CH6 - 6 AGGREGATESUPPLY:WAGES,PRICES, AND U NEMPLOYMENT...

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6 A GGREGATE  S UPPLY :  W AGES , P RICES AND U NEMPLOYMENT FOCUS OF THE CHAPTER •  In this chapter  we take a closer look at the aggregate supply  curve, and  notice that we can use   it to examine the link between  inflation and  unemployment.   We consider  the effect of  inflationary  expectations. •  We also try to justify the positive relationship  that the AS curve describes between  the amount   of output  produced  and  the price level, and  to explain  why  classical supply  assumptions  do   not hold  at all horizons   (this last  part boils down  to explaining why  prices are “sticky,” or   slow  to adjust ) . SECTION SUMMARIES 1. Inflation and Unemployment The rate of unemployment  fluctuates too much  for unemployment  to be at its natural  rate all the   time the labor market  must  sometimes  be out of equilibrium.   There is also a systematic   relationship  between  the rate of unemployment  and  the rate of  wage inflation the rate at  which wages rise over time.  The rate of wage inflation  seems to rise as the unemployment  rate   falls.  This tradeoff between  wage inflation  and  the rate of unemployment  is captured  by the  Phillips   curve .  It is also described  by the following  equation: ( 29 - ε - = u u g w where  g w  is the rate of wage  inflation  and   u*  the natural  rate of unemployment.    π  is a measure   of how  responsive wages are to changes in the rate of unemployment.    60
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61 C HAPTER  6 While the original Phillips curve was intended  only to capture  the tradeoff between  wage   inflation  and  unemployment,  over the years the Phillips curve has also been used  to describe a  similar relationship  between  the rates of inflation the rate of increase in the price level and   unemployment.   2. Stagflation, Expected Inflation, and the Inflationary-Expectations  Augmented Phillips Curve The simple Phillips curve developed  in Section 6–2 is missing  a very important  element:  it fails  to consider  the effect of people’s  inflationary  expectations .  People negotiate their nominal  wage   with  a particular  real wage in mind.   If their expectations  regarding  the rate of inflation  are   wrong, this real wage will be higher or lower than  they’d anticipated  making, them  want  to   work  more or less than  they’d planned.   The  inflationary- expectations  augmented Phillips  curve , ( 29 - ε - = π - u u g e w    and  its more general form, in which  the rate of price inflation  ( π ) is substituted  for the rate of  wage inflation  ( g w ), ( 29 - ε - = π - π u u e   g w   g w  =  -   ε
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CH6 - 6 AGGREGATESUPPLY:WAGES,PRICES, AND U NEMPLOYMENT...

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