rate the actual
of output parameter price level
The sticky-wage model
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 they set is the product of a target real
wage and the expected price level:
Targe
t real
W ω e
wage
P W P
e ω
P
The sticky-wage model
W Pe
ω
P P
If it turns out that then
Unemployment and output are
PP e
at their natural rates.
Real wage is less than its target,
PPe so firms hire more workers and
output rises above its natural rate.
Real wage exceeds its target,
PPe so firms hire fewer workers and
output falls below its natural
rate.
CHAPTER 13 Aggregate Supply slide 6
The sticky-wage model
Implies that the real wage should be
counter-cyclical, should move in the opposite
direction as output during business cycles:
This prediction does not come true in the real
world:
In booms, when P typically rises,
real wages tend to rise.
In recessions, when P typically
falls,
real wages tend to fall.
The cyclical behavior of the real wage
5
Percentage change
in real wage
1972
4
1965
3 1998
2
1982 2001
1
0
-1 1991
1990 2004 1984
-2
-3 1974
1979
-4
-5
1980
-3 -2 -1 0 1 2 3 4 5 6 7
8
Percentage change in real GDP
The imperfect-information model
Assumptions:
All wages and prices are perfectly flexible,
all markets are clear.
Each supplier produces one good, amongst many
goods.
Each supplier knows the nominal price of the good she
produces, but does not know the prices of all other
goods.
Supply of each good depends on its relative price: the
nominal price divided by the overall price level.
The imperfect-information model
Supplier does not know nominal price at the time so
makes her production decision using the expected price
level, P e.
Suppose the price level rises and supplier confuses this
with a rise in the price of their good only.
Supplier thinks her relative price has risen,
so she produces more.
With many producers thinking this way,
Y will rise whenever P rises above Pe.
Y Y (P P e )
Stupid Humans in United Kingdom
GLOBAL PRESS RELEASE 1-November-2014 | Jaime Pozuelo-Monfort
Read President Bill Clinton’s Letters to [Link] written in 2006 and 2007
There are Stupid Humans everywhere on the planet, also in
United Kingdom. Stupid Humans are greedy, selfish, jealous and
afraid: greedy to accumulate wealth and assets non-stop, selfish
to not be able to look beyond their bellies and help and assist
their neighbours, jealous to always want more than is strictly
needed, afraid to not be able to accept and tolerate other points
of view and lifestyles.
My name is [Link] and I encourage All Humans to start
dreaming and loving, to dream of a better future ahead, to love
one another as if we were all sisters and brothers belonging to
the same Human Family
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).
The sticky-price model
An individual firm’s desired price is
p P a (Y Y )
where a > 0.
Suppose two types of firms:
1. firms with flexible prices, set prices as above
2. firms with sticky prices, set prices as last periods price:
The sticky-price model
If we assume that last periods price is the expectation
of this periods price level, then for sticky firms:
pPe
To derive the aggregate supply curve, we first find an
expression for the aggregate price level.
To do this let s denote the fraction of firms
with sticky prices. Then, we can write the overall
price level as…
The sticky-price model
P s P e (1 s )[P a(Y
Y )]
price set by sticky price set by flexible
price firms price firms
Subtract (1-s)P from both sides
sP sP e
(1 s )
[a(Y Y )]
Divide both sides by s :
P P (1 s ) a (Y Y )
e s
The sticky-price model
P P
(1 s ) a (Y Y )
e s
The aggregate price is determined/driven
by
expectations and excess demand.
Finally, derive AS equation by solving for Y :
Y Y (P P e ),
s
where
(1
s )a
The sticky-price model
In contrast to the sticky-wage model, the sticky-
price model implies a pro-cyclical 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.
Summary & implications
P LRAS
Y Y (P P e
)
PPe Each of the
three models
SRAS of Agg. Supply
PP e
imply the
PPe relationship
summarized by
the SRAS curve
Y & equation.
Y
Summary & implications
Suppose a positive SRAS equation: Y Y (P P e )
AD shock moves
output above its P SRAS2
LRAS
natural rate and
SRAS1
P above the level
people had
expected. P P
e
3 P32
Over time, P P AD2
P2e
P e rises, 1
e
1
AD1
SRAS shifts up,
Y
and output returns
to its natural rate. Y2
Y 3 Y1
Y
Two causes of rising & falling prices
Cost-push inflation: (Eg: oil price shock)
price changes resulting from supply shocks.
Adverse supply shocks typically raise production
costs and induce firms to raise prices,
“pushing” inflation up.
Demand-pull inflation: (Eg: credit crunch)
prices changes resulting from demand shocks.
Negative shocks to aggregate demand causes
unemployment to rise above its natural rate,
which “pulls” the inflation rate down.
Categories of employment
Employed
Working at a paid job
Unemployed
Not employed but looking for a job
Labour force
The amount of labour available for producing goods
and services; all employed plus unemployed persons
Outside the labour force
Not employed, not looking for work
Important labour force concepts
Unemployment rate
Percentage of the labour force that is unemployed
Labour force participation rate
The fraction of the adult population
that “participates” in the labour force
Natural rate (NRH)
The long run levels of output, employment, and
unemployment described by the classical
model.
Inflation, Unemployment and the Phillips
Curve
The expectation augmented Phillips curve states that
depends on
expected inflation, e.
unemployment gap: 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.
Deriving the Phillips Curve from SRAS
(1) Y Y
(P P e ) (2) P
P e (1 )( Y
Y )
(3) P P e (1 )( Y
Y )
(4) (P P ) ( P e P )
(1 )( Y Y )
1
1
The Phillips Curve and SRAS
SRAS: Y Y (P P e )
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.
Graphing the Phillips curve
e (u u n )
1 The short-run
e Phillips curve
In the short
run, policymakers
face a tradeoff
between and u. u
un
Shifting the Phillips curve
People adjust (u u n )
their e
expectations
over time,
so the tradeoff 2e
only holds in the
short run. 1e
E.g., an increase
in e shifts the u
short-run P.C. un
upward.
Chapter Summary
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 13 Aggregate Supply slide 28
Chapter Summary
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
CHAPTER 13 Aggregate Supply slide 29
