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               CHAPTER 13
Aggregate Supply and the Short-run Tradeoff
   Between Inflation and Unemployment

                            A PowerPointTutorial
                                    To Accompany

             MACROECONOMICS, 7th. Edition
                  N. Gregory Mankiw
                               Tutorial written by:
                       Mannig J. Simidian
                 B.A. in Economics with Distinction, Duke University            1
 Chapter Thirteen
              M.P.A., Harvard University Kennedy School of Government
   M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
When we introduced the aggregate supply curve of Chapter 9, we
established that aggregate supply behaves differently in the short run
than in the long run. In the long run, prices are flexible, and the
aggregate supply curve is vertical. When the aggregate supply curve is
vertical, shifts in the aggregate demand curve affect the price level, but
the output of the economy remains at its natural rate. By contrast, in
the short run, prices are sticky, and the aggregate supply curve is not
vertical. In this case, shifts in aggregate demand do cause fluctuations
in output. In Chapter 9, we took a simplified view of price stickiness
by drawing the short-run aggregate supply curve as a horizontal line,
representing the extreme situation in which all prices are fixed. So,
now we’ll refine our understanding of short-run aggregate supply to
better reflect the real world in which some prices are sticky and others
are not.
    Chapter Thirteen                                                2
Inflation, p After examining the basic theory of the short-run aggregate
             supply curve, we establish a key implication. We show that
             this curve implies a trade-off between two measures of
             economic performance– inflation and unemployment. This
                      trade-off, called the Phillips curve, tells us that to
                      reduce the rate of inflation policymakers must
                              temporarily raise unemployment, and to
                              reduce unemployment, they must accept
                                      higher inflation. But, this tradeoff is
                                                 only temporary. One goal
                                                 of this module is to help
                           Unemployment, u
                                                 explain how and why
             policymakers face such a tradeoff in the short run and, why
             just as importantly, they do not face it in the long run.
    Chapter Thirteen                                                  3
Let’s now look into a few prominent models of aggregate supply:
Sticky-price, which is most widely accepted, and an alternative theory

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 is upward sloping, rather than
vertical, and shifts in the aggregate demand curve cause the level of
output to deviate temporarily from its natural level. These temporary
deviations represent the booms and busts of the business cycle.
Although these models takes us down a different theoretical
route, each route ends up in the same place. That final destination is a
short-run aggregate supply equation of the form…
    Chapter Thirteen                                                4
               Y = Y + a(P-EP) where a > 0
                                                      price level
                            positive constant:
                  Natural     an indicator of Actual price level
              rate of output how much
                             output responds
                              to unexpected
                              changes in the
                                price level.
This equation states that output deviates from its natural level when the
price level deviates from the expected price level. The parameter a
     Chapter how
indicates Thirteen much output responds to unexpected changes in the price
level, 1/a is the slope of the aggregate supply curve.
Our first explanation for the upward-sloping short-run aggregate supply
curve is called the sticky-price model. This model emphasizes that firms
do not instantly adjust the prices they charge in response to changes in
demand. Sometimes prices are set by long-term contracts between firms
and consumers.

To see how sticky prices can help explain an upward-sloping aggregate
supply curve, first consider the pricing decisions of individual firms
and then aggregate the decisions of many firms to explain the economy
as a whole. We will have to relax the assumption of perfect competition
whereby firms are price-takers. Now they will be price-setters.

   Chapter Thirteen                                               6
Consider the pricing decision faced by a typical firm. The firm’s
desired price p depends on two macroeconomic variables:
1) The overall level of prices P. A higher price level implies that the
firm’s costs are higher. Hence, the higher the overall price level, the
more the firm will like to charge for its product.
2) 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.
The firm’s desired price is:
                                p = P + a(Y-Y)
This equations states that the desired price p depends on the overall
level of prices P and on the level of aggregate demand relative to its
natural rate Y-Y. The parameter a (which is greater than 0) measures
     much the
howChapter Thirteen firm’s desired price responds to the level of aggregate
Now assume that there are two types of firms. Some have flexible prices:
they always set their prices according to this equation. Others have sticky
prices: they announce their prices in advance based on what they expect
economic conditions to be. Firms with sticky prices set prices according to
                             p = EP + a(EY - EY)
where the capitalized ―E‖ represents the expected value of a variable. For
simplicity, assume these firms expect output to be at its natural rate, so
the last term a(EY - EY), drops out. Then these firms set price so
that p = EP. That is, firms with sticky prices set their prices based on what
they expect other firms to charge.

We can use the pricing rules of the two groups of firms to derive the
aggregate supply equation. To do this, we find the overall price level in the
economy as the weighted average of the prices set by the two groups.
After some manipulation, the overall price level is:

     Chapter Thirteen                                                 8
                         P = EP + [(1-s)a/s](Y-Y)]
The third explanation for the upward slope of the short-run aggregate
supply curve is called the imperfect-information model. Unlike the
sticky-wage model, this model assumes that markets clear—that is, all
wages and prices are free to adjust to balance supply and demand. In this
model, the short-run and long-run aggregate supply curves differ because
of temporary misperceptions about prices.
The imperfect-information model assumes that each supplier in the
economy produces a single good and consumes many goods. Because the
number of goods is so large, suppliers cannot observe all prices at all
times. They monitor the prices of their own goods but not the prices of all
goods they consume. Due to imperfect information, they sometimes
confuse changes in the overall price level with changes in relative prices.
This confusion influences decisions about how much to supply, and it
leads to a positive relationship between the price level and output in the
short run.                                                            9
    Chapter Thirteen
                       P = EP + [(1-s)a/s](Y-Y)]
The two terms in this equation are explained as follows:
1) When firms expect a high price level, they expect high costs. Those
firms that fix prices in advance set their prices high. These high prices
cause the other firms to set high prices also. Hence, a high expected price
level E leads to a high actual price level P.
2) When output is high, the demand for goods is high. Those firms
with flexible prices set their prices high, which leads to a high price level.
The effect of output on the price level depends on the proportion of firms
with flexible prices. Hence, the overall price level depends on the
expected price level and on the level of output. Algebraic rearrangement
puts this aggregate pricing equation into a more familiar form:
                              Y = Y + a(P-EP)
where a = s/[(1-s)a]. Like the other models, the sticky-price model says
that the deviation of output from the natural rate is positively associated
with the deviation of the price level from the expected price level.
    Chapter Thirteen                                                 10
        Let’s consider the decision of a single asparagus farmer, who
earns income from selling asparagus and uses this income to buy
goods and services. The amount of asparagus she chooses to produce
depends on the price of asparagus relative to the prices of other goods
and services in the economy. If the relative price of asparagus is high,
she works hard and produces more asparagus. If the relative price of
asparagus is low, she prefers to work less and produce less asparagus.
The problem is that when the farmer makes her production decision,
she does not know the relative price of asparagus. She knows the
nominal price of asparagus, but not the price of every other good in
the economy. She estimates the relative price of asparagus using her
expectations of the overall price level. See next slide for the equation.
   Chapter Thirteen                                                11
  If there is a sudden increase in the price level, the farmer
  doesn’t know if it is a change in overall prices or just the price
  of asparagus. Typically, she will assume that it is a relative
  price increase and will therefore increase the production of
  asparagus. Most suppliers will tend to make this mistake. To
  sum up, the notion that output deviates from its natural level
  when the price level deviates from the expected price level is
  captured by:

                              Y = Y + a (P - EP), a > 0
                                                           Expected price level
Output           Natural level of output     Price level
  Chapter Thirteen                                                      12
                            SRAS (EP=P2)              Y = Y + a (P-EP)
 P            LRAS*                            Start at point A; the economy is at full employment Y and the
                  SRAS (EP=P0)                 actual price level is P0. Here the actual price level equals the
P2            B                                expected price level. Now let’s suppose we increase the price
P1                 A'                          level to P1.
P0              A
                                               Since P (the actual price level) is now greater than Pe (the
                        AD'                    expected price level) Y will rise above the natural rate, and we
                                               slide along the SRAS (Pe=P0) curve to A' .
                               AD              Remember that our new SRAS (Pe=P0) curve is defined by the
                                               presence of fixed expectations (in this case at P0). So in terms
                 Y Y' Output                   of the SRAS equation, when P rises to P1, holding Pe constant
                                               at P0, Y must rise.
                                                            Y = Y + a (P-EP)
The ―long-run‖ will be defined when the expected price level equals the actual price level. So, as price level
expectations adjust, EPP2, we’ll end up on a new short-run aggregate supply curve, SRAS (EP=P2) at point
Hooray! We made it back to LRAS, a situation characterized by perfect information where the actual price
level (now P2) equals the expected price level (also, P2).
In terms of the SRAS equation, we can see that as EP catches up with P, that entire ―expectations gap‖
disappears and we end up on the long run aggregate supply curve at full employment where Y = Y. 13
        Chapter Thirteen

                                        Y = Y + a (P-EP)
The Phillips curve in its modern form states that the inflation rate
depends on three forces:
1) Expected inflation
2) The deviation of unemployment from the natural rate, called
cyclical unemployment
3) Supply shocks

These three forces are expressed in the following equation:
                     p = Ep - b(m-mn) + n
  Chapter Thirteen
                                  b  Cyclical         Supply
                                  unemployment         shocks
The Phillips-curve equation and the short-run aggregate supply equation
represent essentially the same macroeconomic ideas. Both equations
show a link between real and nominal variables that causes the
classical dichotomy (the theoretical separation of real and nominal
variables) to break down in the short run.

The Phillips curve and the aggregate supply curve are two sides of the
same coin. The aggregate supply curve is more convenient when
studying output and the price level, whereas the Phillips curve
is more convenient when studying unemployment and inflation.

    Chapter Thirteen                                             15
To make the Phillips curve useful for analyzing the choices facing
policymakers, we need to say what determines expected inflation. A
simple often plausible assumption is that people form their expectations
of inflation based on recently observed inflation. This assumption is
called adaptive expectations. So, expected inflation Ep equals last year’s
inflation p-1. In this case, we can write the Phillips curve as:

                  p = p-1       - b(m-mn)          +n
which states that inflation depends on past inflation, cyclical
unemployment, and a supply shock. When the Phillips curve is written in
this form, it is sometimes called the Non-Accelerating Inflation Rate of
Unemployment, or NAIRU.
The term p-1 implies that inflation has inertia—it keeps going
until something acts to stop it. In the model of AD/AS, inflation inertia
is interpreted as persistent upward shifts in both the aggregate supply
curve and aggregate demand curve. Because the position of the SRAS
              upward overtime, it will continue to shift upward until 16
will shift Thirteen
something changes inflation expectations.
The second and third terms in the Phillips-curve equation show the two
forces that can change the rate of inflation. The second term, b(u-un),
shows that cyclical unemployment exerts downward pressure on inflation.
Low unemployment pulls the inflation rate up. This is called
demand-pull inflation because high aggregate demand is responsible for
this type of inflation. High unemployment pulls the inflation rate down.
The parameter b measures how responsive inflation is to cyclical
unemployment. The third term, n shows that inflation also rises and falls
because of supply shocks. An adverse supply shock, such as the rise in
world oil prices in the 70s, implies a positive value of n and causes
inflation to rise.
This is called cost-push inflation because adverse supply shocks are
typically events that push up the costs of production. A beneficial
supply shock, such as the oil glut that led to a fall in oil prices in the
80s, makes n negative and causes inflation to fall.
    Chapter Thirteen                                             17
                        In the short run, inflation and unemployment
 Inflation, p           are negatively related. At any point in time, a
                        policymaker who controls aggregate demand
                        can choose a combination of inflation and
                        unemployment on this short-run Phillips

Ep + n

                      un Unemployment, u

   Chapter Thirteen                                               18
 Let’s start at point A, a point of price stability ( = 0%) and full employment (u = un).
 Remember, each short-run Phillips curve is defined by the presence of fixed expectations.
 Suppose there is an increase in the rate of growth of the money supply causing LM and AD to shift out,
 resulting in an unexpected increase in inflation. The Phillips curve equation  = E – b(u-un) + v
 implies that the change in inflation misperceptions causes unemployment to decline. So, the economy
 moves to a point above full employment at point B.

                                            As long as this inflation misperception exists, the economy will
                      LRPC (u=u     n)
                                            remain below its natural rate un at u'.
                                            When the economic agents realize the new level of inflation, they
10%                D              E         will end up on a new short-run Phillips curve where expected
                                            inflation equals the new rate of inflation (5%) at point C, where
                                            actual inflation (5%) equals expected inflation (5%).
                                                     If the monetary authorities opt to obtain a lower u again,
                                                     then they will increase the money supply such that  is 10
 5%                B               C                 percent, for example. The economy moves to point D,
                                                     where actual inflation is 10%, but, E is 5%p.
                                                                  When expectations adjust, the
                                                                  economy will land on a new SRPC, at
                                  A                SRPC (E = 10%)point E, where both  and E equal
                                                                  10 percent.
                  u'         un           SRPC (E = 5%)
      Chapter Thirteen                           Unemployment, u                                      19
                                  SRPC (E = 0%)
Rational expectations make the assumption that people optimally use all
the available information about current government policies, to forecast
the future. According to this theory, 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 do form their
expectations rationally, then inflation may have less inertia than it first
Proponents of rational expectations argue that the short-run Phillips
curve does not accurately represent the options that policymakers have
available. They believe that if policy makers are credibly committed to
reducing inflation, rational people will understand the commitment and
lower their expectations of inflation. Inflation can then come down
without a rise in unemployment and fall in output.

    Chapter Thirteen                                               20
Our entire discussion has been based on the natural rate hypothesis.
The hypothesis is summarized in the following statement:

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.

Recently, some economists have challenged the natural-rate hypothesis
by suggesting that aggregate demand may affect output and employment
even 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. Hyteresis is the term
used to describe the long-lasting influence of history on the natural
    Chapter Thirteen                                             21
                   Sticky-price model
                   Sticky-wage model
                   Imperfect-information model
                   Phillips curve
                   Adaptive expectations
                   Demand-pull inflation
                   Cost-push inflation
                   Sacrifice ratio
                   Rational expectations
                   Natural-rate hypothesis

Chapter Thirteen                                 22