Chapter 14 – Aggregate supply and the short-run trade-off between inflation and unemployment

Question 1

What do the three models of aggregate supply have in common?

Answer 1

In all the models, some market imperfection causes the output of the economy to deviate from its natural level – as a result, the short-run aggregate supply curve slopes upward and shifts in the aggregate demand curve cause output to fluctuate

These temporary deviations of output from its natural level represent the booms and bursts of the business cycle

Short-run aggregate supply equation Y=Y ̅+α(P-P^e ),α>0

Where Y= output, Y ̅ = natural level of output, P = price level and Pe = expected price level

Thus, the equation states that output deviates from its natural level when the price level deviates from the expected price level

If price level is higher than expected price level, output exceeds natural level and vice versa

The parameter α indicates how much output responds to unexpected changes in the price level

1/α is the slope of the aggregate supply curve

The models are not incompatible

Important principle: long-run monetary neutrality and short-run monetary non-neutrality are perfectly compatible

Question 2

How does the economy respond to an unexpected increase in aggregate demand?

Answer 2

In the short-run, equilibrium moves up

Actual price level increases

As price increase was unexpected, expected price level remains the same

Output rises to be above natural level

Thus, the unexpected expansion in aggregate demand causes the economy to boom

Does not last – in the long run, the expected price level rises to catch up with reality causing short-run aggregate supply curve to shift upward

As the expected price level rises, the equilibrium moves up and to the left

The actual price level rises and the output falls

The economy returns to natural level of output but at a much higher price level

Question 3

What does the sticky-price model emphasise and say?

Answer 3

Emphasis that firms do not instantly adjust the price they charge in response to changes in demand

Says that the deviation of output from its natural level is positively associated with the deviation of the price level from the expected price level

Assumes firms have some market power – they are able to set their own prices

Question 4

What are 3 reasons prices are sticky?

Answer 4

(1) Long-term contracts between firms and customers
(2) Menu costs
(3) Firms do not wish to annoy customers with frequent price changes

Question 5

What two macroeconomic variables does a firm’s desired price depend on (Sticky-Price model)?

Answer 5

The overall level of prices P: the higher the firm’s costs, the higher the price they would like to charge

The level of aggregate income Y: a higher level of income raises the demand for the firm’s product – because marginal cost increases at higher levels of production, the greater the demand, the higher the firm’s desired price

p=P+a(Y-Y ̅)

a – measures how much the firm’s desired price responds to the level of aggregate output

This equation says that the desired price depends on the overall level of prices and the level of aggregate output relative to the natural level

Question 6

How do firms with flexible vs. sticky prices set their prices in the sticky-price model?

Answer 6

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

Firms with sticky prices set prices after p=P^e+a(Y^e-Y ̅^e)

Assume they expect output to be at natural level, i.e. a(Y^e-Y ̅^e )=0

Then they set prices at p=P^e i.e. what they expect other firms to charge

Question 7

How can we explain the two terms of the equation P=P^e+(1-s)(a/s) (sticky-price model)?

Answer 7

When firms expect high price level, they expect high costs, hence the firms that fix prices in advance set their prices high, causing other firms to also set high prices. High expected price level leads to actual high price level

High output = high demand. Firms with flexible prices set their prices high leading to high price level. The effect of output on the price level depends on the proportion of firms with flexible prices

Hence, overall price level depends on the expected price level and the level of output

α=s/[(1-s)a]
Algebraic rearrangement: Y=Y ̅+α(P-P^e )

Question 8

What does the sticky-price model imply about the real wage?

Answer 8

In contrast to sticky-wage model it implies a pro-cyclical real wage. Suppose aggregate output/income falls. Firms see falling demand, firms with sticky prices reduce product and thus demand for labour. The leftward shift in labour demand causes the real wage to fall.

Question 9

What does the sticky-wage model say about nominal wages and what does that imply for aggregate supply?

Answer 9

Nominal wages sticky in the short run

When the nominal wage is stuck, a rise in the price level lower the real wage, making labour cheaper

The lower real wage induces firms to higher more labour

The additional labour hired produces more output

This positive relationship between the price level and the amount of output means that the aggregate supply curve slopes upward during the time when the nominal wage cannot adjust to a change in the price level

Question 10

What is the intuition behind the sticky-wage model?

Answer 10

Assume firms and workers bargain over wage before they know price level

Have a real target wage in mind, probably higher than the equilibrium real wage

Firms and workers set nominal wage W based on the target real wage ω and their expectation of price level

W=ω*P^e

After nominal wage has been set and before labour has been hired, firms learn actual price level P

The real wage: W/P=ω*(P^e/P)

Real wage deviates from target if the actual price level differs from expected price level

Question 11

What is employment determined by and how can we describe the firms’ hiring decisions (sticky-wage model)?

Answer 11

Final assumption – employment is determined by the quantity of labour that firms demand

Firms’ hiring decision is described by the labour demand function: L=L^d (W/P) – the lower the real wage, the more labour firms hire

Output determined by production function Y=F(L) – the more labour hired, the more output produced

Question 12

When does output deviate from the natural level according to the sticky-wage model?

Answer 12

Because the nominal wage is sticky, an unexpected change in the price level moves the real wage away from the target real wage, and this change in real wage influences the amounts of labour hired and output produced. Output deviates from its natural level when the price level deviates from the expected price level

Question 13

What does the sticky-wage model imply about the real wage?

Answer 13

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

Question 14

What are the assumptions of the imperfect-information model?

Answer 14

Assumes markets clear – all wages and prices are free to adjust to balance supply and demand

Assumes each supplier in the economy produces a single good and consumes many goods

Each supplier knows the nominal price of the good he/she produces, but does not know the overall price level

Question 15

What does the imperfect-information model imply?

Answer 15

Short-run and long-run aggregate supply curves differ because of temporary misperceptions about prices

Suppliers cannot observe all prices at all times, monitor prices of the good they produce, less monitoring of goods they consume

Because of imperfect info, they sometimes confuse changes in the overall level of prices with changes in relative prices – influences decisions about how much to supply and leads to positive relationship between the price level and output in the short run

When firm makes production decision, they do not know the relative price of the goods but does know nominal price and has expectation of overall price level

When price levels rise unexpectedly, all suppliers in the economy observe increases in the prices of the goods they produce – they all infer that the relative prices of the goods they produce have risen – they produce more
Y=Y ̅+α(P-P^e)

Says that when actual prices exceed expected prices, suppliers raise output. Output deviates from the natural level when the price level deviates from the expected price level

Question 16

What is the Phillips curve?

Answer 16

A reflection of the short-run aggregate supply curve: as policy makers move the economy along the short-run aggregate supply curve, unemployment and inflation move in opposite directions. Unemployment is related to unexpected movements in the inflation rate

Question 17

What does the Phillips curve state the inflation rate depends on?

π=π^e-β(u-u^n )+v

Answer 17

Expected inflation, the deviation of unemployment from the natural rate i.e. cyclical unemployment and supply shocks

Inflation = Expected Inflation – (β*Cyclical unemployment) + Supply Shock

β – parameter measuring the response of inflation to cyclical unemployment, exogenous constant

The minus in front of cyclical unemployment: other things equal, higher unemployment is associated with lower inflation

Question 18

What is the connection between the Phillips curve equation and the aggregate supply equation?

Answer 18

Both equations show a link between real and nominal variables which causes the classical dichotomy to break down in the short run

According to the short-run aggregate supply equation, output is related to unexpected movements in the price level

According to the Phillips curve equation, unemployment is related to unexpected movements in the inflation rate

The aggregate supply curve is more convenient when we are studying output and the price level

The Phillips curve is more convenient when we are studying unemployment and inflation

Question 19

What is the assumption of adaptive expectations and why do we make it?

Answer 19

To make the Phillips curve useful for analysing the choices facing policy makers, we need to say what determines expected inflation. Assumption – people form their expectations of inflation based on recently observed inflation.

Question 20

What do we call the Phillips curve when written as: π=π_(-1)-β(u-u^n )+v ?

Answer 20

Then expected inflation equals last year’s inflation (adaptive expectations assumption). Hence, inflation depends on past inflation, cyclical unemployment and a supply shock. When written in this form, the natural rate of unemployment is sometimes called the Non-Accelerating Inflation Rate of Unemployment – NAIRU.

Question 21

What does it mean that inflation has inertia?

Answer 21

π_(-1) implies this. Inflation keeps going unless something acts to stop it. If unemployment is at NAIRU and there are not supply shocks, the continued rise in price level neither speeds up nor slows down. This inertia arises because past inflation influences expectations of future inflation and because these expectations influence the wages and prices that people set.

Question 22

How is inflation inertia interpreted in the model of aggregate supply and demand?

Answer 22

As persistent upward shifts in both aggregate supply and demand curves

Short-run aggregate supply curve will shift upward over time as it depends on expected price level

Will continue to shift upward until some event changes inflation and thereby changes expectations of inflation

Aggregate demand must also shift upward to confirm inflation expectations

Usually the continued rise in aggregate demand is due to persistent growth in M

If CB stops growing M, aggregate demand would stabilize and the upward shift in aggregate supply would cause recession

The high unemployment in the recession would reduce inflation and expected inflation, causing inflation inertia to subside

Question 23

What are two causes of rising and falling inflation?

Answer 23

Cost-push inflation: raise production costs and induce firms to raise prices, “pushing” inflation up – a favorable shock would “push” inflation down
Demand-pull inflation: positive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up. A negative demand shock which raises cyclical unemployment will “pull” inflation down

Question 24

The second and third terms of the Phillips curve equation show the two forces that can change the rate of inflation β(u-u^n )+v. Explain what they show

Answer 24

The second term shows that cyclical unemployment exerts upward or downward pressure on inflation

Low unemployment pulls inflation rate up: demand-pull inflation (high aggregate demand is responsible for this type of inflation)

The parameter β measures how responsive inflation is to cyclical unemployment

The 3rd term shows inflation also rises and falls because of supply shocks

An adverse supply shock implies a positive value of v and causes inflation to rise: cost-push inflation (as adverse supply shocks are typically events that push up production costs)

Question 25

Why does the trade-off in the Phillips curve only hold in the short run?

Answer 25

People adjust their expectations over time, so the tradeoff only holds in the short run. E.g. an increase in expected inflation shifts the short run PC upward.

Question 26

What is stagflation?

Answer 26

Simultaneously rising inflation and unemployment

Question 27

What is the short-run trade-off between inflation and unemployment and which options does it give the policy maker?

Answer 27

In the short run, inflation and unemployment are negatively related.

At any point in time, a policy maker who controls aggregate demand can choose a combination of inflation and unemployment on this short-run Phillips curve.

When unemployment is at the natural rate (u=u^n), inflation depends on expected inflation and supply shocks (π=π^e+v)

β determines the slope of the trade-off between inflation and unemployment

The position of the short-run Phillips curve depends on the expected rate of inflation
If expected inflation rises, the curve shifts upward, and the policy maker’s trade-off becomes less favorable: inflation is higher for any level of unemployment

Question 28

Why can a policy maker not keep inflation above expected inflation forever (and unemployment below the natural rate)?

Answer 28

People adjust their expectations of inflation over time

Eventually, expectations adapt to whatever inflation rate the policy maker has chosen

In the long run, the classical dichotomy holds, unemployment returns to its natural rate, and there is no trade-off between inflation and unemployment

Question 29

What is the sacrifice ratio?

Answer 29

The percentage of a year’s real GDP that must be foregone to reduce inflation by 1 percentage point

Question 30

How can we interpret the sacrifice ratio in terms of the Phillips curve?

Answer 30

When we move along the short-run Phillips curve, we trade off inflation against unemployment. A typical estimate of this trade-off says that a change of 1 percentage point n the unemployment rate translates to a change of 1.5 percentage points in GDP.

Question 31

What is an alternative assumption to the assumption of adaptive expectations?

Answer 31

Rational expectations – people optimally use all the available information to forecast the future i.e. expected inflation should also depend on the monetary and fiscal policies in effect

A change in monetary or fiscal policy will change expectations and an evaluation of any policy change must incorporate this effect on expectations

If people form expectations rationally, inflation may have less inertia than it first appears

Advocates of rational expectations argue that the short-run Phillips curve does not accurately represent the options that policy makers have available

If policy makers are committed to reducing inflation, rational people will understand the commitment and lower their expectations for inflation

Inflation can then come down without a rise in unemployment and fall in output – traditional estimates of the sacrifice ratio are thus not useful

Question 32

What are two requirements of a painless disinflation?

Answer 32

Reducing the rate of inflation without causing a recession

(1) The plan to reduce inflation must be announced before the workers and firms who set wages and prices have formed their expectations
(2) The workers and firms must believe the announcement

If both requirements are met, the announcement will immediately shift the short-run trade-off between inflation and unemployment downward, permitting a lower rate of inflation without higher unemployment

Question 33

What is the natural-rate hypothesis assumption?

Answer 33

Fluctuations in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment and unemployment described by the classical model.

Question 34

What is hysteresis?

Answer 34

The term used to describe the long-lasting influence of history on the natural rate. Some economists have suggested that aggregate demand may affect output and employment in the long run. They have pointed out a number of mechanisms through which recessions might leave permanent scars on the economy by altering the natural rate of unemployment.

Question 35

How can a recession have permanent effects?

Answer 35

Changes the people who become unemployed. Workers might lose valuable job skills when unemployed, lowering ability to find job when recession ends

A long period of unemployment might alter individual’s attitude towards work

Changing the process that determines wages – those who become unemployed might lose their influence on the wage-setting process

Some insiders in wage-setting process might become outsiders – if the smaller group of insiders care more about a high real wage and less about high employment, then the recession may permanently push real wages further above equilibrium level and raise the amount of structural unemployment

Hysteresis raises the sacrifice ratio because output is lost even after the period of disinflation is over

Question 36

When does inflation have inertia?

Answer 36

If expected inflation depends on recently observed inflation, then inflation has inertia, which means that reducing inflation requires either a beneficial supply shock or a period of high unemployment and reduced output. If people have rational expectations, however, then a credible announcement of a change in policy might be able to influence expectations directly, and therefore reduce inflation without causing a recession.