Econ 282: The basic theory of Aggregate Supply

Question 1

Three models of aggregate supply in the short run

Answer 1

-Sticky wage model
-Sticky price model
-Imperfect-information model

Question 2

Equation

Answer 2

Y=Ybar + a(P-EP)
Y = aggregate output
Ybar = natural rate of output
a = a positive parameter
P = actual price level
EP = expected price level
-Other things equal, Y and P are positively related, so the SRAS curve is upward sloping

Question 3

The sticky wage model

Answer 3

-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
-W/P = w x (Pe/P)

Question 4

If P=Pe

Answer 4

then, unemployment and output are at their natural rates

Question 5

If P > Pe

Answer 5

then, Real wage is less than its target, so firms hire more workers and output rises above its natural

Question 6

If P < Pe

Answer 6

then real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate

Question 7

Counter-cyclical

Answer 7

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

Question 8

Sticky price model

Answer 8

-long terms contracts between firms and customers
-menu costs
-firms not wishing to annoy customers with frequent price changes
-Assumption: firms set their own prices (as in monopolistic competition)

Question 9

An individual firms desired price is…

Answer 9

p=P+a(Y-Ybar)
where a >0
Assumes two types of firms:
Firm with flexible prices - set prices as above
Firms with sticky prices - must set their prices before they know how P and Y will turn out
p=EP+a(EY-EYbar)

Question 10

p=EP

Answer 10

-To derive the aggregate supply curve, first find an expression for the overall price level
s=fraction of firms with sticky prices

Question 11

Overall price level equation

Answer 11

P= s[EP] + (1-s)[P+a(Y-Ybar)]
EP= prices set by sticky price firms
P + a (Y-Ybar) = price set by flexible price firms
-Subtract (1-s)P from both sides:
sP=s[EP] + (1-s)[a(Y-Ybar)]
-Divide both sides by s:
P=EP + (1-s)a)/(s)

Question 12

High EP…

Answer 12

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

Question 13

High Y

Answer 13

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 (change in Y) on P
-Finally, derive the AS equation by solving for Y
Y=Ybar+a(P-EP),
where
a=(s/[(a-s)a]

Question 14

The imperfect information model Assumptions

Answer 14

Assumptions:
-All wages and prices are perfectly flexible
-all markets clear
-Each supplier produces one good and consumes many goods
-Each supplier knows the nominal price of the good he produces but does not know the overall price level

Question 15

The imperfect-information model (explained)

Answer 15

-The supply of each good depends on its relative price
-The supplier doesn’t know the price level at the time she makes production so uses EP
-Suppose P rises but EP does not
-Supplie thinks her relative price has risen so she produces more, with many producers thinking this way Y will rise whenever P rises above EP