Chapter 14 Flashcards
What are the types of aggregate supply curves?
A vertical aggregate supply curve (AS) when prices are flexible in the long run
A horizontal aggregate supply curve (AS), by simplification that the prices are completely fixed in the short run
What is the aggregate supply upward sloping formula, what does it mean?
Y = Y + (P - Pe)
Y: Actual Output
Y : Potential Output
: Positive Parameter
P: Actual Price Level
Pe: Expected Price Level
This means that the output deviates from its natural level, when price levels deviate from its expected level
Essentially the short run exist because of some confusion in the economy Pe =/ P
In the long run there is no confusion: Pe = P -> Y = Y u = u
Why is aggregate supply upward sloping in the short run? List two reason
There are two prominent models of aggregate supply in the short run: Sticky-price model, imperfect-information model
Explain the sticky price model assumptions
Assumptions: Firms have some degree of market power (like monopolistic competition, so can set their own prices)
Different firms choose different frequencies for setting their prices, based on a list of reasons (like long-term contracts, menu costs, hierarchical and administrative delays, sticky wages that leads to sticky production costs, or not annoying customers)
Suppose a typical firm’s desired price level is set as this:
p = P + a (Y - Y)
(Y - Y) : When the economy is weak (output is below its natural rate), the firm set its price lower, and in a boom when demand is high the firm sets its price higher.
P: The overall price level. Higher overall price level means higher production costs.The firm’s price should be set higher.
p = the firm’s price
What are the two types of sticky price model?
Suppose there are two types of firms in an economy
Type 1 (flexible price firms): These firms are well-informed about the overall price level, P, and their demand so have flexible prices. They set their prices according to:
p1 = P + a (Y - Y)
These firms increase their prices either if the overall price level, P, increases or if demand Y is higher (during booms when demand is strong)
Type 2(sticky price firms): These firms must know their prices in advance before they know how P and Y will turn out. They set and hold their prices fixed in the short run (sticky) accordiong to following rule, and supply for any amount of demand for output at this price:
p2 = Pe + a (Y - Y)e
(Y - Y)e: The price should be set lower or higher if the firms expect a weak (recession) or strong (boom) demand
Pe: Expected price, if these firms expect a higher overall price level, they set higher prices
Suppose (Y - Y)e = 0 then P2 = Pe
In the sticky price level what is the firms OVERALL price level? SRAS?
SRAS: P = Pe + a ( 1- s)/s (Y - Y)
If Pe↑ -> P↑
If the sticky price firms expect a higher pierce, they set price higher prices, high overall price, the flexible price firms set prices higher to, the overall price is even higher
If Y↑ -> P↑
Higher income: Higher demand for goods, the flexible price firms set higher prices, the overall prices is higher
The greater the fraction of flexible price firms: the smaller is s, the bigger the effect of change of Y on P
What is the imperfect information model?
Based on this model the upward sloping short run aggregate supply curve is due to a misperception of firms about prices, confusing changes in price levels with changes in relative prices
In the short run, suppliers do not know the overall price level, P
In the short run, suppliers set there expected price, Pe and keep it fixed in the short run
In the short run, each firm makes there output decisions based on: Pf/Pe
Draw the imperfect information model and explain.
Suppose initially the economy is at point O: Pe = P
If overall price, P rises above Pe: P > Pe
Firms may confuse the rise in the overall price with the rise in their relative prices so raise, so raise the output y
If the overall price, P, falls below Pe: P < Pe
Price of each firm falls with P: Pf ↓ -> Pf/Pe↓
Firms may confuse the fall in overall price with the rise in their relative prices so reduce the output.
Demand Side Policies and Shocks: What happens with unexpected expansionary fiscal policy?
Short Run & Long Run
Short Run:
Planned expenditure rises
Inventory levels fall
Output/Income Y rises
Type 1 firms (flexible price firms) set higher prices
Overall price level P rises
Supply real money falls,people need liquidity
People tend to sell bonds
Price of bonds fall
Interest rate rises
Investment, I, falls
Also:
Consumption C, rises
Unemployment, I falls
Long Run:
Expected price, Pe, is adjusted upward
Type 2 firms (sticky price firms) set higher prices
Overall price, P rises
Real money supply, M/P shrinks
People tend to sell bonds
Price of bonds fall
Interest rate, r , rises
Investment, I falls
Planned Expenditure falls
Inventory levels rise
Output/Income Y falls back to Ybar
Consumption C falls
Also:
Unemployment rises back to u
Demand Side Policies and Shocks: What happens with unexpected expansionary monetary policy?
Short Run
Central bank buys bonds
Price of bonds rises
Interest rate falls
Investment rises
Planned Expenditure rises
Inventory levels fall
Output/Income Y rises
Type 1 firms (flexible price firms) set higher prices
Overall price, P, rises
Also:
Consumption, C, rises
Unemployment falls
Long Run:
Expected price, Pe is adjusted upward
Type 2 (Sticky Price firms) set higher prices
Price P increases
Real money supply, M/P shrinks
People tend to sell bonds
Price of bonds fall
Interest rate, r rises
Investment, I fall
Planned expenditure falls
Inventory levels rise
Output/income, Y , falls back to Ybar
Also:
Consumption, C, falls
Unemployment rises back to U
