Chapter 13: Aggregate Supply

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Chapter 13Aggregate Supply
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The Model

• The relationship between production of goods and
  services and the general price level
• Y Y a (P Pe)
• Where
• Y actual level of output
• Y full-employment level of output
• P actual price level
• Pe expected price level

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Aggregate Supply
Price level
Long-run AS where P Pe
Short-run AS where P gt or lt Pe
P
Output, Income
Y
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Sticky Wage Model

• Nominal wages are sticky downward. They adjust to
  price changes slowly.
• Demand for Labor Ld L(W/P)
• Production Function Y F(L,K)
• As price (P) increases, the real wage (W/P)
  falls, firms respond by hiring more labor (L) and
  producing more output (Y).

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Sticky Wage Model
Real Wage
Output
Y1
Y
Y2
W/P1
W/P2
Ld
Labor
Labor
L1
L1
L2
L2
Price
Short-run AS
P2
P1

Output
Y1
Y2
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Workers Misperception Model

• Workers confuse nominal wage changes with
  real wage changes when the price level changes
  unexpectedly
• Demand for Labor Ld L(W/P)
• Supply for Labor Ls L(W/Pe)
• Write the expected real wage as W/Pe W/P
  P/Pe
• As P increases, W/P declines but P/Pe increases.
  Workers confuse the real wage decline with a
  nominal wage increase, hence supplying more labor
  services

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Workers Misperception Model
Real Wage
Price
Ls1
Short-run AS
Ls2
P2
W/P1
P1
W/P2
Ld
Output
Labor
L1
L2
Y1
Y2
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Imperfect Information Model

• Firms track price changes of their own product
  more closely than changes of the general price
  level. Perceptions of an increase in the
  relative price level causes the labor demand,
  employment, and output to rise.
• Let PW price of wheat and P general price
  level. With inflation, farmers perceive Pw/P is
  increased, hence hiring more labor and producing
  more output

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Imperfect Information Model
Real Wage
Output
Y1
Ls
Y
Y2
W/P2
W/P1
Ld2
Ld1
Labor
Labor
L1
L1
L2
L2
Price
Short-run AS
PW2
PW1

Output
Y1
Y2
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Sticky Price Model

• Two kinds of firms
• Flexible-price firms those with market power to
  adjust their prices in response to market changes
• p P a (Y Y)
• Fixed-price firms those with no market power,
  hence unable to adjust their prices
• p Pe

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Sticky Price Model

• The general price level is the weighted average
  price charged by the flexible-price and
  fixed-price firms
• P sPe (1-s)P a (Y Y)
• Here s is the market share of the fixed-price
  firms and (1-s) is the market share of the
  flexible-price firms

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Sticky Price Model

• The aggregate supply curve is
• Y Y a (P Pe)
• Where a s / a(1-s)

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Shift in Aggregate Demand

• Assume the AD rises due to greater expenditures
  in the economy, increasing the level of price and
  output.
• People adjust their expectations for higher
  prices. A higher expected price level results in
  a lower expected real wage.
• The supply of labor declines, reducing the AS and
  the level of output. Long-run equilibrium is
  achieved at the natural level of output, but a
  higher price level

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Shift in Aggregate Demand
Price level
Long-run AS
SRAS2
SRAS1
C
P3
P2
B
P1
A
AD2
AD1
Output, Income
Y
Y1
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The Phillips Curve

• The relationship between inflation rate and
  unemployment rate, In the short-run
• p p - ß(u- u) v
• p actual inflation rate
• p expected inflation rate
• u actual unemployment rate
• u natural unemployment rate
• v cost-push factor
• ß the output adjustment factor

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The Phillips Curve

• There is a trade-off between inflation and
  unemployment
• In the long-run, u u and v 0, so p p no
  trade-off between inflation and unemployment
• Stagflation is depicted by a shift of the
  Phillips Curve, resulting in higher unemployment
  and inflation

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Shift of the Phillips Curve
Inflation Rate
p2
B
P2
p1
A
P1
u2
u1
Unemployment Rate