Topic 4 - Aggregate Supply and the Short run tradeoff between Inflation and Unemployment

Question 1

What are the 3 models of Aggregate Supply in the SR?

Answer 1

1) Sticky wage model
2) Sticky price model
3) Imperfect Information Model

Question 2

What do all 3 models imply?

Answer 2

That aggregate output is equal to the natural rate of output + a positive parameter multplied by the actual price level minus the expected price level

(Y = Ybar +a(P-Pe)

SEE IN NOTES

Question 3

What does the Sticky wage model assume?

Answer 3

Assumes that firms and workers negotiate contracts and fix nominal wage before they know what the price level will turn out to be

Question 4

How do we calculate the Nominal Wage (Sticky wage model)?

Answer 4

W = w x Pe

Where:
W = Nominal Wage
w = Target real wage (What you aim your target wage is)
Pe = Expected Price

Question 5

How do we find the Real Wage (Sticky wage model)?

Answer 5

W/P = w x Pe/P

Where:
W/P = Real wage

Question 6

How do we find the Equilibrium level of Employment (Sticky wage model)?

Answer 6

MPL = W/P = w x Pe/P

So firms employ up until the MPL

Question 7

How do find the Labour demand (Sticky wage model)?

Answer 7

L = Ld (W/P)
which gives us:

Ld (w) = Lbar (Natural rate of employment)

Question 8

How do we find the Output (Sticky wage model)?

Answer 8

(Y) = f(Kbar,L) = f(Kbar, Ld (W x(Pe/P))

Note if Pe = P, then W/P =w so Ld(W/P) = L and Y=Ybar

Question 9

What does the Sticky wage model imply about the AS curve?

Answer 9

Implies it can be represented as Y= Y+α (P - Pe)

Approximates that the true AS Curve implied by the model, which says that deviations of output from Ybar depend on P/Pe

Question 10

When is the level of employment not/at its optimal level?

Answer 10

If:

• P = Pe: Unemployment and Output is at its natural rates
• P> Pe: Real wages less than its target so firms hire more workers and output rise above its natural rates
• P

Question 11

What does the Sticky wage model imply about the economy?

Answer 11

-Implies that the real wage should be counter-cyclical

i. e.
- In booms, when P is rising, the real wage should fall
- In recessions, when P falls the real wage should rise

This dont happen in real life

Question 12

What does Barsky and Solon (1989) claim about the Sticky wage model?

Answer 12

• Real wages were, in turn, acyclical, procyclical, and countercyclical
• Looking at industry-wide data, Barsky and Solon (1989) find that there is little if any evidence of countercyclical real wages
• Studies of micro data, however, provide quite strong evidence of procyclicality in the real wage.
• Find procyclicality when they look at data from the Panel Study of Income Dynamics, which studies the behavior of individual households.

Question 13

What does Sumner and Silver (1989) claim about the sticky wage model?

Answer 13

-Results on the cyclicality of the real wage are sensitive to sample period.

Argument is that shocks to aggregate demand will cause prices to be procyclical and shocks to aggregate supply will cause prices to be countercyclical.

If nominal wages are sticky, then we should observe procyclical real wages when inflation is countercyclical, and vice versa. This is borne out by the data

Question 14

What are the reasons for Sticky prices according to the Sticky Price model?

Answer 14

• Long-term contracts between firms and customers
• Menu costs
• Firms not wishing to annoy with frequent price changes

Question 15

What is assumed in the Sticky Price Model?

Answer 15

• Firms set their own prices(like Monopolistic Competition)

Question 16

What is a Firm desired price? (Sticky price model)

Answer 16

p = P + α( Y - Ybar)

Where: α > 0

(Firms with flexible prices set prices using this)

Question 17

What are the two types of Firms in the economy? (According to the Sticky price model)

Answer 17

firms with flexible prices

firms with sticky prices—must set their prices before they know how P and Y will turn out

Question 18

How do Sticky price firms set their prices? (Sticky price model)

Answer 18

According to the equation:

p = EP - α (EY -EYbar)

Question 19

What can we identify off the firms desired price? (The flexible firm price strat)

Answer 19

-If P high then firms assume costs higher, causing desired prices to go higher

• Y > Ybar, means the economy is in a boom
• Y

Question 20

How do we simplify the Sticky price firm desired price strat?

Answer 20

Assume that expected output is equal to Expected natural level of output (EY = EYbar)
So leaves the equation as,

p = EP

Question 21

How do we find the overall price level (P)? (Sticky price model) (Part 1)

Answer 21

1. Create value S to represent:
   Fraction of firms with sticky prices
   Implies 1-S, gives us number of flexible firms
2. Combine non- sticky wages desired prices and sticky wages desired price:
   P = S[EP] + (1-S)[ P+ α(Y-Ybar)]
3. Multiply (1-S) by P and the 2nd term:
   P = S[EP] + (1-S)P) + [(1-S)α(Y-Ybar)

Question 22

How do we find the overall price level (P)? (Sticky price model) (Part 2)

Answer 22

4. Minus (1-S) on both sides:
   sP = s [EP] + (1-S)[α(Y-Ybar)]
5. Divide both sides by S to give final answer:
   P= EP + (1-S)α/S (Y-Ybar)

Question 23

What is the equation for the overall price level in the economy?

Answer 23

P = EP + (1-S)α/S (Y-Ybar)

Question 24

What can be implied from the overall price level in the economy?

Answer 24

High EP means high P
If firms expect high prices, then firms that must set prices in advance will set them high.Other firms respond by setting prices high.

High Y leads to high P
When income is high, the demand for goods is high. Firms with flexible prices set prices high.

The greater the fraction of flexible-price firms, the smaller is s and the bigger the effect of ΔY on P.

Question 25

How do we derive the AS Equation (Sticky price model)

Answer 25

By using the Overall price level equation and solve for Y:
Gives Y = Ybar + α (P-EP)

Where α = S/(1-S)a >0

Question 26

What are the assumptions behind the Imperfect Information model?

Answer 26

All wages and prices are perfectly flexible, and all markets are clear.

Each supplier produces one good and consumes many goods.

Each supplier knows the nominal price of the good she produces but does not know the overall price level.

Question 27

What does the Supply of each good depend on? (Imperfect Information Model)

Answer 27

-The supply of each good depends on its relative price: the nominal price of the good divided by the overall price level.

Question 28

How does the supplier make a production decision? (Imperfect Information Model)

Answer 28

The supplier doesn’t know price level at the time she makes her production decision so uses EP.

Suppose P rises but EP 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 EP.

Question 29

What are the implications shown by all 3 models seen in diagram 1?

Answer 29

• We can identify why the SRAS curves due to α changing.
  (As P is high the curve is steeper and vice versa)
• The curve is steeper as we are producing more than the potential output, so large changes in price lead to small change in output
• When curve is flatter (where P

Question 30

What are the implications shown by all 3 model seen in Diagram 1.1?

Answer 30

P1 to P2 represents a Short run increase in price level.

The real long term shift in AS comes from the expectations shifting from EP1/2 to EP3

AS2 (shift left) is caused by the revision of price expectations as AS1/AD2 showed a situation where there was more demand than supply so prices would increase.

Question 31

What does the Phillips Curve state?

Answer 31

That π (Inflation) depends on:

• Expected Inflation (Eπ)
• Cyclical Unemployment: The deviation of the actual rate of unemployment (u) from the natural rate (Un)
  (N is to the power of)

-Supply Shocks: (v)

Question 32

How do you calculate the Phillips Curve?

Answer 32

π = Eπ - 𝜷(𝒖−𝒖𝒏 ) + v

Where:
- where 𝛽> 0 is an exogenous constant

Question 33

How you derive the Phillips Curve off of the SRAS Curve?

Answer 33

CHECK NOTES

Question 34

What is the difference between the SRAS Curve and the Phillips Curve?

Answer 34

SRAS:
Output is related to unexpected movements in the price level

Phillips Curve
Unemployment is related to unexpected movements in the inflation rate

Question 35

What are Adaptive Expectations and how do they relate to the Phillips Curve?

Answer 35

Approach that assumes people form their expectations of future inflation based on recently observed inflation

That expected inflation is based on last year’s actual inflation:
Eπ = π -1

Question 36

As a result of Adaptive Expectations how do we now calculate the Phillips Curve?

Answer 36

π = π-1 - β(u - un) + v

Question 37

Following Adaptive Expectation what does the Phillips Curve imply?

Answer 37

That inflation has inertia

• Without any supply shocks or cyclical unemployment, inflation will continue at n-1
• This is because past inflation influences expectations of current inflation, which influences wages and prices people set

Question 38

What are the 2 causes of inflations?

Answer 38

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.

Question 39

What does changing expectations do the LRPC?

Answer 39

People will always revise their expectations and return to the NAIRU, so the tradeoff only holds in the SR.

This is because if inflation increases due to a supply shock, wages may seem cheaper in SR causing employment to rise, in LR people renegotiate their wages causing employment to fall and it to return to natural rate (see graph in notes)

Because AS is constant, AD shocks only cause inflation

Question 40

What is the Sacrifice Ratio?

Answer 40

Measures the percentage of a year’s real GDP that must be forgone to reduce inflation by 1 percentage point.

Typical estimate is 5%

e. g. Reducing Inflation from 6% to 2% = 20% reduction in GDP
(4x5) (4 is reduction and 5 is the ratio)

• Can be incurred in one go or over 4 years

Question 41

How can we translate the Sacrifice Ratio into unemployment?

Answer 41

Can use Okun’s law
2 Versions:
- The Gap version
- The Difference Version

Question 42

What is the Gap Version of Okun’s law?

Answer 42

For every 1% increase in the unemployment rate, a country’s GDP will be roughly an additional 1.5-2% lower than its potential GDP. (Use 1.5% for the exam)

Question 43

What is the difference version of Okun’s law?

Answer 43

Describes the relationship between quarterly changes in unemployment and quarterly changes in real GDP.

Question 44

What are Rational Expectations?

Answer 44

People base their Expectations on all available information, including information about current and prospective future policies.

Question 45

How and Why do people believe in Rational Expectations believe the Sacrifice Ratio can be small?

Answer 45

Suppose u = un and π = Eπ = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6% to 2% as soon as possible.

If the announcement is credible, then Eπ will fall, perhaps by the full 4 points.
Then, π can fall without an increase in u.

-Seen in Volcker’s time as head of the Fed and the Volcker disinflation