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**Unformatted text preview: **slide 1 CHAPTER 13 Aggregate Supply In this chapter, you will learn three 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 slide 2 CHAPTER 13 Aggregate Supply Three models of aggregate supply 1. The sticky-wage model 2. The imperfect-information model 3. The sticky-price model All three models imply: ( ) e Y Y P P = +- natural rate of output a positive parameter the expected price level the actual price level agg. output slide 3 CHAPTER 13 Aggregate Supply 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 real wage and the expected price level: e W P = e W P P P = Target real wage slide 4 CHAPTER 13 Aggregate Supply The sticky-wage model If it turns out that e W P P P = e P P = e P P e P P < 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. CHAPTER 13 Aggregate Supply slide 5 slide 6 CHAPTER 13 Aggregate Supply 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: The cyclical behavior of the real wage Percentage change in real wage Percentage change in real GDP-5-4-3-2-1 1 2 3 4 5-3-2-1 1 2 3 4 5 6 7 8 1974 1979 1991 1972 2004 2001 1998 1965 1984 1980 1982 1990 slide 8 CHAPTER 13 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. slide 9 CHAPTER 13 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 the expected price level, P e . Suppose P rises but P e 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 P e . slide 10 CHAPTER 13 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 ( e.g ., as in monopolistic competition). slide 11...

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