Macroeconomics Week 4: Short-Run Aggregate Supply and the Phillips Curve

Question 1

Describe & interpret the simple representation of the short-run supply model

What’s the issue with it?

Answer 1

• “Income, output, Y” as x-axis and “Price level, P” at y-axis.
• Horizontal line, “SRAS” drawn from y-axis and vertical line.
• Vertical line, “LRAS” drawn from x-axis, where there’s a point “Ybar”.
• Point “A” is where LRAS and SRAS cross. There’s also a downard (with a positive d^2 y / dx^2) sloping line, “ADbottom right1”.
• There’s another slope parallel to AD1, on its right, “AD2”.
• Arrow from AD1 to AD2 (representing a shift in AD), with label “1. A rise in aggregate demand…”
• Point “B” at where AD2 and SRAS cross with label “2. …raises output in the short run…”. Also, arrows going through SRAS from A to B.
• Point “C” at where AD2 and LRAS cross with label “3. …but in the long run only affects the price level.”. Also, arrows going through AD2 from B to C.

Interpretation

Key point: shifts in AD only affect output in the short-
run and only affect the price level in the long-run.
It’s as if prices cannot change in the short-run. This is
not particularly realistic, with the possible exception of
a deep recession/depression (Keynes).
Now: we still accept that shocks/policy changes affect
only the price level in the long-run (A to C) but we need
to rethink the short-run (A to B).

Question 2

What can we derive from the ‘new’ SRAS model?

Answer 2

The Phillips Curve

Question 3

What does the Phillips Curve show?

Answer 3

The Phillips curve shows the short-run tradeoff
between inflation and unemployment…
…but the tradeoff is temporary (it only applies in the
short-run); this has important policy implications.