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 supplySticky 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 firms 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
. Then
the firm expects
(2)

where
level.

is the expectation operator and

is the expected price

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
(B) when
(C) when

is (positively negatively) related to output .

rises, SRAS shifts (up down)

Due to (A), SRAS is (upward downward) sloping. Due to (B),

SRAS shifts when people change their expectation about price.
Example:
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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?

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 Okuns 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,
disappear.

will adjust so that the short-run tradeoff will

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 years real GDP that must be forgone to reduce
inflation by 1 percent.
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(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
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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
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recession is over. That is, recession (when AD curve shifts left)

to fall because falls (some workers
may cause
never find jobs again and are out of labor force)

Exercise:
Please draw a graph comparing the natural-rate hypothesis and
hysteresis.