B1: Aggregate Supply

Question 1

Recall a rise in AD effect in short run vs long run

Evaluation - is this realistic

Answer 1

Shift in AD increases output on SRAS curve

But in the long run - only price level increases - output falls back to long run level Ybar.

Prices not changing in short run is not realistic - so we need to rethink the short run. (A>B)

Question 2

How to model short run trade-off between inflation and unemployment

Answer 2

As we said prices fixed is not particularly realistic, we use an upward sloping SRAS.

Then we can use new SRAS to derive the Phillips curve. (Phillips curve trade off only short run!!)

Question 3

Why do we have upward sloping SRAS instead of horizontal fixed? (2 models)

Answer 3

Sticky prices -some fixed, some flexible, so upward

Imperfect information - GPL is not perfectly observed

Question 4

Equation for this new upward sloping SRAS

Answer 4

Y = Ybar + α(P-EP)

Y is output
Ybar is natural level of output
P is GPL
EP is expected GPL.

Question 5

From this, how does output differ from its natural level

Answer 5

Output differs from its natural level if P ≉EP

Question 6

Why do we then rearrange to make P subject

Answer 6

P = EP + 1/a (Y-Ybar)

1/a is slope of SRAS

Rearrange to make it fit to the diagram (P yaxis, Y x-axis)

Question 7

Model 1: Sticky Price Model

Answer 7

Firms do not immediately adjust their prices following a change in demand.

Question 8

Why do they not change prices immediately in this model? (3)

Answer 8

Long term agreements with customers

Menu costs

Sticky wages

Question 9

An individual firm’s desired price (notated p)

i.e if they were able to change prices continuously

Answer 9

p=P + a(Y-Ybar)

P is general price level
p is desired price.

So basically don’t have to use EP as can change continuously.

Costs are higher when P is higher (e.g wages)
A higher level of (Y) increases demand.

Question 10

Firms with sticky prices equation

Answer 10

Must set price in advance

p=EP + a(EY-EYbar)

Further assume EY=EYbar , so p=EP. So price is set to the expected general price level for firms with sticky prices.

Question 11

So in this model we have 2 firms and their equations

Answer 11

Firms with flexible prices
p=P+a(Y-Ybar)

Firms with sticky prices
p=EP+a(EY-EYbar)

Question 12

General price level equation INTEGRATES BOTH GROUPS, what does this look like?

Answer 12

P = sEP + (1-s) [P+a(Y-Ybar)]

sEP represents firms with sticky prices (shown in prev slide)
[P+a(Y-Ybar)] represents firms with flexible prices

s is the fraction of firms with sticky prices, and so 1-s is the ones with flexible prices.

Question 13

Rearrange to get…

And what do we find when comparing the general price level slope to the SRAS slope

Answer 13

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

Slope is (1-s/s)a , and if we compare this to the slope of the SRAS curve 1/a, shows us >0 so upward sloping as (0<s<1)

Question 14

We can also rearrange in terms of Y to get a on its own rather than 1/a…

What does it show us

Answer 14

Deviation of output from its natural level depends on the deviation of price from its expected level

Question 15

Model 2: Imperfect information model: assumptions (3)

Answer 15

Prices fully flexible

Many goods - unable to observe all prices at all times, too costly to monitor.

Each supplier produces a single good, and consumes goods from other suppliers.

Question 16

Supplier problem - what do they base their decision of how much to produce on?

Answer 16

They produce based on RELATIVE PRICES.
(Pi/p in this example)

Supplier i sells at price Pi and uses the income to buy goods from other suppliers.

If Pi/P (relative price) is high, incentive to supply more goods to the market.

PROBLEM WITH THIS:
They know their own price Pi, but P is hard to observe!!! (imperfect information)

Question 17

Example scenario assuming FULL information

Suppose that all prices rise by x%
Should supplier i increase output?

How could the decision differ with imperfect information?

Answer 17

Supply function is supply=f(Pi/P)
Should Supplier i increase output?
– No, its relative price has not changed (since all prices have risen so Pi/P is constant).

However, with imperfect information Supplier i could misinterpret the rise in Pi as an increase in Pi/P, and decide to produce more. (This shows upward sloping SRAS, as P increases, incentive to supply increases)

Question 18

What if we include expectations into the model? What is the supply function?
If all price rise by x%…

Should supplier i increase output?

Answer 18

Now becomes supply = f(Pi/EP)
(Supply is a function of its own price, and expected general price)

No if the price increase was expected.
Yes if was unexpected.

Question 19

Expectations based AS equation and intuition

What does a represent?

Answer 19

Y=Ybar + a(P-EP) (Same as original)

Intuition:
Output deviates from its natural level when the price level deviates from its expected level.

So if P>EP then suppliers mistakenly interpret a rise in ‘own price’ as a rise in relative prices and increase production.

The extent to which they increase production upon the change depends upon α.

Question 20

Model 2 and 1/a (slope of SRAS curve)

What are suppliers perceptions in countries where AD fluctuates a lot…

Answer 20

AD changing a lot means P changes a lot too.
So they learn unexpected changes in their own price are unlikely to change relative prices, as they are sceptical and aware of the volatility in their economy.

So they won’t adjust their output much upon unexpected changes in Pi. So a (extent to which they respond) should be small

Question 21

How would this look on an SRAS curve

Answer 21

Since a small, slope should be big/steep!

P=EP+1/a(Y-Ybar)

So for a country where AD is stable, a is higher so SRAS flatter.

Question 22

AS-AD diagram

Increase in AD

Answer 22

AD shifts out, we move from A>B where we see a short run increase in price, so supply moves upwards.

But eventually EP catches up with P and so AS falls (since EP influences intercept/shift) , where we end up back at the long run output, but at a higher price level (P=EP)