Chapter 14: Aggregate Supply and the

Short-run Tradeoff between Inflation

and Unemployment

Lingnan (University) College

Sun Yat-sen University
 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
 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.
 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 firms 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 )
 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
 The sticky-price model
P s[ EP ] (1 s )[ P a(Y Y )]

price set by sticky price set by flexible

price firms price firms

Subtract (1s)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
 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 is the effect of Y
on P.
 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
 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.
 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.
 Summary & implications

P LRAS
Y Y (P EP)

P EP
Both models of
SRAS agg. supply
P EP imply the
relationship
P EP
summarized by
the SRAS curve
Y
Y & equation.
 Summary & implications
Suppose a positive AD SRAS equation: Y Y (P EP)
shock moves output
P SRAS2
above its natural rate LRAS
and SRAS1
P above the level
people had expected.
P3 EP3
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
 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.

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 P1 ) ( EP P1 ) (1 )(Y Y )

(5) E (1 )(Y Y )

(6) (1 )(Y Y ) (u un )

(7) E ( u u n )
 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.
 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 years actual inflation

E 1
Then, P.C. becomes
1 (u un )
 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.
 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.
 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
 Shifting the Phillips curve
People adjust

E ( u u n )
their
expectations
over time,
so the tradeoff E 2
only holds in the E 1
short run.

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

upward.
 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 years real GDP
that must be foregone to reduce inflation
by 1 percentage point.
A typical estimate of the ratio is 5.
 The sacrifice ratio
Example: To reduce inflation from 6 to 2 percent, must
sacrifice 20 percent of one years GDP:
GDP loss = (inflation reduction) x (sacrifice ratio)
= 4 x 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 Okuns law to translate this cost into
unemployment.
 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.
 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.
 Calculating the sacrifice ratio
for the Volcker disinflation
1981: = 9.7%
Total disinflation = 6.7%
1985: = 3.0%

year u un uu 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%
 Calculating the sacrifice ratio
for the Volcker disinflation
From previous slide: Inflation fell by 6.7%,
total cyclical unemployment was 9.5%.
Okuns law:
1% of unemployment = 2% of lost output.
So, 9.5% cyclical unemployment
= 19.0% of a years 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 (Chaps. 3-8).
 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.
 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 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.
 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
 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
 CHAPTER SUMMARY

4. The natural rate hypothesis and hysteresis

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