#15 Aggregate Supply And The Short-Run Tradeoff Between Inflation And Unemployment

Question 1

Sticky-price model assumption

Answer 1

Firms set their own prices (as in monopolistic competition)

Question 2

Reasons for sticky prices

Answer 2

Long term contracts between firms and customers

Menu costs

Firms not wanting frequent price changes

Question 3

Individual firms price-setting decision

Answer 3

p = P +a( Y - Y* )

Question 4

2 types of firms

Answer 4

Firms with flexible prices - set prices as
p = P +a( Y - Y* )

Firms with sticky prices - must set their prices before they know how P and Y will turn out
p = EP +a( EY - EY* )

Question 5

P = EP + (1-s) a (Y-Y*) / s

Answer 5

High EP —> High P
Firms expect high prices so must set high in advance

High Y —> High P
Income is high and demand for goods is high, firms with flexible prices set prices high

Question 6

SRAS Equation

Answer 6

Y = Y• + a( P - EP )

Question 7

Imperfect-information model

Answer 7

All wages and prices are perfectly flexible and markets are clear

Each supplier produces one good and consumes many goods

Each supplier knows the nominal price of goods she produces but not overall price level

Question 8

AD shifts

Short run

Answer 8

AD increases unexpectedly

New equilibrium where AS crosses —> Price level and GDP increase in short-run

Question 9

AD shifts

Answer 9

AD increases unexpectedly —> AD to right

Price level rises —> AS to the left

New equilibrium —> where AS and AD cross Y line

Question 10

Phillips curve

Answer 10

Pi = Epi - b(u-u’n) + v

Pi depends on

Expected inflation Epi

Cyclical unemployment - deviation of actual rate of unemployment (u) from the natural rate (u’n)

Supply shocks V

Question 11

Phillips curve
Curve

Answer 11

Short run inflation and unemployment are negatively related

Question 12

Phillips curve definition

Answer 12

Unemployment is related to unexpected movements in the inflation rate

Question 13

Adaptive expectations

Answer 13

People form their expectations of future inflation based on recently observed one

Question 14

Cost push inflation

Answer 14

Inflation resulting from supply shocks

Adverse supply shocks raise production costs and induce firms to raise prices

Question 15

Demand pull inflation

Answer 15

Inflation resulting from demand shocks

Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which pulls inflation up

Question 16

Sacrifice ratio

Answer 16

Measures % of year’s real GDP that must be forgone to reduce inflation by 1 percentage point

Question 17

Rational expectations

Answer 17

People base their expectations on all available information, including about current and prospective future policies

Question 18

Natural rate hypothesis

Answer 18

Changes in aggregate demand affect output and employment only in the short run

In the long run, economy returns to the levels of output employment and unemployment described by classical model

Question 19

Hysterisis

Answer 19

Long run influence of history variables such as the natural rate of unemployment