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# Lecture 12 - LECTURE12 EC205.01 FALL2009 ALPER 1 Outline...

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12/2/2009 1 LECTURE LECTURE 12 EC205.01 FALL 2009 ALPER 1 Outline y Three models of aggregate supply y The sticky price model y The sticky wage model y The imperfect information model y The Phillips Curve y The short run trade off between inflation and unemployment y Adaptive and rational expectations y Sacrifice Ratio y Hysteresis EC205.01 FALL 2009 ALPER 2 Three models of aggregate supply 1. The sticky price model 2. The sticky wage model 3. The imperfect information model All three models imply: Slope = 1/ α EC205.01 FALL 2009 ALPER 3 () e Y YP P =+ α natural rate of output a positive parameter the expected price level the actual price level agg. output

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12/2/2009 2 The sticky price model y Reasons for sticky prices: y long term contracts between firms and customers y menu costs y firms not wishing to annoy customers with frequent price changes y Assumption: y Firms set their own prices ( e.g ., as in monopolistic competition). EC205.01 FALL 2009 ALPER 4 The sticky price model y An individual firm’s desired price is where a > 0. () p PY Y =+ a Overall Price EC205.01 FALL 2009 ALPER 5 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: ee e pP Y Y a The sticky price model y Assume sticky price firms expect that output will equal its natural rate. Then, a EC205.01 FALL 2009 ALPER 6 = ± To derive the aggregate supply curve, we first find an expression for the overall price level. ± Let s denote the fraction of firms with sticky prices. Then, we can write the overall price level as…
12/2/2009 3 The sticky price model (1 )[ ( )] e PsP sP YY =+ −+ a price set byflexible price firms price set by sticky price firms y Subtract (1 s ) P from both sides: EC205.01 FALL 2009 ALPER 7 )[ ( sP s P s Y a ± Divide both sides by s : ) () PP ⎡⎤ ⎢⎥ ⎣⎦ a The sticky price model y High P e 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 ) a Other firms respond by setting high prices. y High Y High P When income is high, the demand for goods is high. Firms withflexible prices set high prices. The greater the fraction of flexible price firms, the smaller is s and the bigger is the effect of Δ Y on P . EC205.01 FALL 2009 ALPER 8 The sticky price model y Finally derive AS equation by solving for Y ) a Finally, derive : EC205.01 FALL 2009 ALPER 9 , YP P α where = 1 a

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12/2/2009 4 The sticky price model y The sticky price model implies a pro cyclical real wage: Suppose aggregate output/income falls Then Suppose aggregate output/income falls. Then, y Firms see a fall in demand for their products.
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Lecture 12 - LECTURE12 EC205.01 FALL2009 ALPER 1 Outline...

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