AS and the Phillips Curve

Question 1

How does timeframe affect the shape of the Aggregate Supply (AS) curve?

Answer 1

• 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

Question 2

What are the two models used to determine the AS curve?

Answer 2

• Sticky-Price Model
• Imperfect-Information Model

Question 3

State the aggregate output equations (including NLO, Prices and exp. prices)

Answer 3

• Y = Ȳ + α (P - EP); where α>0

Question 4

Give some examples of why Prices are sticky, and thus the assumption on Price levels

Answer 4

• Long-term Contracts, Menu costs and avoiding angering customers are reasons for rigid prices
• The assumption is that firms set their own PL

Question 5

How can we derive the price set for firms with flexible prices?

Answer 5

• Price = P + α (Y-Ȳ), where P is the exogenous price level

Question 6

How can we derive the price set for firms with sticky prices? (refer back to firms with flexible prices)

Answer 6

• Price = EP + α (EY-EȲ)
• The stickiness of prices means that p=EP {EY = EȲ}

Question 7

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

Answer 7

• 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)]

Question 8

What does high expected prices mean in terms of price level?

Answer 8

• High Price level

Question 9

What does high aggregate output mean in terms of price level?

Answer 9

• High Price level

Question 10

What does a small level of s mean in terms of affects on aggregate output and price level?

Answer 10

• Big affect on Y and P

Question 11

What does high expected aggregate output mean in terms of price level(Supply-Side) ?

Answer 11

• Low Price level
• This is because CoP is low and price is lower

Question 12

By rearranging the price level equation for the overall market, you can achieve the equation for Y. What would α be?

Answer 12

• α = S / (1-s)a

Question 13

How do you calculate relative prices?

Answer 13

• Nominal Prices / Overall Prices

Question 14

Using the Imperfect information theory, what are the assumptions reached?

Answer 14

• All wages and prices are perfectly flexible
• Each supplier produces one good
• Each supplier knows nominal price level, but not overall price

Question 15

How does the relative price affect Y?

Answer 15

• 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

Question 16

In the SR, how do changes in AD affect the relationship between P and EP?

Answer 16

• 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)

Question 17

What is the Phillips Curve? How can it change with Government policy?

Answer 17

• 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

Question 18

What is the equation for the Phillips curve?

Answer 18

• 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

Question 19

How do you derive the PC from the AS curve?

Answer 19

• 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)

Question 20

What are some determinants of Eπ?

Answer 20

• 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)

Question 21

How can policymakers manipulate the Phillips Curve to meet policy targets?

Answer 21

• 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

Question 22

What is the sacrifice ratio?

Answer 22

• 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

Question 23

What is the difference between Adaptive and Rational expectations

Answer 23

• Adaptive expectation is expectation based on recent information
• Rational expectation is expectation based on all available information

Question 24

What is the Natural Rate hypothesis

Answer 24

• That regardless of short run fluctuations, the economy will always return to Ȳ and uⁿ
• This is challenged by hysteresis, which may increase uⁿ