Supply 13
Aggregate and the
Short-run Tradeoff Between
Inflation and Unemployment
In this chapter, you will learn
three models of aggregate supply in which
output depends positively on the price level in
the short run (only 2 presented in the book)
about the short-run tradeoff between inflation
and unemployment known as the Phillips curve
Three models of aggregate supply
1. The sticky-wage model
2. The imperfect-information model
3. The sticky-price model
All three models imply:
Y Y (P P e )
the expected
price level
agg.
output
natural rate
of output
a positive
parameter
the actual
price level
1
Summary & implications
P
LRAS
Y Y (P P e )
P Pe
SRAS
P Pe
P Pe
Y
Y
The sticky-wage model
Assumes that firms and workers negotiate contracts
and fix the nominal wage before they know what the
price level will turn out to be.
The nominal wage they set is the product of a target
r eal wage and the expected price level:
w
W
Pe
The sticky-wage model
If it turns out that
P P
e
P Pe
P Pe
then
Unemployment and output are
at their natural rates.
Real wage is less than its target,
so firms hire more workers and
output rises above its natural rate.
Real wage exceeds its target,
so firms hire fewer workers and
output falls below its natural rate.
2
The sticky-wage model
Implies that the real wage should be
counter-cyclical, should move in the opposite
direction as output during business cycles:
In booms, when P typically rises,
real wage should fall.
In recessions, when P typically falls,
real wage should rise.
This prediction does not come true in the real
world:
Percentage change
in real wage
The cyclical behavior of the real wage.
The real wage is pro-cyclical
5
1972
4
1965
1998
3
2
2001
1982
1
0
1991
-1
1990
-2
-3
1984
2004
1974
1979
-4
1980
-5
-3
-2
-1
0
1
2
3
4
5
6
7
8
Percentage change in real GDP
3
Summary & implications
P
LRAS
Y Y (P P e )
P Pe
SRAS
P Pe
P Pe
Y
Y
What shifts the curves?
Y Y ( P Pe )
Y Y (P Pe )
Change in Pe
Change in Y-bar
Summary & implications
SRAS equation: Y Y (P P e )
Suppose a positive
AD shock moves
SRAS2
P
LRAS
output above its
natural rate (to Y2)
SRAS1
and P above the
level people had
P3 P3e
expected (to P2)
P2
Over time,
P2e P1 P1e
P e rises,
SRAS shifts up,
and output returns
to its natural rate.
AD2
AD1
Y
Y3 Y1 Y
Y2
4
Inflation, Unemployment,
and the Phillips Curve
The Phillips curve states that depends on
expected inflation, e.
cyclical unemployment: the deviation of the
actual rate of unemployment from the natural rate
supply shocks, (Greek letter nu).
e (u u n )
where > 0 is an exogenous constant.
Deriving the Phillips Curve from SRAS
(1)
Y Y (P P e )
(2)
P P e (1 ) (Y Y )
(3)
P P e (1 ) (Y Y )
(4)
(P P1 ) ( P e P1 ) (1 ) (Y Y )
(5)
e (1 ) (Y Y )
(6)
(1 ) (Y Y ) (u u n )
(7)
e (u u n )
The Phillips Curve and SRAS
SRAS:
Phillips curve:
Y Y (P P e )
e (u u n )
SRAS curve:
Output is related to
unexpected movements in the price level.
Phillips curve:
Unemployment is related to
unexpected movements in the inflation rate.
5
How are expectations about inflation
formed?
Adaptive expectations
Adaptive expectations: an approach that
assumes people form their expectations of future
inflation based on recently observed inflation.
A simple example:
Expected inflation = last years actual inflation
e 1
Then, the Phillips Curve becomes
1 (u u n )
Inflation inertia
1 (u u n )
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.
Two causes of rising & falling inflation
1 (u u n )
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.
6
Graphing the Phillips curve
In the short
In the short
run, policymakers
run, policymakers
fface a tradeoff
ace a tradeoff
between and u..
between and u
e (u u n )
1
The short-run
Phillips curve
e
un
u
Here, the short run is the period until people adjust their expectations of
inflation
Shifting the Phillips curve
People adjust
People time,
over adjust
ttheir
heir
expectations
expectations
over time,
so the tradeoff
so the tradeoff
only holds in
only holds in
tthe short run.
he short run.
e (u u n )
e
2
e
1
E.g., an increase
E.g., an increase
iin e shifts the
n e shifts the
short-run Phillips
short-run Phillips
Curve upward.
Curve upward.
un
u
The sacrifice ratio
To reduce inflation, policymakers can
contract agg. demand, causing
unemployment to rise above the natural rate.
The sacrifice ratio measures
the percentage of a years real GDP
that must be foregone to reduce inflation
by 1 percentage point.
A typical estimate of the ratio is 5.
7
The sacrifice ratio
Example: To reduce inflation from 6 to 2 percent,
must sacrifice 20 percent of one years GDP:
GDP loss = (inflation reduction) x (sacrifice ratio)
=
4
x
5
This loss could be incurred in one year or spread
over several, e.g., 5% loss for each of four years.
The cost of disinflation is lost GDP.
One could use Okuns law to translate this cost
into unemployment.
Rational expectations
Ways of modeling the formation of expectations:
adaptive expectations:
People base their expectations of future inflation
on recently observed inflation.
rational expectations:
People base their expectations on all available
information, including information about current
and prospective future policies.
Painless disinflation?
Proponents of rational expectations believe
that the sacrifice ratio may be very small:
Suppose u = u n and = e = 6%,
and suppose the Fed announces that it will
do whatever is necessary to reduce inflation
from 6 to 2 percent as soon as possible.
If the announcement is credible,
then e will fall, perhaps by the full 4 points.
Then, can fall without an increase in u.
8
Calculating the sacrifice ratio
for the Volcker disinflation
1981: = 9.7%
Total disinflation = 6.7%
1985: = 3.0%
year
u
un
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%
Calculating the sacrifice ratio
for the Volcker disinflation
From previous slide: Inflation fell by 6.7%,
total cyclical unemployment was 9.5%.
Okuns law:
1% of unemployment = 2% of lost output.
So, 9.5% cyclical unemployment
= 19.0% of a years real GDP.
Sacrifice ratio = (lost GDP)/(total disinflation)
= 19/6.7 = 2.8 percentage points of GDP were lost
for each 1 percentage point reduction in inflation.
The natural rate hypothesis
Our analysis of the costs of disinflation, and of
economic fluctuations in the preceding chapters,
is based on the natural rate hypothesis:
Changes in aggregate demand affect output
and employment only in the short run.
In the long run, the economy returns to
the levels of output, employment,
and unemployment described by
the classical model (Chaps. 3-8).
9
An alternative hypothesis:
Hysteresis
Hysteresis: the long-lasting influence of history
on variables such as the natural rate of
unemployment.
Negative shocks may increase un,
so economy may not fully recover.
Hysteresis: Why negative shocks
may increase the natural rate
The skills of cyclically unemployed workers may
deteriorate while unemployed, and they may not
find a job when the recession ends.
Cyclically unemployed workers may lose
their influence on wage-setting;
then, insiders (employed workers)
may bargain for higher wages for themselves.
Result: The cyclically unemployed outsiders
may become structurally unemployed when the
recession ends.
Chapter Summary
1. Three models of aggregate supply in the short run:
sticky- wage model
imperfect-information model
sticky- price model
All three models imply that output rises above its
natural rate when the price level rises above the
expected price level.
CHAPTER 13
Aggregate Supply
slide 29
10
Chapter Summary
2. Phillips curve
derived from the SRAS curve
states that inflation depends on
expected inflation
cyclical unemployment
supply shocks
presents policymakers with a short-run tradeoff
between inflation and unemployment
CHAPTER 13
Aggregate Supply
slide 30
Chapter Summary
3. How people form expectations of inflation
adaptive expectations
based on recently observed inflation
implies inertia
rational expectations
based on all available information
implies that disinflation may be painless
CHAPTER 13
Aggregate Supply
slide 31
Chapter Summary
4. The natural rate hypothesis and hysteresis
the natural rate hypotheses
states that changes in aggregate demand can
only affect output and employment in the short
run
hysteresis
states that aggregate demand can have
permanent effects on output and employment
CHAPTER 13
Aggregate Supply
slide 32
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