AS and the Phillips Curve Flashcards
How does timeframe affect the shape of the Aggregate Supply (AS) curve?
- In the Long run, the price level is flexible, contradicting the Short run assumption
- If prices are fixed, AS is Horizontal
- If prices are fully flexible, AS is Vertical
What are the two models used to determine the AS curve?
- Sticky-Price Model
- Imperfect-Information Model
State the aggregate output equations (including NLO, Prices and exp. prices)
- Y = Ȳ + α (P - EP); where α>0
Give some examples of why Prices are sticky, and thus the assumption on Price levels
- Long-term Contracts, Menu costs and avoiding angering customers are reasons for rigid prices
- The assumption is that firms set their own PL
How can we derive the price set for firms with flexible prices?
- Price = P + α (Y-Ȳ), where P is the exogenous price level
How can we derive the price set for firms with sticky prices? (refer back to firms with flexible prices)
- Price = EP + α (EY-EȲ)
- The stickiness of prices means that p=EP {EY = EȲ}
Assuming that s= the % of firms with sticky & a firm is either sticky or flexible, what is the new price level equation for the overall market
- P = sEP + (1-s) [P + a(Y-Ȳ)]
- sP - sEP + (1-s) [a(Y-Ȳ)] (subtracting {1-s} p)
- P = EP + (1-s)/s [a(Y-Ȳ)]
What does high expected prices mean in terms of price level?
- High Price level
What does high aggregate output mean in terms of price level?
- High Price level
What does a small level of s mean in terms of affects on aggregate output and price level?
- Big affect on Y and P
What does high expected aggregate output mean in terms of price level(Supply-Side) ?
- Low Price level
- This is because CoP is low and price is lower
By rearranging the price level equation for the overall market, you can achieve the equation for Y. What would α be?
- α = S / (1-s)a
How do you calculate relative prices?
- Nominal Prices / Overall Prices
Using the Imperfect information theory, what are the assumptions reached?
- All wages and prices are perfectly flexible
- Each supplier produces one good
- Each supplier knows nominal price level, but not overall price
How does the relative price affect Y?
- As suppliers know the Nominal Price level but not the Overall Price level, EP is used
- If P>EP, Y increases
- Y deviated from Ȳ what P deviated from EP
In the SR, how do changes in AD affect the relationship between P and EP?
- SR, when AD shifts right, there is an upward movement along the AS curve (P>EP)
- When they readjust expectations, AS will contract to Ȳ (NLO)
What is the Phillips Curve? How can it change with Government policy?
- Phillips Curve is the SR trade-off between inflation and unemployment
- Exp: SRAD right, unemployment down but inflation up
- Con: SRAD left, unemployment up but inflation down
What is the equation for the Phillips curve?
- π = Eπ - β (u - un) + ν
- Where π is inflation
- Eπ is expected inflation
- β > 0
- (u - uⁿ) is unemployment minus the natural rate [cyclical]
- v is supply side shocks
How do you derive the PC from the AS curve?
- Y = Ȳ + α (P - EP)
- P = EP + 1/α (Y-Ȳ)
- P = EP + 1/α (Y-Ȳ) + v
- P - (p-1) = EP - (p-1) + 1/α (Y-Ȳ) + v
- As P - (p-1) = π,
- π = Eπ + 1/α (Y-Ȳ) + v
- Okun’s Law states the deviation from Y to Ȳ is inversely proportional to cyclical unemployment:
- Hence: 1/α (Y-Ȳ) = - β (u - uⁿ)
What are some determinants of Eπ?
- People make expectations of inflation on observed inflation recently, so Eπ = Last yrs inf.
- This means that the PC equation becomes π = (π₋₁) - β (u - uⁿ) + ν
- Cosh Push inflation: via v
- Demand Pull inflation: via (u-uⁿ)
How can policymakers manipulate the Phillips Curve to meet policy targets?
- Eπ and ν are not under control
- Can use monetary or fiscal to influence AD and Y
- If AD increases, u decreases and π increases until π1 = Eπ0 - β (u - uⁿ) + ν [Where u>uⁿ]
- Over time, expectations Eπ0 -> Eπ1 , u->un and π1 = Eπ1 + ν
What is the sacrifice ratio?
- The percentage of RGDP lost for the reduction of 1% in inflation
- It is estimated at 5
- Okun’s Law Staes that 1% change in GDP leads to a 2% change in u
- If a policy is credible, Eπ = π
What is the difference between Adaptive and Rational expectations
- Adaptive expectation is expectation based on recent information
- Rational expectation is expectation based on all available information
What is the Natural Rate hypothesis
- That regardless of short run fluctuations, the economy will always return to Ȳ and uⁿ
- This is challenged by hysteresis, which may increase uⁿ
