Intermediate macroeconomics chapt13

Chapter 13:
Aggregate Supply


The Model
The relationship between production of goods and
services and the general price level
Y = Y + α (P – Pe)
Where
–
–
–
–

Y = actual level of output
Y = full-employment level of output
P = actual price level
Pe = expected price level


Aggregate Supply
Price level
Long-run AS where P = Pe

Short-run AS where P > or < Pe
P

Y

Output, Income

Sticky Wage Model
Nominal wages are sticky downward. They adjust to price
changes slowly.
Demand for Labor: Ld = L(W/P)
Production Function: Y = F(L,K)
As price (P) increases, the real wage (W/P) falls, firms
respond by hiring more labor (L) and producing more
output (Y).


Sticky Wage Model
Real Wage

Y1 Output
Y2

W/P1
W/P2

Y

Ld
L1 L2 Labor

L1 L2

Price
P2
P1

Labor

Short-run AS

Y1 Y2

Output


Workers Misperception Model
Workers confuse nominal “wage” changes with “real” wage changes
when the price level changes unexpectedly
Demand for Labor: Ld = L(W/P)
Supply for Labor: Ls = L(W/Pe)
Write the “expected” real wage as W/Pe = W/P * P/Pe
As P increases, W/P declines but P/Pe increases. Workers confuse the
real wage decline with a nominal wage increase, hence supplying more
labor services


Workers Misperception Model
Real Wage

Price

Ls1

Short-run AS

Ls2
P2
W/P1

P1

W/P2

Ld
L1 L2

Labor

Output
Y1

Y2


Imperfect Information Model
Firms track price changes of their own product more
closely than changes of the general price level.
Perceptions of an increase in the “relative” price level
causes the labor demand, employment, and output to rise.
Let PW = price of wheat and P = general price level. With
inflation, farmers perceive Pw/P is increased, hence hiring
more labor and producing more output


Imperfect Information Model

Real Wage

Ls

W/P2
W/P1

Y1 Output
Y2

Y

Ld2
Ld1
L1 L2 Labor
Price

L1 L2

Labor

Short-run AS

PW2
PW1

Y1 Y2

Output

Sticky Price Model
Two kinds of firms:
– Flexible-price firms: those with market power to adjust their
prices in response to market changes
p = P + α (Y – Y)
– Fixed-price firms: those with no market power, hence unable to
adjust their prices

p = Pe


Sticky Price Model
The general price level is the “weighted” average price
charged by the flexible-price and fixed-price firms
P = sPe + (1-s)[P + α (Y – Y)]
Here s is the market share of the fixed-price firms and (1-s)
is the market share of the flexible-price firms


Sticky Price Model
The aggregate supply curve is:
Y = Y + α’ (P – Pe)
Where α’ = s / α(1-s)


Shift in Aggregate Demand
Assume the AD rises due to greater expenditures in the
economy, increasing the level of price and output.
People adjust their expectations for higher prices. A higher

expected price level results in a lower expected real wage.
The supply of labor declines, reducing the AS and the level
of output. Long-run equilibrium is achieved at the natural
level of output, but a higher price level


Shift in Aggregate Demand
Price level

Long-run AS

C
P3
P2
P1

SRAS2
SRAS1

B
A

AD2
AD1

Y

Y1

Output, Income

The Phillips Curve
The relationship between inflation rate and unemployment
rate, In the short-run:
π = π* - β(u- u*) + v
π = actual inflation rate
π* = expected inflation rate
u = actual unemployment rate
u* = natural unemployment rate
v = cost-push factor
β = the output adjustment factor


The Phillips Curve
There is a “trade-off” between inflation and unemployment
In the long-run, u = u* and v = 0, so π = π*: no trade-off
between inflation and unemployment
Stagflation is depicted by a shift of the Phillips Curve,
resulting in higher unemployment and inflation


Shift of the Phillips Curve
Inflation Rate

π2
π1

B

P2

A

u1

P1
u2

Unemployment Rate