L5 - Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment

Question 1

What do all the Model of Short-run Aggregate Supply converge to?

Answer 1

output is positively related to the deviation between the actual price level and expected price level

Question 2

What are some assumptions about the sticky-wage model of SRAS?

Answer 2

• Assumes that firms and workers negotiate contracts and fix the nominal wage before they knwon what the price level will turn out to be
• Nominal Wage, W, they set is the product of a target real wage,ω, and the expected price level

So nominal wage = the target real wage * expect price level

so the real wage which is W/P is the target real wage * the ratio of expected prices to real price level

Question 3

How can the sticky-wage model be derived mathematically?

Answer 3

• Firms will have an equilibrium level of unemployment where the Marginal Product of Labour (MPL - additional output of an extra unit of labour ) = the real wage(W/P) –> this is the real cost of hiring a worker for the firm
• Therefore there is a negative relationship between the demand for labour and the real wage –> as the lower the real wage the more people a firm employ
• However if Labour demand depend on the target real wage -> L^d(ω) then the level of employment depends on the natural rate of unemployment L(bar) (bar normally means fixed) –> NAIRU??
• The natural rate of unemployment means when output is at its natural level –> when L is at L(bar) , Y is at Y(bar) –> this is the economy’s long run position
• Capital is fixed in this model

Question 4

What does the sticky wage model look like on a graph?

Answer 4

• when prices increase, our real wage falls, so labour increases, output therefore increases
• As Prices have deviated from what we have expected it to be, both labour and output have deviated from their natural level

Question 5

What is the implication of the Marginal Product of Labour formula?

Answer 5

Question 6

What is the flaw of the sticky wage model?

Answer 6

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 –> the real wage has actual been shown to be pro-cyclical, meaning when we have booms wages increase and in recessions they decrease or acyclical meaning it has no relationship with economic cycles

Question 7

What are the two pieces of empirical evidence about the sticky-wage model?

Answer 7

Barsky and Solon (1989)

Sumner and Silver (1989)

Question 8

What did Barsky and Solon (1989) say about the sticky-wage model?

Answer 8

• Barsky and Solon (1989) starts by quoting three studies, all published in the 1980s, which concluded that real wages were, in turn, acyclical, procyclical, and countercyclical.
• Looking at industry-wide data, Barsky and Solon (1989) find that there is little if any evidence of countercyclical real wages.
• Studies of micro data, however, provide quite strong evidence of procyclicality in the real wage. –> which correlates with wages in the US real wage –> output are real wage rise together
• Barsky and Solon (1989) find procyclicality when they look at data from the Panel Study of Income Dynamics, which studies the behavior of individual households. These findings are broadly in accordance with those of Bils (1985), who studied microeconomic data from the National Longitudinal Survey.

Question 9

What did Sumner and Silver (1989) say about the sticky-wage model?

Answer 9

• Sumner and Silver (1989), note that results on the cyclicality of the real wage are sensitive to sample period.
• the data are consistent with sticky-wage theories.
• Basically, their argument is that shocks to aggregate demand will cause prices to be procyclical and shocks to aggregate supply will cause prices to be countercyclical.
• If nominal wages are sticky, then we should observe procyclical real wages when inflation is countercyclical, and vice versa. This is borne out by the data.

Question 10

What are reasons for sticky prices?

Answer 10

Firms do not always change their prices immediately when AD changes and they remain the same for a shoret-period of time, so reasons for this are:

• Long-term contracts between firms and customers
• menu costs –> cost of repricing (changing on computer systems, menus, on shelfs, new barcodes)
• firms do ot wish to annoy customers with freuqent price changes

Question 11

What is the assumption for the stick-price model?

Answer 11

Firms set their own prices (as in monopolistic competition)

Question 12

What is a individual firm’s desired price in the sticky-price model?

Answer 12

p = desired price

P = overall price level

Y-Y(bar)= Aggregate output - Natural level of output

a = how responsive a firms prices are to changes to output around its natural level

In a boom (when output exceeds the natural level) their is an inflationary effect on the price level and a firms desired price level rises

Question 13

What are the two types of firms in the sticky price model?

Answer 13

firms with sticky prices –> base P and Y on expectation (E) because they do not have all the information so they must anticipate what they must be

Question 14

What assumption do we make about sticky-price firms?

Answer 14

That EY = EY(bar) thus making the bracket 0

Using this assumption the pricing strategy for the sticky-price firm is p=EP –> just based on expected prices

Question 15

How do you derive the overall price level for the sticky- price model?

Answer 15

• To derive the aggregate supply curve first we must find an expression for the overall price level –> if s = the fraction of firms with sticky prices thus (1-s) = the fraction of firms with flexible prices we can derive the overall price level as follows:

Question 16

What can we derive from the Overall Price Level in the Sticky-Price model?

Answer 16

• Hight EP –> high P
  
  • If firms expect high prices, then firms that must set prices in advance will set them high.
    Other firms respond by setting prices high
• High Y –> high P
  
  • When income is high, the demand for goods is high. Firms with flexible prices set prices high.
• •The greater the fraction of flexible-price firms, the smaller is s and the bigger the effect of ΔY on P.

Question 17

What is the equation for the aggregate Supply Curve in the Sticky-Price Model?

Answer 17

Question 18

What are the assumptions of the Imperfect-information model?

Answer 18

•All wages and prices are perfectly flexible, and
all markets are clear.

• Each supplier produces one good and consumes many goods.
• Each supplier knows the nominal price of the good she produces but does not know the overall price level.

Question 19

What does supply depend on in the imperfect-information model?

Answer 19

• The supply of each good depends on its relative price: the nominal price of the good divided by the overall price level. (P-EP)
• The supplier doesn’t know price level at the time she makes her production decision so uses EP.
• Suppose P rises but EP does not.
  
  • Supplier thinks her relative price has risen, so she produces more.
  • With many producers thinking this way, Y will rise whenever P rises above EP.

Question 20

What does the imperfect information model look like on a graph and what are its implication?

Answer 20

P > EP –> Output exceeds natural level

P=EP –> output is equal to natural level

P < Ep –> output is below the natural level

If α is constant, the SRAS would be linear, but what we have seem is that the aggregate supply curve can be curve this is because:

• When P is high, the curve tends to be steeper –> output is higher than the natural level, and Production Possibiltiy Frontier, resources are been used in excess of their potential, so producers are relucant to increase supply further, thus a larger incentive in rise in P would be need for this to occur –> large amounts of inflation for a small change in output
• When P is low, the curve tends to be flatter –> output is below its natural level, thus they are not producing on their production possibility frontier, so some resources are idle, this means you can increase output by small incremental rises in P as resources are already idle and they would make more money from producing more at the higher price

This is important for policy changes e.g. if you want to implement a tax cut, you need to know which side of the curve you are on, when P is low the increase in output from the reduction in tax will bring about low inflation, but when P is high this may bring unwanted amounts of inflation

Question 21

What does the complete model of AD-AS look like and what are the implications of it?

Answer 21

• At A if we had expansionary fiscal policy e.g. increase in government spending, this will shift AD₁ to AD₂–> causes AD > AS in the short run and output exceeds it natural rate (boom)
• this lead to an increase in prices (P) in the economy (inflationary) but EP has not risen in the short term
• in the long term peoples expectation changes (as prices are higher than expected) people adjust there prices –> this lead to a shift upwards of the AS curve from AS₁ to AS₂
• So in the long-run we revert to the natural level of output but at a higher price level and higher expectations

Question 22

What is the Phillips Curve?

Answer 22

• The Phillips curve states that π depends on:
  
  • expected inflation, Eπ
  • cyclical unemployment: the deviation of the actual rate of unemployment (u) from the natural rate (uⁿ)
  • supply shock, ν (greek letter nu)

π=Eπ- β(u-uⁿ) + v

where β>0 is an exogenous constant –> responsiveness of inflation to changes in cyclical unemployment

• the trade off between inflation and unemployment only occurs in the short-run
• Phillips curve relations to the AD-AS model as –> if output is change, employment is changing, and in Price levels are change, so is inflation

Question 23

How do you derive the Phillips curve from the SRAS?

Answer 23

1. SRAS curve
2. make price the subject
3. Add supply shock, v
4. move from level to rate (take a lag on the price value to get a percentage change as inflation is measured as a percentage)
5. sub in inflation and expected inflation
6. Okun’s law states that a one-point increase in the cyclical unemployment rate is associated with two percentage points of negative growth in real GDP. –> relate unemployment to output
7. Phillips curve

Question 24

What is the difference between SRAS and the Phillips curve?

Answer 24

Question 25

How can Expecations been encorporated into the Phillips curve?

Answer 25

Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation.

A simple version: expected inflation = last year’s actual inflation

Eπ=π_t-1

Then the Phillips curve equation becomes:

π=π_t-1-β(u-uⁿ) + v

Question 26

What is Inflation inertia?

Answer 26

π=π_t-1-β(u-uⁿ) + v

In this form, the Phillips curve implies that inflation has inertia:

• In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate.
• Past inflation influences expectations of current inflation, which in turn influences the wages and prices that people set

Question 27

What are the two different types of inflation?

Answer 27

π=π_t-1-β(u-uⁿ) + v

• cost-push inflation:
  
  • inflation resulting from supply shock
  • Adverse supply shocks typically raise production costs and induce firms to raise prices, pushing inflation up.
• demand-pull inflation:
  
  • inflation resulting from demand shocks
  • Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which pulls the inflation rate up.

Question 28

What does the Phillips curve look like on a graph?

Answer 28

• Trade-off between unemployment and inflation only applies short-term, in the long run because LRAS is constant shift in AD only lead to inflation, and when peoples expectation adjusts, inflation will be higher even for previous values of unemployment

Question 29

What does a cost push nflation shock look like on a graph?

Answer 29

1. when their is a spike in prices, inflation deviates from expected inflation –> causes unemployment to be lower in the short run because real wage w/p so cost of employment has fallen so firms higher more labour
2. People adjust their expectation in the long run –> pushes the phillips curve outwards –> unemployment is higher on the new phillips curve as firms believe there costs have gone up so employ less labour. then when expectations have adjusts after the shock and unemployment is at its natural rate

Question 30

What is the sacrifice ratio?

Answer 30

• To reduce inflation, policymakers can contract aggregate demand, causing unemployment to rise above the natural rate.
• The sacrifice ratio measures the percentage of a year’s real GDP that must be forgone to reduce inflation by 1 percentage point. (how much unemployment can I accept to reduce inflation)
• A typical estimate of the ratio is 5.
• See Ball (1994) for more estimates.

GDP loss = (inflation reduction) x (sacrific ratio)

• The cost of disinflation is lost GDP. One could use Okun’s law to translate this cost into unemployment.
• As a policy maker you can decide how large the GDP loss is be how aggressive your policy is, you could reduce inflation a little every year instead of all at once to keep the loss at a constant and not have a huge drop in GDP

Question 31

What are the ways of modelling the formation of expectation?

Answer 31

•Ways of modeling the formation of expectations:

•adaptive expectations:
People base their expectations of future inflation on recently observed inflation.

•rational expectations:
People base their expectations on all available information, including information about current and prospective future policies.

Question 32

How can rational expectations be linked to the sacrifice ratio?

Answer 32

• Proponents of rational expectations believe that the sacrifice ratio may be very small:
• Suppose u = uⁿ and π = Eπ = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6% to 2% as soon as possible.
• If the announcement is credible and users are rational, then Eπ will fall, perhaps by the full 4 points.
• Then, π can fall without an increase in u. –> as people believe the government and immediately adjust their expectations so the new lower of inflation already matches expected inflation causing unemployment to not deviate from its natural level

Question 33

What is Okun’s Law?

Answer 33

In economics, Okun’s law is an empirically observed relationship between unemployment and losses in a country’s production. The “gap version” states that for every 1% increase in the unemployment rate, a country’s GDP will be roughly an additional 2% lower than its potential GDP

Check calculation on lecture for practice