THE SHORT-RUN AGGREGATE SUPPLY CURVE WITH A POSITIVE SLOPE. Based on EXPECTATIONS: Lecture. t t t t

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1 THE SHORT-RUN AGGREGATE SUL CURVE WITH A OSITIVE SLOE. Basd on EXECTATIONS: Lcur., 0. In Mankiw:, 0 Ths quaions sa ha oupu dvias from is naural ra whn h pric lvl dvias from h xpcd pric lvl. Th paramr a indicas how much oupu rsponds o unxpcd changs in h pric lvl, 1/a is h slop of h aggrga supply curv. On hory bhind h SRAS-curv: Th Sicky (NOMINAL) Wag Modl Workrs and firms s h nominal wag (W) basd on h arg ral wag ( ), and on hir xpcaion of h pric lvl, : E W Exampl of a arg ral wag = 0.7*(/L). A wag conrac ypically lass 1-3 yars. E W /. If >, hn W/ L and.

2 Anohr hory bhind h SRAS-curv: Th Sicky-ric Modl A hird xplanaion for h upward-sloping shor-run aggrga supply curv is calld h sicky-pric modl. This modl mphasizs ha firms do no insanly adjus h prics hy charg in rspons o changs in dmand. Somims prics ar s by long-rm conracs bwn firms and consumrs. W will hav o rlax h assumpion of prfc compiion whrby firms ar pric akrs. Now hy will b pric srs. Considr h pricing dcision facd by a ypical firm. Th firm s dsird pric p dpnds on wo macroconomic variabls: 1) Th ovrall lvl of prics. A highr pric lvl implis ha h firm s coss ar highr. Hnc, h highr h ovrall pric lvl, h mor h firm will lik o charg for is produc. 2) Th lvl of aggrga incom. A highr lvl of incom raiss h dmand for h firm s produc. Bcaus marginal cos incrass a highr lvls of producion, h grar h dmand, h highr h firm s dsird pric. Th firm s dsird pric is: p This quaions sas ha h dsird pric p dpnds on h ovrall lvl of prics and on h lvl of aggrga dmand rlaiv o is naural ra. Th paramr a (which is grar han 0) masurs how much h firm s dsird pric rsponds o h lvl of aggrga oupu. Now assum ha hr ar wo yps of firms. Som hav flxibl prics: hy always s hir prics according o his quaion abov. Ohrs hav sicky prics: hy announc hir prics in advanc basd on wha hy xpc conomic condiions o b. Firms wih sicky prics s prics according o p whr h suprscrip rprsns h xpcd valu of a variabl. For simpliciy, assum hs firms xpc oupu o b a is naural ra so ha h las rm, drops ou. Thn hs firms s pric so ha p =. Tha is, firms wih sicky prics s hir prics basd on wha hy xpc ohr firms o charg. W can us h pricing ruls of h wo groups of firms o driv h aggrga supply quaion. To do his, w find h ovrall pric lvl in h conomy as h wighd avrag of h prics s by h wo groups. Afr som manipulaion, h ovrall pric lvl is: = + [(1-s)a/s](-)]

3 2 1 0 ERIOD 0: 0=xpcd 0. SRAS ( = 2 ) LRAS* SRAS ( B = 0 ) A' A ' AD' AD Oupu ERIOD 1:Th AD-curv shifs ou (.g.: du o M inrs ra ) and if nominal wag (W) is fixd: > = + (- ) Sar a poin A; h conomy is a full mploymn and h acual pric lvl is 0. Hr h acual pric lvl quals h xpcd pric lvl. Now l s suppos w incras h pric lvl o 1. Sinc (h acual pric lvl) is now grar han (h xpcd pric lvl) will ris abov h naural ra, and w slid along h SRAS ( = 0 ) curv o A'. Rmmbr ha our nw SRAS ( = 0 ) curv is dfind by h prsnc of fixd xpcaions (in his cas a 0 ). So in rms of h SRAS quaion, whn riss o 1, holding consan a 0, mus ris. = + (- ) Th long-run will b dfind whn h xpcd pric lvl quals h acual pric lvl. So, as pric lvl xpcaions adjus, 2, w ll nd up on a nw shor-run aggrga supply curv, SRAS ( = 2 ) a poin B. Hooray! W mad i back o LRAS, a siuaion characrizd by prfc informaion whr h acual pric lvl (now 2 ) quals h xpcd pric lvl (also, 2 ). In rms of h SRAS quaion, w can s ha as cachs up wih, ha nir xpcaions gap disappars and w nd up on h long run aggrga supply curv a full mploymn whr =. = + (- ) E W/ L.. ERIOD 2: If W is flxibl in priod 2, workrs dmand highr nominal wags o compnsa for h unxpcd fall in h ral wag du o h unxpcd. In h nw long-run quilibrium: = 2 and 2 =, W2/ W0/ 2 0. In h shor-run changs in aggrga dmand impacs if: * Nominal wags (W) ar fixd, as hy ar drmind by conracs. *Nominal wags ar flxibl bu workrs ar surprisd by shocks o aggrga dmand so ha W/ L. If W is flxibl and workrs ar no surprisd by.g. a dmand shock, W adjus whn so ha rmains a. Raional xpcaions imply ha popl s xpcaions on avrag ar corrc. Somims hy undrsima, somims hy ovrsima. Bu popl do no mak sysmaic misaks.

4 Lcur: From h Shor-Run Aggrga Supply Curv o h Shor-Run hillips-curv: Th SRAS-curv:, 0. Thus, if acual > han xpcd, hn acual ral wag < xpcd ral wag mploymn > full-mploymn, unmploymn < h naural ra of unmploymn, acual oupu > ponial oupu. According h Sicky (Nominal) Wag Modl. From h SRAS-curv w driv h Shor-Run hillips-curv. / /., 1 ( ) ( ), whr 1/ 0 (, In Mankiw: ), v is a random disurbanc rprsning supply shocks. v is posiiv if oil prics go up, and is ngaiv if oil prics go down. According o h Shor-Run hillips-curv, h inflaion dpnds on: 1. Expcd inflaion 2. If oupu gap, / > 0, > : Dmand-ull inflaion. 3. Supply shocks (posiiv or ngaiv). If v>0, Cos-ush inflaion. Expcd (v) = 0. Somims h Shor-Run hillips-curv is in rms of unmploymn: Whn acual unmploymn (u) = h naural ra of unmploymn u Whn u u Whn u u

5 ( uu) v, 0 2. Th scond rm, b(u-u n ), shows ha cyclical unmploymn xrs downward prssur on inflaion. Low unmploymn pulls h inflaion ra up. This is calld dmand-pull inflaion bcaus high aggrga dmand is rsponsibl for his yp of inflaion. High unmploymn pulls h inflaion ra down. Th paramr b masurs how rsponsiv inflaion is o cyclical unmploymn. 3. Th hird rm, v, shows ha inflaion also riss and falls bcaus of supply shocks. An advrs supply shock, v>0, such as h ris in world oil prics in h 70 s, causs inflaion o ris.this is calld cos-push inflaion bcaus advrs supply shocks ar ypically vns ha push up h coss of producion. A bnficial supply shock, v<0, such as h oil glu ha ld o a fall in oil prics in h 80 s, causs inflaion o fall. Or a suddn incras of nominal wags is a supply shock! Thr xiss a shor-run rad-off bwn inflaion and unmploymn: 1. If inflaion xpcaions ar no raional,.g. adapiv: 1. Tha is, inflaionary xpcaions ar las yar s inflaion. Thn an incras in aggrga dmand hrough for xampl hrough an incras of h growh ra of mony supply (ha lowrs h nominal and hrby h ral inrs ra), which rsuls in highr han xpcd inflaion which lowr h ral wag and hrby incras mploymn and lowr unmploymn in h shor run. 2. If inflaion xpcaions ar raional bu h growh ra of nominal wags ar fixd by nominal wag conracs.

6 Lcur: Exampl: Adapiv xpcaions: 1 ( u u) v : Expcd inflaion quals las yar s inflaion. Hr: 1 Sicky (Nominal) Wag Modl: Exampl of a arg ral wag ( ) = 0.7*(/L), whr /L is labor produciviy. In his cas: / ( / L)/( / L) Wag conracs ypically rgards h nominal wag (W): Th arg nominal wag is W W / W ( / L)/( / L) / Ex. If ( / L)/( / L) = 1 % and / = 2%. W / W 1% 2% 3% Th growh ra of h acual ral wag is: W/ W / ( / L)/( / L) / / If / > /, W/ W/ ( / L)/( / L) Ex. if 3% hn W / W / 0% L /

7 Thus: Whn inflaion xpcaions ar adapiv, an unxpcd incras in h growh ra of h mony supply (which lowrs h nominal and ral inrs ra) lowrs unmploymn blow h naural ra in h shor run. EXERCISE: Assum: ( u0.06) v, and ha v=0. A. If , draw h shor-run hillips-curv for 1 in a diagram. B. If , draw h shor-run hillips-curv for 1 in a diagram. C. Assum ha h cnral Bank wans o lowr inflaion by 5%. Th insrumn h cnral Bank uss o impac Aggrga Dmand is h inrs ra (or in our xbook: h growh ra of nominal mony supply). How much dos unmploymn nd o incras o achiv a 5 prcnag poins rducion in h inflaion ra? Answr: ( u 0.06) ( u 0.06) ( u 0.06) ( u 0.06) 0.05/ 0.5 ( u 0.06) 0.1 ( u 0.06) u 0.16 Unmploymn mus incras o 16 prcn o rduc inflaion by 5 prcn. Unmploymn is a bad hing, h conomy loos incom. Can inflaion b rducd wihou loosing incom? In h 80s and 90s inflaion was high in h Wsrn World, including Swdn. On way o rduc inflaion ha dos no cra unmploymn is hrough inflaion xpcaions: ( u u) v In h 90s, mos counris mad hir cnral banks indpndn from h Minisris of Financ and also inroducd inflaionary args. In Swdn for xampl h inflaion arg is 2 prcn. A ha im inflaion was high in Swdn, so his rform was a way o rduc inflaion hrough lowr inflaion xpcaions. Raional xpcaion school argus ha h shor-run hillips curv dos no accuraly rprsn h opions ha policymakrs hav availabl. If policy makrs ar crdibly commid o rducing inflaion, raional popl will undrsand h commimn and lowr hir xpcaions of inflaion. Inflaion can hn com down wihou a ris in unmploymn and fall in oupu. SO FAR WE hav assumd ha h conomy in long-run rvrs o is long-run quilibrium wih a naural ra of unmploymn c. An alrnaiv hory is ha unmploymn has long-lasing ffc. Hysris mans ha a rcssion has prmann or long-lasing ffc on unmploymn. In ohr words, high unmploymn impac h naural ra of unmploymn. Unmployd nvr com back hy bcom drunks so hy will b uslss in producion in h fuur. rsonally, I hink i is a qusion of how long i aks o rvr o h long-run quilibrium. I can ak a long im bu i is possibl is my viw.

8 Ch. 14 An Aggrga Dmand -curv in h hillips-curv Diagram. Ch. 14 shows h inflaion and oupu dynamics ha follows afr a dmand shock and/or a supply shock givn ha h cnral Bank has a monary policy rul. Firs rcall, Th AD-curv in h -diagram dpnds ngaivly on as a highr lowrs M/, which raiss h ral inrs ra. Th AD-curv in h hillips-curv Diagram builds on a monary policy rul ha implis ha h cnral bank ss h nominal and hrby h ral inrs ra. If inflaion incrass, h nominal and hrby h ral inrs ra incras, which lowrs AD. Th main advanag of using h inrs ra, rahr han h mony supply, as h policy insrumn AD-AS modl is ha i is mor ralisic. Today mos cnral banks, including h Fdral Rsrv, s a shor-rm arg for h nominal inrs ra. Kp in mind ha hiing ha arg rquirs adjusmns in h mony supply. So, whn a cnral bank dcids o chang h inrs, i is also commiing islf o adjus h mony supply accordingly. Driving h AD-curv : Firs, assum h following simpl policy rul of h cnral bank wih an inflaion arg: W assum ha h cnral bank ss h nominal inrs ra i basd on inflaion using his rul: i 1 ( ) (1A) Whr = long-run ral inrs ra, and = inflaion arg. i ( ) 1 (1B) r i, r i, r Thus: If If Th IS-curv : ( ) ( r ) In Mankiw: ( r ) Th IS-curv shows ha h dmand for goods and srvics dpnds ngaivly on h ral inrs ra. = random dmand shock,.g. incrasd xpor dmand, c.

9 lugging h monary policy rul (1B) ino h IS-curv givs: ( ) 1 ( ) In Mankiw: ( ) 1 This is h IS or AD-curv in h inflaion-oupu-diagram. *This AD-curv dpnds ngaivly on inflaion bcaus a highr inflaion mans a highr nominal and ral inrs ra bcaus of h policy rul of h cnral bank. Thus: If If i, r, AD i, r, AD * Th facors ha shif h AD-curv ar h sam facors ha shif h IS-curv. (If inflaion is high du o ngaiv supply chock (highr oil prics) raising h inrs ra will dcras oupu vn furhr away from full-mploymn oupu.) AS-supply is: (, In Mankiw: ), Making h modl mor sophisicad in rms of h monary policy rul: 1 ( ) i 2 Or in Mankiw: i 1 ( ) 2 Ths quaions suggs ha cnral bank should incras nominal and ral inrs ra whnvr oupu xcds is ponial. Thus, monary policy should no only pay anion o inflaion bu also o whhr hr is a rcssion or boom. Th conomiss Taylor pluggd in valus for h paramrs: THE TALOR RULE which dscribs how h Cnral Bank in h US bhav: John Taylor has proposd a simpl rul for h fdral funds ra ( rpo-ränan ): i ( 2.0) 0.5

10 ANALSE h inflaion-oupu dynamics of: 1. A supply shock, a dmand shock and a lowr inflaion arg.