MACROECONOMICS

Aggregate Supply
Labor Issue
Ekonomi Makro Kelas A
Week #11, 9 Mei 2022
Introduction
In previous discussion, 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
 Both models imply

Y  Y   (P  EP)
Aggregate Expected Price
output Level

A Positive
Natural Rate Of Parameter Actual Price
Output 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

1. long-term contracts between firms and customers
2. menu costs
3. firms not wishing to annoy customers with frequent price
changes
 Assumption
Firms set their own prices
(e.g., as in monopolistic competition)
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 )
 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
 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
 (1 s )a
P  EP  (Y  Y )
s
 High EP g 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 g 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
ΔY on P
 (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

1. All wages and prices are perfectly flexible,

all markets are clear
2. Each supplier produces one good, consumes
many goods
3. Each supplier knows the nominal price of the
good she produces, but does not know the
overall price level
 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 aggregate
P  EP supply imply
the relationship
P  EP summarized by
the SRAS curve
& equation
Y
Y
Suppose a positive
AD shock moves SRAS equation: Y  Y   (P  EP)
output above its
natural rate and P SRAS2
P above the level LRAS
people had SRAS1
expected

P3  EP3
P2
AD2
Over time, EP2  P1  EP1
EP rises, AD1
SRAS shifts up,
and output returns Y
to its natural rate Y2
Y3  Y1  Y
Inflation, Unemployment, the Phillips curve

The Phillips curve states that π depends on

• expected inflation, Eπ
• cyclical unemployment: the deviation of the actual
rate of unemployment from the natural rate
• supply shocks, υ (Greek letter “nu”)

  E   ( u  u )   n

where β > 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  P1 )  ( EP  P1 )  (1  )(Y  Y )  
(5)   E  (1  )(Y Y )  
(6) (1  )(Y Y )    (u  un )
(7)   E   (u  un )  
 SRAS: Y  Y   (P  EP )
Phillips curve:   E   (u  un )  

 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 year’s 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

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

u
n
u
 Shifting the Phillips curve

π   E   ( u  u n )  
People adjust
their expectations
over time,
so the tradeoff
E 2  
only holds in the
short run
E 1  
E.g., an increase
in Eπ shifts the
short-run P.C.
upward u
n
u