Inflation and Unemployment
Inflation and Unemployment
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Aggregate Supply and the
Short-Run Tradeoff Between
Inflation and Unemployment
14CHAPTER
IN THIS CHAPTER, YOU WILL LEARN:
§ two models of aggregate supply in which output
depends positively on the price level in the short
run
§ about the short-run tradeoff between inflation and
unemployment known as the Phillips curve
1
2CHAPTER 14 Aggregate Supply
Introduction
§ In previous chapters, we assumed the price
level P was “stuck” in the short run.
§ This implies a horizontal SRAS curve.
§ Now, we consider two prominent models of
aggregate supply in the short run:
§ Sticky-price model
§ Imperfect-information model
3CHAPTER 14 Aggregate Supply
Introduction
§ Both models imply:
( )Y Y P EPa= + -
natural rate
of output
a positive
parameter
expected
price level
actual
price level
agg.
output
§ Other things equal, Y and P are positively
related, so the SRAS curve is upward sloping.
4CHAPTER 14 Aggregate Supply
The sticky-price model
§ Reasons for sticky prices:
§ long-term contracts between firms and
customers
§ menu costs
§ firms not wishing to annoy customers with
frequent price changes
§ Assumption:
§ Firms set their own prices
(i.e. firms have some market power).
5CHAPTER 14 Aggregate Supply
The sticky-price model
§ An individual firm’s desired price is:
where a > 0.
Suppose two types of firms:
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
before they know how P and Y will turn out:
p P a Y Y= + -( )
p EP a EY EY= + -( )
6CHAPTER 14 Aggregate Supply
The sticky-price model
§ Assume sticky-price firms expect that output will
equal its natural rate. Then,
§ To derive the aggregate supply curve,
first find an expression for the overall price level.
§ s = fraction of firms with sticky prices.
Then, we can write the overall price level as…
p EP a EY EY= + -( )
=p EP
7CHAPTER 14 Aggregate Supply
The sticky-price model
§ Subtract (1−s)P from both sides:
price set by
flexible-price firms
price set by
sticky-price firms
§ Divide both sides by s:
1= + - + -[ ] ( )[ ( )]P s EP s P a Y Y
1= + - -[ ] ( )[ ( )]sP s EP s a Y Y
1-
= + -
( ) ( )s aP EP Y Y
s
8CHAPTER 14 Aggregate Supply
The sticky-price model
§ High EP g High P
If firms expect high prices, then firms that must set
prices in advance will set them high.
Other firms respond by setting high prices.
§ High Y g High P
When income is high, the demand for goods is high.
Firms with flexible prices set high prices.
The greater the fraction of flexible-price firms,
the smaller is s and the bigger the effect of ΔY on P.
1-
= + -
( ) ( )s aP EP Y Y
s
9CHAPTER 14 Aggregate Supply
The sticky-price model
§ Finally, derive AS equation by solving for Y :
( ),Y Y P EPa= + -
0
1
= >
-
where
( )
s
s a
a
1-
= + -
( ) ( )s aP EP Y Y
s
10CHAPTER 14 Aggregate Supply
The imperfect-information model
Assumptions:
§ All wages and prices are perfectly flexible,
all markets are clear.
§ Each supplier produces one good, consumes
many goods.
§ Each supplier knows the nominal price of the
good she produces, but does not know the
overall price level.
11CHAPTER 14 Aggregate Supply
The imperfect-information model
§ Supply of each good depends on its relative
price: the nominal price of the good divided by
the overall price level.
§ Supplier does not know price level at the time
she makes her production decision, so uses EP.
§ Suppose P rises but EP does not.
§ Supplier thinks her relative price has risen,
so she produces more.
§ With many producers thinking this way,
Y will rise whenever P rises above EP.
12CHAPTER 14 Aggregate Supply
Summary & implications
Both models
of agg. supply
imply the
relationship
summarized
by the SRAS
curve &
equation.
Y
P LRAS
Y
SRAS
( )Y Y P EPa= + -
P EP=
P EP>
P EP<
13CHAPTER 14 Aggregate Supply
Summary & implications
Suppose a positive
AD shock moves
output above its
natural rate and
P above the level
people had
expected.
Y
P LRAS
SRAS1
SRAS equation: ( )Y Y P EPa= + -
1 1P EP=
AD1
AD2
2EP =
2P
3 3P EP=
Over time,
EP rises,
SRAS shifts up,
and output returns
to its natural rate.
1Y Y=
2Y
3Y =
SRAS2
14CHAPTER 14 Aggregate Supply
Inflation, unemployment,
and the Phillips curve
The Phillips curve states that π depends on
§ expected inflation, Eπ
§ cyclical unemployment: the deviation of the
actual rate of unemployment from the natural rate
§ supply shocks, υ (Greek letter “nu”).
( )nE u up p b n= - - +
where β > 0 is an exogenous constant.
15CHAPTER 14 Aggregate Supply
Deriving the Phillips curve from SRAS
(1) ( )Y Y P EPa= + -
(2) (1 )( )P EP Y Ya= + -
1 1(4) ( ) ( ) (1 )( )P P EP P Y Ya n- -- = - + - +
(5) (1 )( )E Y Yp p a n= + - +
(6) (1 )( ) ( )nY Y u ua b- = - -
(7) ( )nE u up p b n= - - +
(3) (1 )( )P EP Y Ya n= + - +
16CHAPTER 14 Aggregate Supply
Comparing SRAS and the Phillips curve
§ SRAS curve:
Output is related to
unexpected movements in the price level.
§ Phillips curve:
Unemployment is related to
unexpected movements in the inflation rate.
Y Y P EPa= + -SRAS: ( )
( )nE u up p b n= - - +Phillips curve:
17CHAPTER 14 Aggregate Supply
Adaptive expectations
§ Adaptive expectations: an approach that
assumes people form their expectations of future
inflation based on recently observed inflation.
§ A simple version:
Expected inflation = last year’s actual inflation
1 ( )
nu up p b n-= - - +
1Ep p-=
§ Then, Phillips curve eq’n becomes
18CHAPTER 14 Aggregate Supply
Inflation inertia
In this form, the Phillips curve implies that
inflation has inertia:
§ In the absence of supply shocks or
cyclical unemployment, inflation will
continue indefinitely at its current rate.
§ Past inflation influences expectations of
current inflation, which in turn influences
the wages & prices that people set.
1 ( )
nu up p b n-= - - +
19CHAPTER 14 Aggregate Supply
Two causes of rising & falling inflation
§ cost-push inflation:
inflation resulting from supply shocks
Adverse supply shocks typically raise production
costs and induce firms to raise prices,
pushing inflation up.
§ demand-pull inflation:
inflation resulting from demand shocks
Positive shocks to aggregate demand cause
unemployment to fall below its natural rate,
which pulls the inflation rate up.