Chapter 12: Aggregate Supply and Phillips Curve In this chapter we explain the position and slope of the short run aggregate supply (SRAS) curve. SRAS curve can also be relabeled as Phillips curve. A basic theory of aggregate supply—Sticky Price Model Suppose there are two types of firms. Both have some monopolistic control and are price-setters (so the market is not perfect since it is not competitive). The first type of firm adjusts the price frequently (so price is flexible). We can write the firm’s desired price as ̅ (1) Question: why does depend positively on the price level ? Question: why does depend positively on the output ? The price of the second type of firm is sticky. The firm has to set the price in advance based on the expected-form of (1). Suppose the firm expects ̅. Then (2) 1 where is the expectation operator and is the expected price level. The price level is weighted average of (1) and (2): (3) where is the weight for the sticky-price firm. It follows that ̅ (4) Exercise: derive equation (4) Equation (4) represents SRAS. In particular, (A) price level is (positively negatively) related to output . (B) when rises, SRAS shifts (up down) (C) when ̅ Due to (A), SRAS is (upward downward) sloping. Due to (B), SRAS shifts when people change their expectation about price. Example: 2 Suppose Fed increases money supply unexpectedly. Step 1: in short run, for given price, the supply curve for real money balance shifts (right left) Step 2: in short run, LM curve shifts (down up) Step 3: in short run, AD curve shifts (right left), and SRAS curve_________________ because _____________ Step 4: in short run, output (rises falls) and price level (rises falls) Step 5: when price changes, the expectation of price changes accordingly. In this case, people expect price to (rise fall). As a result, SARA curve shifts (up down) Step 6: finally the output___________________________ and price ___________________________. This example shows long run monetary neutrality and short run monetary nonneutrality. Question: what would happen if the increase in money supply is expected? Question: why did Greenspan often say something very vague? 3 Question: can an unexpected expansionary monetary policy affect output in long run? Phillips Curve Equation (4) can be rewritten as (5) where denotes inflation rate, the unemployment rate, the natural rate of unemployment, and the supply shock. Exercise: derive (5) based on (4) and Okun’s Law. Equation (5) represents the Phillips Curve. It shows that (a): inflation and unemployment have (positive negative) relationship for given . Therefore, if remains unchanged, the policymaker faces a short-run tradeoff between inflation and unemployment. (b): in long run, will adjust so that the short-run tradeoff will disappear. 4 Because (5) comes directly from (4), Phillips curve and SRAS are the two sides of the same coin. Adaptive Expectation and Inflation Inertia The hypothesis of adaptive expectation says that people form their expectation about inflation based on recently observed inflation, i.e. (6) Equations (5) and (6) jointly imply that (7) Equation (7) implies that: (a) if . So the continued rise in price level (inflation) neither speeds up or slows down. In other words, there is inflation inertia, which is implied by adaptive expectation. (b) if only if . So in order to cut inflation, the economy must have (higher lower) unemployment. More explicitly, sacrifice ratio gives the percentage of a year’s real GDP that must be forgone to reduce inflation by 1 percent. 5 (c) if only if . So the economy must face (higher lower) inflation when it tries to push the unemployment rate below the natural level. (d) everything else equal, rises when (rises falls). This is called demand-pull inflation because higher aggregate demand is needed to boost employment. (e) everything else equal, rises when This is called cost-push inflation because adverse supply shock pushes up the cost of production. Rational Expectation and Painless Disinflation Suppose people correctly expect future inflation, that is, (8) Equation (8) is an extreme form of rational expectation. More generally, people have rational expectation when they use all available information (not just past history) to forecast the future. Under (8) and equation (5) becomes: So the unemployment rate can always remain at its natural level. That means, when the current inflation rate is too high, the 6 government can reduce it without increasing the unemployment rate. We call this ideal result painless disinflation, which can only occur if expectation is rational, and if the policy aiming at reducing inflation is credible. Discuss: Which expectation makes more sense? Rational or adaptive expectation? Under what condition, the adaptive expectation is also the rational expectation? Hysteresis The natural-rate hypothesis states that fluctuations in aggregate demand affect output and unemployment only in short run. In the long run, the economy returns to the levels of output, employment described by the classical model (natural level). Hysteresis is a different hypothesis saying that fluctuations in aggregate demand may affect output and unemployment even in long run, because the natural level can be affected by aggregate demand. For example, workers might lose valuable job skills when unemployed, lowering their ability to find a job even after 7 recession is over. That is, recession (when AD curve shifts left) may cause ̅ ̅ ̅ to fall because ̅ falls (some workers never find jobs again and are out of labor force) Exercise: Please draw a graph comparing the natural-rate hypothesis and hysteresis. 8 .