Chaptr 14 Aggrgat Supply and th Short-run Tradoff Btwn Inflation and Unmploymnt Modifid by Yun Wang Eco 3203 Intrmdiat Macroconomics Florida Intrnational Univrsity Summr 2017 2016 Worth Publishrs, all rights rsrvd
In this chaptr, you will larn thr modls of aggrgat supply in which output dpnds positivly on th pric lvl in th short run about th short-run tradoff btwn inflation and unmploymnt known as th Phillips curv 2
Thr modls of aggrgat supply 1. Th sticky-wag modl 2. Th imprfct-information modl 3. Th sticky-pric modl All thr modls imply: agg. output natural rat of output Y Y ( P P ) a positiv paramtr th actual pric lvl th xpctd pric lvl 3
Th sticky-wag modl Assums that firms and workrs ngotiat contracts and fix th nominal wag bfor thy know what th pric lvl will turn out to b. Th nominal wag thy st is th product of a targt ral wag and th xpctd pric lvl: W ω P W ω P P P Targt ral wag 4
Th sticky-wag modl If it turns out that P P P P P P W P P ω P thn Unmploymnt and output ar at thir natural rats. Ral wag is lss than its targt, so firms hir mor workrs and output riss abov its natural rat. Ral wag xcds its targt, so firms hir fwr workrs and output falls blow its natural rat. 5
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Th sticky-wag modl Implis that th ral wag should b countr-cyclical, should mov in th opposit dirction as output during businss cycls: In booms, whn P typically riss, ral wag should fall. In rcssions, whn P typically falls, ral wag should ris. This prdiction dos not com tru in th ral world: 7
Th cyclical bhavior of th ral wag Prcntag chang in ral wag 5 4 3 2 1 0-1 -2 1982 2001 1991 1990 1998 1972 2004 1965 1984-3 -4-5 1974 1979 1980-3 -2-1 0 1 2 3 4 5 6 7 8 Prcntag chang in ral GDP 8
Th imprfct-information modl Assumptions: All wags and prics ar prfctly flxibl, all markts ar clar. Each supplir producs on good, consums many goods. Each supplir knows th nominal pric of th good sh producs, but dos not know th ovrall pric lvl. 9
Th imprfct-information modl Supply of ach good dpnds on its rlativ pric: th nominal pric of th good dividd by th ovrall pric lvl. Supplir dos not know pric lvl at th tim sh maks hr production dcision, so uss th xpctd pric lvl, P. Suppos P riss but P dos not. Supplir thinks hr rlativ pric has risn, so sh producs mor. With many producrs thinking this way, Y will ris whnvr P riss abov P. 10
Th sticky-pric modl Rasons for sticky prics: long-trm contracts btwn firms and customrs mnu costs firms not wishing to annoy customrs with frqunt pric changs Assumption: Firms st thir own prics (.g., as in monopolistic comptition). 11
Th sticky-pric modl An individual firm s dsird pric is whr a > 0. p P a ( Y Y ) Suppos two typs of firms: firms with flxibl prics, st prics as abov firms with sticky prics, must st thir pric bfor thy know how P and Y will turn out: p P a ( Y Y ) 12
Th sticky-pric modl p P a ( Y Y ) Assum sticky pric firms xpct that output will qual its natural rat. Thn, p P To driv th aggrgat supply curv, w first find an xprssion for th ovrall pric lvl. Lt s dnot th fraction of firms with sticky prics. Thn, w can writ th ovrall pric lvl as 13
Th sticky-pric modl P s P (1 s)[ P a( Y Y )] pric st by sticky pric firms pric st by flxibl pric firms Subtract (1 s)p from both sids: sp s P (1 s )[ a( Y Y )] Divid both sids by s : (1 s) a P P ( Y Y ) s 14
Th sticky-pric modl (1 s ) a P P ( Y Y ) s High P High P If firms xpct high prics, thn firms that must st prics in advanc will st thm high. Othr firms rspond by stting high prics. High Y High P Whn incom is high, th dmand for goods is high. Firms with flxibl prics st high prics. Th gratr th fraction of flxibl pric firms, th smallr is s and th biggr is th ffct of Y on P. 15
Th sticky-pric modl Finally, driv AS quation by solving for Y : Y Y ( P P ), (1 s ) a P P ( Y Y ) s whr s ( 1 s ) a 16
Th sticky-pric modl In contrast to th sticky-wag modl, th sticky-pric modl implis a pro-cyclical ral wag: Suppos aggrgat output/incom falls. Thn, Firms s a fall in dmand for thir products. Firms with sticky prics rduc production, and hnc rduc thir dmand for labor. Th lftward shift in labor dmand causs th ral wag to fall. 17
Summary & implications P LRAS Y Y ( P P ) P P P P P P Y SRAS Y Each of th thr modls of agg. supply imply th rlationship summarizd by th SRAS curv & quation. 18
Summary & implications Suppos a positiv AD shock movs output abov its natural rat and P abov th lvl popl had xpctd. P SRAS quation: P 3 3 P Y Y P P ( ) SRAS LRAS 2 SRAS 1 Ovr tim, P riss, SRAS shifts up, P2 and output rturns to its natural rat. P P 2 P 1 1 Y 3 Y1 Y Y 2 AD 2 AD 1 Y 19
Inflation, Unmploymnt, and th Phillips Curv Th Phillips curv stats that dpnds on xpctd inflation,. cyclical unmploymnt: th dviation of th actual rat of unmploymnt from th natural rat supply shocks, (Grk lttr nu ). whr > 0 is an xognous constant. 20
Driving th Phillips Curv from SRAS (1) Y Y ( P P ) (2) P P (1 )( Y Y ) (3) P P (1 )( Y Y ) (4) ( P P ) ( P P ) (1 )( Y Y ) 1 1 (5) (1 )( Y Y ) (6) n (1 )( Y Y ) ( u u ) (7) n ( u u ) 21
Th Phillips Curv and SRAS Phillips curv: SRAS: Y Y ( P P ) n ( u u ) SRAS curv: Output is rlatd to unxpctd movmnts in th pric lvl. Phillips curv: Unmploymnt is rlatd to unxpctd movmnts in th inflation rat. 22
Adaptiv xpctations Adaptiv xpctations: an approach that assums popl form thir xpctations of futur inflation basd on rcntly obsrvd inflation. A simpl xampl: Expctd inflation = last yar s actual inflation 1 Thn, th P.C. bcoms n 1 ( u u ) 23
Inflation inrtia n 1 ( u u ) In this form, th Phillips curv implis that inflation has inrtia: In th absnc of supply shocks or cyclical unmploymnt, inflation will continu indfinitly at its currnt rat. Past inflation influncs xpctations of currnt inflation, which in turn influncs th wags & prics that popl st. 24
Two causs of rising & falling inflation n 1 ( u u ) cost-push inflation: inflation rsulting from supply shocks Advrs supply shocks typically rais production costs and induc firms to rais prics, pushing inflation up. dmand-pull inflation: inflation rsulting from dmand shocks Positiv shocks to aggrgat dmand caus unmploymnt to fall blow its natural rat, which pulls th inflation rat up. 25
Graphing th Phillips curv In th short run, policymakrs fac a tradoff btwn and u. n ( u u ) 1 Th short-run Phillips curv n u u 26
Shifting th Phillips curv Popl adjust thir xpctations ovr tim, so th tradoff only holds in th short run. 2 1 n ( u u ) E.g., an incras in shifts th short-run P.C. upward. n u u 27
Th sacrific ratio To rduc inflation, policymakrs can contract agg. dmand, causing unmploymnt to ris abov th natural rat. Th sacrific ratio masurs th prcntag of a yar s ral GDP that must b forgon to rduc inflation by 1 prcntag point. A typical stimat of th ratio is 5. 28
Th sacrific ratio Exampl: To rduc inflation from 6 to 2 prcnt, must sacrific 20 prcnt of on yar s GDP: GDP loss = (inflation rduction) x (sacrific ratio) = 4 x 5 This loss could b incurrd in on yar or sprad ovr svral,.g., 5% loss for ach of four yars. Th cost of disinflation is lost GDP. On could us Okun s law to translat this cost into unmploymnt. 29
Rational xpctations Ways of modling th formation of xpctations: adaptiv xpctations: Popl bas thir xpctations of futur inflation on rcntly obsrvd inflation. rational xpctations: Popl bas thir xpctations on all availabl information, including information about currnt and prospctiv futur policis. 30
Painlss disinflation? Proponnts of rational xpctations bliv that th sacrific ratio may b vry small: Suppos u = u n and = = 6%, and suppos th Fd announcs that it will do whatvr is ncssary to rduc inflation from 6 to 2 prcnt as soon as possibl. If th announcmnt is crdibl, thn will fall, prhaps by th full 4 points. Thn, can fall without an incras in u. 31
Calculating th sacrific ratio for th Volckr disinflation 1981: = 9.7% 1985: = 3.0% Total disinflation = 6.7% yar u u n u u n 1982 9.5% 6.0% 3.5% 1983 9.5 6.0 3.5 1984 7.4 6.0 1.4 1985 7.1 6.0 1.1 Total 9.5% 32
Calculating th sacrific ratio for th Volckr disinflation From prvious slid: Inflation fll by 6.7%, total cyclical unmploymnt was 9.5%. Okun s law: 1% of unmploymnt = 2% of lost output. So, 9.5% cyclical unmploymnt = 19.0% of a yar s ral GDP. Sacrific ratio = (lost GDP)/(total disinflation) = 19/6.7 = 2.8 prcntag points of GDP wr lost for ach 1 prcntag point rduction in inflation. 33
Th natural rat hypothsis Our analysis of th costs of disinflation, and of conomic fluctuations in th prcding chaptrs, is basd on th natural rat hypothsis: Changs in aggrgat dmand affct output and mploymnt only in th short run. In th long run, th conomy rturns to th lvls of output, mploymnt, and unmploymnt dscribd by th classical modl (Chaps. 3-8). 34
An altrnativ hypothsis: Hystrsis Hystrsis: th long-lasting influnc of history on variabls such as th natural rat of unmploymnt. Ngativ shocks may incras u n, so conomy may not fully rcovr. 35
Hystrsis: Why ngativ shocks may incras th natural rat Th skills of cyclically unmployd workrs may dtriorat whil unmployd, and thy may not find a job whn th rcssion nds. Cyclically unmployd workrs may los thir influnc on wag-stting; thn, insidrs (mployd workrs) may bargain for highr wags for thmslvs. Rsult: Th cyclically unmployd outsidrs may bcom structurally unmployd whn th rcssion nds. 36
1. Thr modls of aggrgat supply in th short run: sticky-wag modl imprfct-information modl sticky-pric modl All thr modls imply that output riss abov its natural rat whn th pric lvl riss abov th xpctd pric lvl. 37
2. Phillips curv drivd from th SRAS curv stats that inflation dpnds on xpctd inflation cyclical unmploymnt supply shocks prsnts policymakrs with a short-run tradoff btwn inflation and unmploymnt 38
3. How popl form xpctations of inflation adaptiv xpctations basd on rcntly obsrvd inflation implis inrtia rational xpctations basd on all availabl information implis that disinflation may b painlss 39
4. Th natural rat hypothsis and hystrsis th natural rat hypothss stats that changs in aggrgat dmand can only affct output and mploymnt in th short run hystrsis stats that aggrgat dmand can hav prmannt ffcts on output and mploymnt 40