THE NEW KEYNESIAN

MACROECONOMICS: AGGREGATE SUPPLY

Main feature:
The degree to which prices are determined in
advance and its consequence for the output-
inflation trade-off.
I - Households
(Differentiated products and Money in the Utility
Function):
Max
0
0
( ; ) ( ; ) ( ( ); )
n
t t
o t t t t t
t t
M
E u C h j dj
P

1
+
1
]

s.t.


+
+ + + + +

n
t t
n
t
t t t
t
t t t
t
t t t t t t t
dj j dj j h j w
B i B B i f B M M T P C P
0 0
1 1
1
* *
1 , 1
*
1
) ( ) ( ) (
) 1 ( ) 1 (
B
t
= bond holdings at the end of date t
(denominated in the domestic currency)
B
t
*
= bond holdings at the end of date t
(denominated in the foreign currency)
M
t
= money holdings at the end of date t
P
t
= aggregate domestic price level
C
t
= consumption index
h
t
(j) = supply of labor of type j by the
representative individual
w
t
(j) = Nominal wage rate of labor of type j
1
i
t
* = world interest rate

t
(j) = Nominal profit of firm j (domestic)

t
= exchange rate in period t
T
t
= government lump-sum transfers

t
= preference shock
f
t,t+1
= forward exchange rate (the price paid in
period t in terms of domestic currency, of one unit
foreign currency to be delivered in period t+1)
Interest parity (can be obtained by obtaining the FOC
with respect to B
t
and B
t
*
, without borrowing
constraints of any kind, and then dividing one FOC by
the other) :
t
t t
t t
f
i i

1 , *
) 1 ( 1
+
+ +

There is a constant elasticity of substitution between
any two goods in the economy. C
t
is a composite of all
these goods.
1
0
1
1
*
1
) ( ) (


1
]
1

n
n
t t t
dj j c dj j c C
c
t
= goods produced at home
c
t
*
= goods produced abroad (imports)
Corresponding price index (the minimum expenditure
that buys one unit of the consumption index):

1
]
1

+

1
1
0
1
1 * 1
)) ( ( ) (
n
n
t t t t
dj j p dj j p P
2
p
t
(j) = price of domestic good j (in domestic
currency)
p
t
*(j) = price of foreign good j (in foreign
currency)
[The assumption is that the law of one price (PPP)
prevails,
1
1
1
1 1 1
1 * 1 * 1 * 1
0 0
1
( ) ( ) ( ) ( )
n n
t t t t t t t t t
n n
t
P p j dj p j dj P p j dj p j dj

1
1
+ +
1
1
]
]

1
]
1

+
1
]
1

+


1
1
1
1 *
0
1 *
1
1
1
1 *
0
1
) ( )) (
1
(
)) ( ( ) (
n
t
n
t
t
t t
n
t t
n
t t
dj j p dj j p P
dj j p dj j p P
Taking a log approximation (where a hat (^) over a
variable indicates log deviation from steady state)
yields:
t t n P

) 1 (
3
A one percent movement in the exchange rate
will have an effect on domestic consumers
prices equal to the share of imports in
consumption.
Introduction of non-traded goods would allow
for deviations from PPP. Alternatively, a
fraction of firms set prices in the buyers
currency, or Local Currency Pricing (LCP).
Accordingly, let s represent the fraction of
foreign firms who set prices in domestic
currency and use
p
to indicate that a price is
fixed, we have:

+

1
]
1

+
1
]
1

+ +


1
1
1
1 *
0
1 * *
1
1
1
) 1 (
1 *
0
) 1 (
1 * 1
) ( ) (
)} ( { ) ( ) (
n
t
n
t t t t
s n n
t t
n s n n
n
t t t
dj j p dj j p P
dj j p dj j p dj j p P
4
It is useful to compare the case s=0, full
Producers Currency Pricing (PCP, which
amounts to PPP), with LCP. If PPP prevails
there is full pass through of exchange rate
movements to import prices.
t t n P

) 1 ( .
Whereas, if LCP prevails,

t t s n n P

+ )) ) 1 ( ( 1 ( .
That is, the degree of Pass Through is
lessened. ]
Now lets go back to the PPP assumption.
The First-Order Conditions
5
Labor:

) ( ) ); ( ( j w j h v
t t t t h

Consumption:
t t t t c
P C u ) ; (
= Lagrange multiplier

Substituting for
t
:
t
t
t t c
t t h
P
j w
C u
j h ) (
) ; (
) ); ( (

(1) (labor supply)
The First-Order Inter-temporal Condition:
1 1 1
) 1 (
) ; (
) ; (
+ + +
+
t t
t
t
t t c t
t t c
P E
P
i
C u E
C u

) ( ) 1 (
) ; (
) ; (
1 1 1 + + +
+
t
t
t t
t t c t
t t c
P
P
E i
C u E
C u

(2) (consumption-saving
choice)
The Fisher equation:
) 1 (
) ; (
) ; (
1 1
t
t t c t
t t c
r
C u E
C u
+
+ +

=>
1
) 1 (
1
1
1
+
+
+
+
+
t t
t
t
t
t
t
P E
P
i
i
r

) ( ) 1 (
1
1
1
1 +
+
+
+
+
t
t
t t
t
t
t
P
P
E i
i
r

Demand for a variety:

t
t
t
t
C
P
j p
j c

,
_

) (
) (
(Dixit-Stiglitz demand for good j)
6
Government budget:

t
t t
t
P
M M
T
1
0

+
(Government income, seigniorage:
t
t t
P
M M
1

,
is rebated to the public in the form of a lump sum
transfer T
t
).
II Producers
( ) ) ( ) ( j h f A j y
t t t

(The production function)
A
t
= random productivity shock
Variable cost of supplying:

,
_

t
t
t t t
A
j y
f j w j h j w
) (
) ( ) ( ) (
1
Nominal Marginal cost:
t t
t
t
t
t t
t
A A
j y
f j w
j y
j h j w
j x
1 ) (
) (
) (
)) ( ) ( (
) (
'
1

,
_

Real marginal cost:
t t t
t
t
t
t
t
P A A
j y
f j w
P
j x
j s
1 ) (
) (
) (
) (
'
1

,
_

(3)
7
Substituting (3) in (1) and assuming a symmetric
equilibrium (dropping the index j because of the
symmetry assumption):
t t
t
t t c
t t h
t
A A
y
f
C u
h
s
1
) ; (
) ; ( '
1

,
_

=>
t t
t
t t c
t t t h
t t t t t
A A
y
f
C u
A y f
A C y s
1
) ; (
) ); / ( (
) , ; , (
'
1
1

,
_

World demand for the firm j product:

W H F H F
t t t t t
Y Y Y C C + +
An index for all the goods produced around the world.
Producer j demand function:

,
_

t
t W
t t
P
j p
Y j y
) (
) (

8
III. The Labor Market
The market for each type of goods-specific skill of
labor service is characterized by workers as wage-
takers and producers as wage-makers, as in the
monopsony case.
Figure 1 describes equilibrium in one such market.
The downward-sloping, marginal-productivity curve,
is the demand for labor. Labor supply is implicitly
determined by the utility-maximizing condition for h.
The upward-sloping marginal factor cost curve is the
marginal cost change from the producer point of view.
It lies above the supply curve because, in order to elicit
more hours of work, the producer has to offer a higher
wage not only to that (marginal) hour but also to all the
(intra-marginal) existing hours. Equilibrium
employment occurs at a point where the marginal factor
costs is equal to the marginal productivity (point A).
Equilibrium wage is shown at point B, with the
9
worker's real wage marked down below her marginal
product by a distance AB.
1
Full employment obtains because workers are offered a
wage according to their supply schedule. This is why
our Phillips curve will be stated in terms of excess
capacity (product market version) rather than
unemployment (labor market version).
In fact, the model can also accommodate unemployment
by introducing a labor union, which has monopoly
power to bargain on behalf of the workers with the
monopsonistic firms over the equilibrium wage. In such
case, the equilibrium wage will lie somewhere between
the labor supply and the marginal productivity curves,
and unemployment can arise so that the labor market
version of the Phillips curve can be derived as well. To
simplify the analysis, we assume in this paper that the
workers are wage-takers.
1
In the limiting case where the producers behave perfectly competitive in the labor market, the
real wage becomes equal to the marginal productivity of labor and the marginal cost of labor
curve is not sensitive to output changes. Thus, with a constant mark-up
1

, the Phillips curve

becomes flat, i.e., no relation exists between inflation and excess capacity.
10
Figure 1: The Labor Market
Equilibrium
h
W/P
Marginal Factor Cost
Labor Supply
Marginal Productivity
Mark
Down
wage
Marginal
product
A
B
Note: wages are perfectly flexible.
Price Setting
A fraction of the firms set their prices flexibly at p
1t
,
supplying y
1t
.
A fraction 1- of the firms set their prices one period in
advance (in period t-1) at p
2t
, supplying y
2t
.
The flexible price producer (type-1 firms) sets a
constant mark-up,

>1 ,
above the actual marginal cost.:
11
) , ; (
1
1
t t t t
t
t
A C y s
P
p

(4)
The producer who sets the price one period in advance
(type-2 firms), charging p
2t
. The objective function,
expected discounted profit, is:
( )
1
1
]
1

1
1
]
1

,
_

,
_

1
]
1

,
_

t
t t
W
t
t t
W
t t
t
t t t t t
t
t
A
P p Y
f w P Y p
i
E h w y p
i
E

2 1 1
2
1
1 2 2
1
1
1
1
1
1
.
The maximization problem:
1
1
]
1

1
1
]
1

,
_

,
_

t
t t
W
t
t t
W
t t
t
t
p
A
P p Y
f w P Y p
i
E Max
t

2 1 1
2
1
1
1
1
2
The FOC:
0 ) 1 (
1
1
1
2 2
'
1
2
1
1

'

1
1
]
1

,
_

,
_

t
t t
W
t
t
t t
W
t
t t
W
t t
t
t
A
P p Y
A
P p Y
f w P Y p
i
E

(5)
Substituting

,
_

,
_

t
t
t t
t
t t
t
t t c
t t t h
t t t t
A
y
f
P A
w
A A
y
f
C u
A y f
A C y s
'
1
'
1
1
1
) ; (
) ); / ( (
) , ; , (

in (5), we get
[ ] 0 ) , ; , ( ) 1 (
1
1
1 1
2 2 2
1
1

'

,
_

+
+

t t
W
t t t t t t
W
t t
t
t
P p Y A C y s P Y p
i
E
=>
0
1
) , ; , ( ) 1 (
1
1
1 1
2 2 2
1
1

'

1
]
1

,
_

+
+

t t t t t t t t
W
t
t
t
P p A C y s P p Y
i
E
12
=>
0 ) , ; , ( ) 1 (
1
1
2
2 1 1
2
1
1

'

1
]
1

,
_

+
+

t t t t
t
t
t t
W
t
t
t
A C y s
P
p
P p Y
i
E

(6)
A weighted average of the deviation of relative price
from the marked up marginal costs is set equal to zero.
Where,

,
_

1 1
2
1
) 1 (
1
1
t t
W
t
t
t
P p Y
i

can be viewed as a weight at

a given state of nature.
Aggregate price index:
[ ] { }

+ +
1
1
1
* 1
2
1
1
) 1 ( ) 1 (
t t t t t
p n p p n P
Potential Output
The potential (or the Natural level of ) output (Y
t
N
) is
the output level under perfect price flexibility ( = 1).
Using (4) and (6) with = 1 we get:
{ }
1
1
1 *1 1
1
( , ; , )
(1 )
n n t
t t t t
t t t
p
s Y C A
np n p

+
If there are no capital flows (closed capital account),
then C
t
N
= Y
t
N
. In this case the natural output is defined
by:
{ }
1
1
1 *1
1
1
( , ; , )
(1 )
n n t
t t t t
t t t
p
s Y Y A
np n p

+
13
If there are no capital flows and no commodity trade,
then the economy is completely closed (A closed capital
account and closed current account), then n = 1 and C
t
N
= Y
t
N
. The natural output is defined by:
) , ; , ( 1
t t
n
t
n
t
A Y Y s

The natural output is independent of monetary
policy.
Note that the efficient output,
) , ; , ( 1
* *
t t t t
A Y Y s
is larger
than the natural output under monopolistic competition.
IV. The Aggregate Supply
The aggregate supply is a set of 6 equations:
[ ] { }

+ +
1
1
1
* 1
2
1
1
) 1 ( ) 1 (
t t t t t
p n p p n P
) , ; (
1
1
t t t t
t
t
A C y s
P
p

0 ) , ; , ( ) 1 (
1
1
2
2 1 1
2
1
1

'

1
]
1

,
_

+
+

t t t t
t
t
t t
W
t
t
t
A C y s
P
p
P p Y
i
E

,
_

t
t W
t t
P
p
Y y
1
1

,
_

t
t W
t t
P
p
Y y
2
2
1
2 1
1 1
) 1 (

1
]
1

t t t
y y Y
There are 6 endogenous variables that are determined in
the aggregate supply block of the model:
14
THE Quantities-- t
y
1 , t
y
2 , t
Y
THE Nominal prices--- t
p
1 , t
p
2 , t
P
.
The Solution technique: log-linearization of the 6
aggregate-supply equations around the no shock steady
state.
IVa. The No Shock Steady State
Assume
1 ) 1 (
*
+ r
Consider a deterministic steady-state, where
0
t

and
Y t t t t t
Y C C p p A A

, , , , 1
* *
.
Log-linearization of equation (5),
t t
t
t t c
t t t h
t t t t t
A A
y
f
C u
A y f
A C y s
1
) ; (
) ); / ( (
) , ; , (
'
1
1

,
_

, around the steady-

state point yields:
t
c
h
t
c
h
t t t
A
A
A
A y f
C u
A y f
A
A y f
C u
A y f
C y s

,
_

,
_

+
+
]
1
) / (
) 0 ; (
) 0 ); / ( (
log[
]
1
) / (
) 0 ; (
) 0 ); / ( (
log[

_
_ _
'
1
_ _
1
_
_ _
'
1
_ _
1
1

(7)
Where: p w
+
,
A
y
v
f v
h
hh
w
'
1

,
A
y
f
f
p
'
1
' '
1

, and
c
cc
u
C u

1

.
15
The expression for the real marginal cost, evaluated at
the natural level of output, is:
t
c
h
t
c
h
N
t
N
t
N
t
A
A
A
A y f
C u
A y f
A
A y f
C u
A y f
C Y s

,
_

,
_

+
+
]
1
) / (
) 0 ; (
) 0 ); / ( (
log[
]
1
) / (
) 0 ; (
) 0 ); / ( (
log[

_
_ _
'
1
_ _
1
_
_ _
'
1
_ _
1
1

(7)
Subtracting (7) from (7):
)

( )

(
1 N
t t
N
t t
N
t t
C C Y y s s +


(7)
Log-linearizing (4),
) , ; (
1
1
t t t t
t
t
A C y s
P
p

, around the steady-
state yields:
t t t
s P p

1
+
Subtracting the (log-linearized version of the ) equation
evaluated at the natural level of output, substituting
N
t
N
t
P p
1 , and using (7) yields:
)

( )

1
1 1
N
t t
N
t t t t
C C Y y P p + +


(8)
We go through a similar procedure for equation (6)
N
t t
t t t t
t
t
t t
A C y s
P
p
E

'

1
]
1

0 ) , ; , (
2
2
1

(in this case the relevant part
16
of the equation is the term inside the square brackets)
and get:
)]

( )

[
1
2 1 2
N
t t
N
t t t t t
C C Y y P E p + +

(9)
Log-linearizing the price index yields:
) )( 1 ( ] ) 1 ( [

*
2 1 t t t t t
p n p p n P + + +
(10)
Assume now that in steady-state there is zero inflation
; then:
) log( ) log( ) log(
1 1 1 1 t t t t
p p p p
) log( ) log( ) log(

t t t t
P P P P
) log( ) log( ) log(
2 2 2 2 t t t t
p p p p
) log( ) log( ) log(
* * * *
t t t t t t t t
p p p p +
The rate of inflation rate is given by:
1
1 1
1

log

,
_

t t
t
t
t
t t
t
P P
P
P
P
P P

=> t t t t t t
P E P E

1 1

(the surprise rate of
inflation)
The real exchange rate is defined as:
t
t t
t
P
P
e
*

IV c. Deriving the Aggregate Supply Relationship

17
Log-linearizing the (Dixit-Stiglitz) demand for the good
produced by firm j,

,
_

t
t W
t t
P
j p
Y j y
) (
) (
:
]

t jt
w
t jt
P p Y y
, with

F
t
N
t
w
t
Y n Y n Y

) 1 (

+
With symmetry between firms of type 1 (flexible price
firms) and between firms of type 2 (sticky price firms),
we have:
]

1 1 t t
w
t t
P p Y y
]

2 2 t t
w
t t
P p Y y
Substituting for
) , (
2 1 t t
y y
in (8) and (9):
)

(
1
)

(
1

1
1
N
t t
N
t
w
t t t
C C Y Y P p
+
+
+

(8)
1
]
1

+
+
+

)

(
1
)

(
1

1
1 1 2
N
t t
N
t
w
t t t t t
C C Y Y E P E p

(9)
=> t t t
p E p
1 1 2

(11)
From (10):
18
[ ] ) )( 1 ( ] ) 1 ( [
) )( 1 ( ] ) 1 ( [

*
2 1 1
*
2 1 1 1
t t t t t
t t t t t t t t t t
p n p p n E
p n p p n E P E P
+ + +
+ + +

Using (11) t t t
p E p
1 1 2

and t t t t
p E p E
1 1 2 1



yields:
)] ( ) )[( 1 ( ] [
*
1
*
2 1 1 t t t t t t t t t t
p E p n p p n E + + +


(12)
From the definition of the real exchange rate we get:
t t t t
P P e


*
+
=> t t t t
P e P

*
+ +

Substituting in (12) yields:
]

)[ 1 ( ] )[ 1 ( ] [
1 1 2 1 1 t t t t t t t t t t t
P E P n e E e n p p n E

+ +
=>
] )[ 1 ( ] [ ) (
1 2 1 1 t t t t t t t t
e E e n p p n E n

+
(13)
From (10), t
p
2

is given by:
] ) 1 (

[
) 1 (
1

1 2 t t t t
e n p n P n
n
p

Substituting t
p
2

in (13); we have:

,
_

) (
1
1

1
1
]

[
1
1 1 1 t t t t t t t t t
e E e e
n
n
P p E

,
_

) (
1
1
]

[
1
1 1 1 t t t t t t t t t
e E e e
n
n
P p E

Using (8)
)

( )

1
1 1
N
t t
N
t t t t
C C Y y P p + +


to substitute for t t
P p

1


in this expression, we obtain the open-economy
Aggregate Supply (Phillips) Curve:
19

,
_

+
1
]
1

+
+
+

t t t
N
t t
N
t
w
t t t t
e E e
n
n
C C Y Y E
1
1 1
)

(
1
)

(
1 1
1
1
1

But because that the world output is divided between
the domestic and foreign world as:
f
t
h
t
w
t
Y n Y n Y

) 1 (

+

we have
=>
)

)( 1 ( )

(

N
t
f
t
N
t
h
t
N
t
w
t
Y Y n Y Y n Y Y +
and

,
_

+
1
]
1

+
+
+

+
+

t t t
N
t t
N
t
f
t
N
t
h
t t t t
e E e
n
n
C C Y Y
n
Y Y
n
E
1
1 1
)

(
1
)

(
1
) 1 (
)

(
1 1
1
1
1

[If LCP prevails,

t t
s n n domestic P

+ + )) ) 1 ( ( 1 (
.
20

The Pass Through from exchange rate fluctuations to
domestic inflation is lessened, and the effect of the real
exchange rate on surprise inflation is:

,
_

+
t t t
e E e
n
s n n

1
1 ) ) 1 ( ( 1
1

.
s = The fraction of foreign producers which
preset prices in a domestic buyers currency.]
IV.1 Perfect Capital Mobility
If capital is perfectly mobile, then the domestic agent
has a costless access to the international financial
21
market. As a consequence, household can smooth
consumption similarly in the rigid price and flexible
price cases.
=>
N
t t
C C


The Aggregate Supply curve becomes:

,
_

+
1
]
1

+
+

t t t
N
t
f
t
N
t
h
t t t t
e E e
n
n
Y Y
n
Y Y
n
E
1
1 1
)

(
1
) 1 (
)

(
1 1
1 1

IV. 2 Closed Capital Account
If the domestic economy does not participate in the
international financial market, then there is no
possibility of consumption smoothing, and we have that:
22
N
t Yt
N
t Ct t Yt t Ct
Y P C P Y P C P

;

1
]
1

1
]
1

1
1
1
0
1
1
1
0
1
1 * 1
) (
)) ( ( ) (
dj j p P
dj j p dj j p P
t t Y
n
n
t t t t C
In this case, the Aggregate Supply Curve becomes:

,
_

+
1
]
1

+
+
+

t t t
N
t
f
t
N
t
h
t t t t
e E e
n
n
Y Y
n
Y Y
n
E
1
1 1
)

(
1
) 1 (
)

(
1 1
1
1
1

IV.4 Closed Economy
If both the capital and trade accounts are closed, then
the economy is an autarky, completely isolated of the
23
rest of the world. In this case, all the goods in the
domestic consumption index are produced domestically,
which means that n = 1.
The Aggregate Supply Curve becomes:
)

(
1 1
1
1
N
t
h
t t t t
Y Y E

,
_

+
+

,
_

IV.4 Slopes (Sacrifice Ratios)
24
The slope of the Aggregate Supply Curve under each
scenario is:
(i)
) 1 )( 1 (
1

n
(perfect capital mobility)
(ii)
) 1 )( 1 (
) (
1
2

+
+

n
(closed capital account)
(iii)
) 1 )( 1 (
) (
1
3

+
+

(closed economy)
It can be seen that 3 2 1
< <
Successive opening of the economy will flatten the
Aggregate Supply Curve.
(Note however that the fraction of flex- and fixed-
price firms is assumed to be given exogenously.
Intuitively, liberalizing trade account transactions
may increase the number of flex-price firms. If so,
opening may increase the slope.)
25
V. Revised Aggregate Supply: Accounting
to the Assumption that Producers Are
Wage-makers.
II Producers
( ) ) ( ) ( j h f A j y
t t t

(The production function)
A
t
= random productivity shock
Variable cost of supplying:

,
_

t
t
t t t
A
j y
f j w j h j w
) (
) ( ) ( ) (
1
Monopsonistic-Wage-adjusted Nominal Marginal cost:

) (
)) ( ) ( (
) (
j y
j h j w
j x
t
t t
t

However, we assume the workers are wage takers and

the producers are wage makers, so
) ( j w
t is a function of
) ( j h
t
:
This relation is characterized by equation (1):
) ; (
) ); ( (
) (
t t c
t t h
t t
C u
j h
P j w

As a result,
26
t t
t
t
t
c
hh
t
c
h
t
t
t
t
t
t
t
t
t
t
t t
t
A A
j y
f
A
j y
f
u
v
P
u
v
P
j h
j dy
j dh
j h
j w
j dy
j dh
j w
j y
j h j w
j x
1 ) ( ) (
) (
) (
) (
) ( (
) ( (
) (
) (
) (
) (
)) ( ) ( (
) (
'
1 1

,
_

1
]
1

,
_

And the wage-adjusted real marginal cost is:
t t
t
t
t
c
hh
c
h
t
t
t
A A
j y
f
A
j y
f
u
v
u
v
P
j x
j s
1 ) ( ) ( ) (
) (
'
1 1

,
_

1
1
]
1

,
_

+

(3)
Substituting (3) in (1) and assuming a symmetric
equilibrium (dropping the index j because of the
symmetry assumption):
=>
t t
t
t
t
t t c
t t t hh
t t c
t t t h
t t t t t
A A
y
f
A
y
f
C u
A y f v
C u
A y f v
A C y s
1
) ; (
) ); / ( (
) ; (
) ); / ( (
) , ; , (
'
1 1
1 1

,
_

1
]
1

,
_

World demand for the firm j product:

W H F H F
t t t t t
Y Y Y C C + +
An index for all the goods produced around the world.
Producer j demand function:
27

,
_

t
t W
t t
P
j p
Y j y
) (
) (

III. The Labor Market
The market for each type of goods-specific skill of
labor service is characterized by workers as wage-
takers and producers as wage-makers, as in the
monopsony case.
Figure 1 describes equilibrium in one such market.
The downward-sloping, marginal-productivity curve,
is the demand for labor. Labor supply is implicitly
determined by the utility-maximizing condition for h.
The upward-sloping marginal factor cost curve is the
marginal cost change from the producer point of view.
28
It lies above the supply curve because, in order to elicit
more hours of work, the producer has to offer a higher
wage not only to that (marginal) hour but also to all the
(intra-marginal) existing hours. Equilibrium
employment occurs at a point where the marginal factor
costs is equal to the marginal productivity (point A).
Equilibrium wage is shown at point B, with the
worker's real wage marked down below her marginal
product by a distance AB.
2
Full employment obtains because workers are offered a
wage according to their supply schedule. This is why
our Phillips curve will be stated in terms of excess
capacity (product market version) rather than
unemployment (labor market version).
In fact, the model can also accommodate unemployment
by introducing a labor union, which has monopoly
power to bargain on behalf of the workers with the
2
In the limiting case where the producers behave perfectly competitive in the labor market, the
real wage becomes equal to the marginal productivity of labor and the marginal cost of labor
curve is not sensitive to output changes. Thus, with a constant mark-up
1

, the Phillips curve

becomes flat, i.e., no relation exists between inflation and excess capacity.
29
monopsonistic firms over the equilibrium wage. In such
case, the equilibrium wage will lie somewhere between
the labor supply and the marginal productivity curves,
and unemployment can arise so that the labor market
version of the Phillips curve can be derived as well. To
simplify the analysis, we assume in this paper that the
workers are wage-takers.
Figure 1: The Labor Market
Equilibrium
h
W/P
Marginal Factor Cost
Labor Supply
Marginal Productivity
Mark
Down
wage
Marginal
product
A
B
Note: wages are perfectly flexible.
Price Setting
30
A fraction of the firms set their prices flexibly at p
1t
,
supplying y
1t
.
A fraction 1- of the firms set their prices one period in
advance (in period t-1) at p
2t
, supplying y
2t
.
The flexible price producer (type-1 firms) sets a
constant mark-up,

>1 ,
above the actual marginal cost.:
) , ; (
1
1
t t t t
t
t
A C y s
P
p

(4)
The producer who sets the price one period in advance
(type-2 firms), charging p
2t
. The objective function,
expected discounted profit, is:
( )
1
1
]
1

1
1
]
1

,
_

,
_

1
]
1

,
_

t
t t
W
t
t t
W
t t
t
t t t t t
t
t
A
P p Y
f w P Y p
i
E h w y p
i
E

2 1 1
2
1
1 2 2
1
1
1
1
1
1
.
The maximization problem:
1
1
]
1

1
1
]
1

,
_

,
_

t
t t
W
t
t t
W
t t
t
t
p
A
P p Y
f w P Y p
i
E Max
t

2 1 1
2
1
1
1
1
2
When we take the first order condition, we need to bare
in mind that
) ; (
) ); ( (
) (
t t c
t t h
t t
C u
j h
P j w

,
And
). ( ) (
2 1
t
t t
w
t
t
A
P p Y
f j h

=
31
=>
0 ) , ; , ( ) 1 (
1
1
2
2 1 1
2
1
1

'

1
]
1

,
_

+
+

t t t t
t
t
t t
W
t
t
t
A C y s
P
p
P p Y
i
E

(6)
A weighted average of the deviation of relative price
from the marked up marginal costs is set equal to zero.
Where,

,
_

1 1
2
1
) 1 (
1
1
t t
W
t
t
t
P p Y
i

can be viewed as a weight at

a given state of nature.
Aggregate price index:
[ ] { }

+ +
1
1
1
* 1
2
1
1
) 1 ( ) 1 (
t t t t t
p n p p n P
Potential Output
The potential (or the Natural level of ) output (Y
t
N
) is
the output level under perfect price flexibility ( = 1).
Using (4) and (6) with = 1 we get:
{ }
1
1
1 *1 1
1
( , ; , )
(1 )
n n t
t t t t
t t t
p
s Y C A
np n p

+
If there are no capital flows (closed capital account),
then C
t
N
= Y
t
N
. In this case the natural output is defined
by:
{ }
1
1
1 *1
1
1
( , ; , )
(1 )
n n t
t t t t
t t t
p
s Y Y A
np n p

+
32
If there are no capital flows and no commodity trade,
then the economy is completely closed (A closed capital
account and closed current account), then n = 1 and C
t
N
= Y
t
N
. The natural output is defined by:
) , ; , ( 1
t t
n
t
n
t
A Y Y s

The natural output is independent of monetary
policy.
Note that the efficient output,
) , ; , ( 1
* *
t t t t
A Y Y s
is larger
than the natural output under monopolistic competition.
IV. The Aggregate Supply
The aggregate supply is a set of 6 equations:
[ ] { }

+ +
1
1
1
* 1
2
1
1
) 1 ( ) 1 (
t t t t t
p n p p n P
) , ; (
1
1
t t t t
t
t
A C y s
P
p

0 ) , ; , ( ) 1 (
1
1
2
2 1 1
2
1
1

'

1
]
1

,
_

+
+

t t t t
t
t
t t
W
t
t
t
A C y s
P
p
P p Y
i
E

,
_

t
t W
t t
P
p
Y y
1
1

,
_

t
t W
t t
P
p
Y y
2
2
1
2 1
1 1
) 1 (

1
]
1

t t t
y y Y
There are 6 endogenous variables that are determined in
the aggregate supply block of the model:
33
THE Quantities-- t
y
1 , t
y
2 , t
Y
THE Nominal prices--- t
p
1 , t
p
2 , t
P
.
The Solution technique: log-linearization of the 6
aggregate-supply equations around the no shock steady
state.
IVa. The No Shock Steady State
Assume
1 ) 1 (
*
+ r
Consider a deterministic steady-state, where
0
t

and
Y t t t t t
Y C C p p A A

, , , , 1
* *
.
Notice that the assumption
0
t

will not cause trouble if

we actually let redefine the system in terms of
) exp(
t

.
Log-linearization of equation (5),
t t
t
t
t
t t c
t t t hh
t t c
t t t h
t t t t t
A A
y
f
A
y
f
C u
A y f v
C u
A y f v
A C y s
1
) ; (
) ); / ( (
) ; (
) ); / ( (
) , ; , ( '
'
1 1
1 1

,
_

1
]
1

,
_

around the steady-state point yields:

t
t t
t
t t
t t t
A
s
A
A
A C y s
s
A C y s
C y s

+
+
)] , 0 ; , (
)] , 0 ; , (

'
_ _
_ _
1

(7)
34
Where:
s
y
y
A A
j y
f
A
j y
f
u
v
A
f
u
A
f v
t t
t
t
t
c
hh
c
hh
1
1
1
1
1
]
1

1
]
1

,
_

,
_

1 ) ( ) (
1
1
'
1 1
'
1
'
1

, and
c
cc
u
C u

1

.
The expression for the real marginal cost, evaluated at
the natural level of output, is:
t
t t
t
t t
N
t
N
t
N
t
A
s
A
A
A C y s
s
A C y s
C Y s

+
+
)] , 0 ; , ( '
)] , 0 ; , ( '

_ _
_ _
1 '

(7)
Subtracting (7) from (7):
)

( )

( ' '
1 N
t t
N
t t
N
t t
C C Y y s s +


(7)
Log-linearizing (4),
) , ; ( '
1
1
t t t t
t
t
A C y s
P
p

, around the steady-
state yields:
t t t
s P p

1
+
Subtracting the (log-linearized version of the ) equation
evaluated at the natural level of output, substituting
N
t
N
t
P p
1 , and using (7) yields:
)

( )

1
1 1
N
t t
N
t t t t
C C Y y P p + +


(8)
35
We go through a similar procedure for equation (6)
N
t t
t t t t
t
t
t t
A C y s
P
p
E

'

1
]
1

0 ) , ; , ( '
2
2
1

(in this case the relevant part
of the equation is the term inside the square brackets)
and get:
)]

( )

[
1
2 1 2
N
t t
N
t t t t t
C C Y y P E p + +

(9)
Log-linearizing the price index yields:
) )( 1 ( ] ) 1 ( [

*
2 1 t t t t t
p n p p n P + + +
(10)
Assume now that in steady-state there is zero inflation
; then:
) log( ) log( ) log(
1 1 1 1 t t t t
p p p p
) log( ) log( ) log(

t t t t
P P P P
) log( ) log( ) log(
2 2 2 2 t t t t
p p p p
) log( ) log( ) log(
* * * *
t t t t t t t t
p p p p +
The rate of inflation rate is given by:
1
1 1
1

log

,
_

t t
t
t
t
t t
t
P P
P
P
P
P P

=> t t t t t t
P E P E

1 1

(the surprise rate of
inflation)
The real exchange rate is defined as:
36
t
t t
t
P
P
e
*

37