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Macroeconomics > SR tradeoff between inflation & unemployment > Flashcards

SR tradeoff between inflation & unemployment Flashcards

1
Q

What is the traditionally accepted presumptions about the LRAS and SRAS curves?

A

LRAS- Output does not change in long run

SRAS- Prices do not change in the short run- they are sticky.

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2
Q

Why might aggregate demand change?

A
  • Increase in the availability of credit cards
  • Tax cut
  • Change in monetary policy e.g. decrease in interest rates
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3
Q

When might a horizontal SRAS be feasible?

A

During a deep recession where firms can employ as much workers without affecting real wages (thus price levels stay fixed or sticky),

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4
Q

What are they key features of the post- Keynesian SRAS curve?

A
  • Upward sloping curve
  • Can be used to derive the Phillip’s curve which depicts the tradeoff between inflation and unemployment
  • Trade off is temporary (i.e. only short run) but still affects policy setters.
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5
Q

What two theories explain the upward- sloping SRAS curve?

A
  • Sticky prices: some firms are more flexible than others and so ca change their prices more frequently, whilst others have fixed prices for a short term period.
  • Imperfect Knowledge: Departure from the world of perfect competition; firms do not know the price of their competitors’ goods.
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6
Q

What is the key friction of the Sticky price model and why does it arise?

A
  1. Some firms cannot change prices in response to aggregate demand.
  2. This is due to sticky wages, menu costs (too expensive to change prices e.g. a restaurant having to reprint all its menus), price commitments to its customers.
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7
Q

What is the SRAS curve equation?

A 
Y=ȳ+α(P-EP)
Where Y is output
ȳ is natural level of output
P is general price level
EP is expected general price level
α is a parameter that determines how much deviations from expected general price level affects output. Output differs from its natural level if p≠EP
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8
Q

How can the SRAS equation be rearranged to make price level the subject?

A 
Y=ȳ+α(P-EP)
1/α.Y= ȳ+(P-EP)
1/α.(Y-ȳ)= P-EP
P=1/α.(Y-ȳ)+EP
So general price level depends on expected price level and deviation from natural level of output.
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9
Q

How can we find a flexible firm’s desired price?

A

p= P- a(Y-ȳ)
p- price of firm’s good
P- General price level

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10
Q

How can we find a sticky firm’s desired price?

A 
Ep= EP+a(EY-Eȳ)
(EY-Eȳ)- Expected deviation from natural level of output
EP- Expected price level.
BUT we take EY=Eȳ so
Ep=EP
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11
Q

How do you find the general price level?

A

By finding the weighted average of sticky and flexible firms.
P=sEP+(1-s)(P+a(Y-ȳ))
s-fraction of sticky firms
(1-s)- fraction of flexible firms

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12
Q

What is wrong with the initial weighted general price level? how is this corrected?

A

Price level is on both sides of the equation. We arrange the formula to get:
P=sEP+(1-s)/s.a.(Y-ȳ)

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13
Q

What is the relationship between EP and general price level?

A
  • EP increases with P
  • If firms pre-empt a higher price level this means there will be higher costs
  • To make up for the higher costs firms increase their prices
  • Firms with flexible prices respond to this by increasing their prices
  • This is like a self- fulfilling prophecy; expecting higher price levels increases price levels.
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14
Q

What is the relationship between Y and general price level with respect to the sticky price theory formula?

A
  • Price levels increase with output
  • Larger output implies a larger demand
  • Firms charge a higher price if demand is high; which increases price levels.
  • The larger a is, the greater the effect of Y on general price levels.
  • The larger s is, the smaller the effect of Y on price levels.
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15
Q

With the rearranged general price formula in mind what happens when:

a. s=0
b. s=1

A

a. When S=0 there are no sticky firms and thus the value of a.(1-s)/s.(Y-ȳ)=0 so output is independent of price levels.
b. If S=1 then there are no flexible firms then by definition price level is held constant as firms are unable to change their price.

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16
Q

What are the key tenets of the imperfect information model?

A
  • Prices are fully flexible (no price stickiness)
  • Each supplier produces a single good but also consumes goods produced by other suppliers
  • Key friction being there are so many goods so suppliers are unable to perfectly observe prices at all times
  • They know the price of their good but to costly to monitor all other goods.
17
Q

What is the supplier’s problem?

A
  • The supplier of good i bases their output on relative prices.
  • The supplier sells good i for price pi and uses this income to buy goods from other suppliers.
  • If pi/P (general price level) is high then the real income is high which motivates the supplier of i to work harder and make more of i.
  • Supplier i knows perfectly the price of i but does not perfectly know the general price level,p.
18
Q

According to the imperfect information model what is the formula for supply?

A

Supply= f(pi/P)

19
Q

According to the perfect information model, what is the significance of ALL goods rising in price by x%?

A
  • no change in real price i.e. pi/P stays the same
  • so supplier should not increase output
  • an increase in output means the supplier mistook what is essentially inflation for a growth in real price.
20
Q

According to the perfect information model AND factoring in expectations, should a firm increase its output if ALL prices of firms incur an increase of x%?

A
  • No as there is no increase in pi/P (real income)
  • The firm will not increase supply if increase in price was expected
  • The firm will increase its supply if the increase is unexpected.
21
Q

What is the problem that all suppliers face according to imperfect information and how is this represented by an equation?

A
  • Y=ȳ-α(P-EP)
  • if price levels deviate from expected price levels then output deviates from its natural level of output.
  • if P>EP then output increases (increases unexpectedly) so suppliers increase their output as they wrongly believe their real income has increased.
22
Q

According to the Philip’s curve what does inflation depend on?

A

-expected inflation
-cyclical unemployment
-supply shocks
Π=EΠ-β(u-u^n)+ν

23
Q

How do we derive the Phillip’s curve from the SRAS price equation?

A 
SRAS equation: P=EP+1/α(Y-Y̅)
We then add supply shock to this: P=EP+1/α(Y-Y̅)+ν
We can re write this as:
Pt-Pt-1=(EPt-Pt-1)+1/α(Y-Y̅)+ν
EPt-Pt-1 represents the difference between expected price level and yesterday's price level.
Changes in price levels is inflation:
Π=EΠ+1/α(Y-Y̅)+ν
We know that Okun's law states:
1/α(Y-Y̅)=-β(u-u^n)
so we can substitute:
Π=EΠ-β(u-u^n)+ν
24
Q

What are the two types of inflation according to the Phillip’s curve?

A
  1. demand pull inflation: -β(u-u^n)
    - If cyclical unemployment decreases this causes inflation. This is because there is an increase in demand for goods so firms hire more workers to meet this, but an increase in demand causes firms to increase prices which increases price levels.
  2. Cost push inflation: v
    - adverse shock causes v to increase eg oil price shock in the 1970’s means v>0 and causes inflation. Oil factor of production to make up for increased costs firms increase prices which increases price levels.
25
Q

What does the Phillip’s curve represent for traditional thought?

A

The breakdown of the classical dichotomy which stated that real values did not depend on nominal values. E.g. the curve shows unemployment depends on inflation rates and output depends on price levels.

26
Q

What is the significance of β in the Phillip’s curve?

A

It represents the trade off between unemployment and inflation rate.

27
Q

What is the sacrifice ratio?

A

It represents the % GDP must decrease by to decrease inflation by 1%. it is currently estimated to be 5%.

28
Q

What happens to the trade off between unemployment and inflation in the long run ?

A

In the long run inflation equates to expected inflation and there are no supply shocks so un=u. The trade off breaks down

29
Q

What is the natural rate hypothesis ?

A

In the long run unemployment will always return to u^n after any deviation.

30
Q

What is the theory of hysteris ?

A

The belief that u^n increases with unemployment due to scars, so the u^n is not constant in the long run.

Macroeconomics (7 decks)

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