[4] AD-AS

Question 1

Three models of aggregate supply in the short run?

Answer 1

sticky wage model
sticky-price model
imperfect-information model

Question 2

Phillips curve
derived from?
presents policymakers with a short-run tradeoff between ?

Answer 2

SRAS curve?

unemployment and inflation

Question 3

How people form expectations of inflation? x2

Answer 3

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.

Question 4

In previous chapters, we assumed that the ___ ___ was “stuck” in the ___run.
This implies a ___ _ _ _ _ curve.

What is the formula for the model of aggregate output?

Answer 4

price level P, short
Horizontal SRAS

Y = Ybar + a( P - eP )

Question 5

What does the sticky-price model assume?

What is the formula for nominal wage (W)?

Answer 5

Assumes that firms and workers negotiate contracts and fix the nominal wage before they know what the price level will turn out to be.

W = w * eP

W=nominal wage, w=real wage target, eP=expected price

Question 6

Based on formula for nominal wage, what is real wage formula? What does this also equal?

Answer 6

W/p = w * eP/p = MPL

Question 7

note that if eP = P then = , so = , and =

[think of AS equation]

Answer 7

Note that if 𝒆P=𝑷 then 𝑾/𝑷=𝝎, so 𝐋^𝐝 (𝐖/𝐏)=𝐋 and 𝒀=𝒀̅

Question 8

Based on the fact that Labour demand: 𝑳=𝑳^𝒅 (𝑾/𝑷)

Note that: 𝑳^𝒅 (𝝎)=𝑳̅ , what is the Output prod func?

Answer 8

: 𝒀=𝒇(𝑲̅,𝑳)=𝒇(𝑲̅,𝑳^𝒅 (𝝎∗(𝑷^𝒆/𝑷)))

Question 9

The model implies that we can represent the ___ ____ curve as Y = Y+ α(P – EP).
This approximates the true aggregate supply curve implied by the model, which says that deviations of output from 𝑌̅ depend on ___/____

Answer 9

aggregate supply

𝑃/𝑃^𝑒

Question 10

If it turns out that 𝑴𝑷𝑳=𝑾/𝑷= 𝝎∗𝑷^𝒆/𝑷 then …?

P = eP then …
P > eP then …
P < eP then …

Answer 10

unemployment and output are at their natural rates

real wage is less than its target, so firms hire more workers and output rises above its natural rate

real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate

Question 11

Implies that the real wage should be ____ - ___, it should move in the opposite direction as ____ over the course of business cycles:
In booms, when ___ typically rises, the ___ ___ should fall.
In _____, when P typically falls, the real wage should rise.
This prediction does not come true in the real world

Answer 11

counter-cyclical , output
price, real wage
recession

Question 12

What does empirical evidence say for Stick-wage model?

What was Silver and Sumner’s Argument?

Answer 12

Looking at industry-wide data, Barsky and Solon (1989) find that there is little if any evidence of countercyclical real wages.
Studies of micro data, however, provide quite strong evidence of procyclicality in the real wage.
Barsky and Solon (1989) find procyclicality when they look at data from the Panel Study of Income Dynamics

S&S; their argument is that shocks to aggregate demand will cause prices to be procyclical and shocks to aggregate supply will cause prices to be countercyclical.

Question 13

STICKY PRICE MODEL:
x3 Reasons for sticky prices:

Assumptions? x1

Answer 13

Reasons for sticky prices:
long-term contracts between firms and customers
menu costs
firms not wishing to annoy customers with frequent price changes

Firms set their own prices (as in monopolistic competition).

Question 14

formula for An individual firm’s desired price is?

Suppose there are two types of firms: What are they? how they set prices?

Answer 14

An individual firm’s desired price is:
𝒑 = 𝑷+𝒂(𝒀−𝒀̄) ,where a > 0

Lower case p is firms desired price
Upper case P is overall P in econ
Y = aggregate output
Y bar = natural level of output

firms with flexible prices—set prices as above
firms with sticky prices—must set their prices before they know how P and Y will turn out:
𝒑=𝑬𝑷+𝒂(𝑬𝒀−𝑬𝒀̄)

Question 15

How can we write the overall price level expression given we know the number/fraction of firms that have sticky prices in the economy?

Answer 15

𝑷 = 𝒔[𝑬𝑷] + (𝟏−𝒔) x [P + (𝒂(𝒀−𝒀̅)]

Proportion of sticky firms in econ multiplied by their price strat plus the proportion of flexible price firms [1-s] in econ multi by their price strat:

𝑷=𝒔[𝑬𝑷]+(𝟏−𝒔)𝑷)+[(𝟏−𝒔)𝒂(𝒀−𝒀̅)]

Subtract (1 − s)P from both sides:
𝒔𝑷=𝒔[𝑬𝑷]+(𝟏−𝒔)[𝒂(𝒀−𝒀̄)]

Divide both sides by s:`
𝑷=𝑬𝑷+((𝟏−𝒔)𝒂)/𝒔(𝒀−𝒀̄)

s = fraction of firms with sticky prices

Question 16

High EP -> high P
If firms expect high _____, then firms that must set prices in advance will set them ____.
__ ___ respond by setting Prices high.

High Y -> high P
When __ is high, the ____ for goods is high. Firms with ___ ____ set prices high.
The greater the fraction of ___-___ firms, the ____ is s and the bigger the effect of ΔY on __.

Answer 16

prices high
Other firms

income demand
flexible prices
flexible-price , smaller p

Question 17

How do we derive the AS equation? What expression do we use and what action do we take?

Answer 17

𝑷=𝑬𝑷+((𝟏−𝒔)𝒂)/𝒔(𝒀−𝒀̄)
Re-arrange the equation : P was subject of Eq for prev, now want to make Y subject
Dividing the fraction is the same as multiplying by it inverse … we call the inverse alpha for simplicity
S is positive and … so alpha is always positive and therefore AS is upward sloping

Question 18

x3 Assumptions of the Imperfect-Information Model?

Answer 18

All wages and prices are perfectly flexible, and all markets are clear.
Each supplier produces one good and consumes many goods.
Each supplier knows the nominal price of the good she produces but does not know the overall price level.

Question 19

The supply of each good depends on its __ ___: the ___ price of the good ____ by the overall price level.
The ___ doesn’t know ___level at the time they make the production decision so uses ___ ___.
Suppose P rises but EP does not.
Supplier thinks the relative price has ____, so they ___ ____
With many producers thinking this way, __ will rise whenever __ rises above ___ __
But because of imperfect information, majority of suppliers assume this and ___ more. This leads to higher relative ___ ___ compare to overall price

Answer 19

relative price, nominal, divided
supplier, price,  EP
risen, produce more
Income(Y), Price , EP
produce, individual price

Question 20

Which of the following will shift the aggregate supply curve up to the left?
an increase in the price level
a decrease in the level of output
an increase in the expected price level
a decrease in the price level

Answer 20

3

Question 21

The Phillips curve states that π depends on: [3]

explain what variables mean

Answer 21

• expected inflation, Eπ
• cyclical unemployment: the deviation of the actual rate of unemployment (u) from the natural rate (un)
• supply shocks, ν (Greek letter nu).
  𝝅=𝑬𝝅−𝜷(𝒖−𝒖^𝒏 )+𝒗

where 𝛽> 0 is an exogenous constant.
Beta is an exogenous variable, measure responsiveness of inflation to cyclical unemp
V is factors that will push pprices up

Question 22

Relationship between unemp and inflation = conflicting (trade off) ONLY occurs in the ___ ___
Essentially Phillips curve is a ___ of __ __ curve!!!
AS looks at ___, Phillips looks at ____

Answer 22

SR

reflection , AS
Prices, Inflation

Question 23

Derive the Phillips curve from SRAS

What is Okums law?

Answer 23

1) Y=Ȳ+α(P−EP)
(2) P=EP+(1/α)(Y−Ȳ)
(3) P=EP+(1/α)(Y−Ȳ)+ν
(4) (P−P_(−1))=(EP−P_(−1))+(1/α)(Y−Ȳ)+ν
(5) π=Eπ+(1/α)(Y−Ȳ)+ν
(6) (1/α)(Y−Ȳ)=−β(u−u^n)
(7) π = Eπ−β(u−u^n) + ν [slide 25]

1. Bring price to LHS
2. +v
3. Move from levels to rate (%).take the difference between prices today and last year. Get a percentage change
4. Gives us inflation and expected inflation
5. Okums law suggests deviation output can result in negative deviations
6. Replace with negative reciprocal

Question 24

SRAS: Output is related to…

Phillips curve: Unemployment is related to..

Answer 24

SRAS curve: : 𝒀=𝒀̄+𝜶(𝑷−𝑬𝑷)
Output is related to unexpected movements in the price level.

Phillips curve: 𝝅 = 𝑬𝝅−𝜷(𝒖−𝒖^𝒏) + 𝝂
Unemployment is related to unexpected movements in the inflation rate.

Question 25

What are adaptive expectations? | Simple eg

Answer 25

an approach that assumes people form their expectations of future inflation based on recently observed inflation. EG: expected inflation = last year’s actual inflation

Question 26

When adaptive expections are introduced to the Phillips curve, what does this imply about Inflation? What is the formula for this?

Answer 26

Implies that inflation has inertia/will continue indefinitely 𝝅 = 𝝅_(−𝟏)−𝜷(𝒖−𝒖^𝒏) + 𝝂 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 and prices that people set.

Question 27

Two causes of inflation? | Their impacts? 3 for each

Answer 27

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.

Question 28

Why does trade off between unemp and Inflation only hold true in SR. EG of shift in Phillips curve?

Answer 28

People adjust their expectations over time, so the tradeoff only holds in the short run. Example: an increase in Eπ shifts the short-run Phillips curve upward.

Question 29

“Oil prices spiked as much as 20 per cent on fears of prolonged supply disruption following attacks in Saudi Arabia that knocked out more than half of the kingdom’s production.” How will such shock change the short-run tradeoff between inflation and unemployment in an oil importing country? Illustrate your answer using a Phillips curve diagram.

Answer 29

Only move along the Philips curve => higher unemployment Philips curve shifts down No change to Philips curve, but expectations of inflation increase Philips curve shifts up [slide 30]

Question 30

How do these effects change in the LR?

Answer 30

In LR however, S shock is prolonged and Expectations adjust- bc inflation has risen so do Exp inflation , resulting in outward shift in Philips If p is inc, real wage [w/p] has fallen , so negotiate higher wage rates = all determined by expectations

Question 31

What is the sacrifice ratio? Formula? What is a typical value for it?

Answer 31

The sacrifice ratio measures the percentage of a year’s real GDP that must be forgone/reduced to reduce inflation by 1 percentage point. Sacrifice ratio = (lost GDP) / (total disinflation) A typical estimate of the ratio is 5.

Question 32

Example: To reduce inflation from 6% to 2%, What will be the GDP loss with a sacrifice ratio of 5?

Answer 32

Example: To reduce inflation from 6% to 2% = -4% GDP loss = (inflation reduction) × (sacrifice ratio) = 4 × 5 = must sacrifice 20% of one year’s GDP:

Question 33

2 Ways of modeling the formation of expectations: | Explain each

Answer 33

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.

Question 34

Proponents of rational expectations believe that the ____ ____ may be very small: Suppose u = un and π = Eπ = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6% to 2% as soon as possible. If the announcement is credible, then Eπ will fall, perhaps by the full 4 points. Then, __ can fall without an increase in ____. Depends on households belief in ___ and their policies [____] as this influences ___

Answer 34

sacrifice ratio π =inflation, u = Unemployment Gov , credibility, expectations