Supplemental Slides From Class Aggregate Supply

Chapter 13-7th and 14-8th edition

The sticky-wage model – not in the 7th and 8th editions

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 based on a target real wage and the expected price level:

e

Ww

P

The sticky-wage model

If it turns out that

eP P

eP P

eP P

then

Unemployment and output are at their natural rates.

Actual real wage is less than the target, firms hire more workers and output rises above its natural rate.

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

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 imperfect-information model

Assumptions: All wages and prices are perfectly flexible,

all markets are clear. (drops the assumption of imperfect competition)

Each supplier produces one good and consumes a lot of others.

Each supplier knows the nominal price of their own good, but not all of the other goods - does not know the overall price level.

The imperfect-information model, also called the Misperceptions Theory Q: What is the best time for an individual producer to increase production?

A: When there has been an increase in demand for her specific product

In that case, price of the good she produces rises relative to the goods that she consumes

Producer will want to take advantage of relative increase in demand

Q: What will be the effect of an increase in aggregate demand (say, from higher M)?

A: All prices will rise

But individual producers will not be able to distinguish this increase from a shift in specific demand

So individual producers will increase production somewhat, at least temporarily

The price of bread is the baker's nominal wage; the price of bread relative to the general price level is the baker's real wage. If the relative price of bread rises, the baker may work more and produce more bread.

If the baker can't observe the general price level as easily as the price of bread, he or she must estimate the relative price of bread

If the price of bread rises 5% and the baker thinks inflation is 5%, there's no change in the relative price of bread, so there's no change in the baker's labor supply

But suppose the baker expects the general price level to rise by 5%, but sees the price of bread rising by 8%; then the baker will work more in response to the wage increase

Example: A bakery that makes bread

With many producers thinking this way, if everyone expects prices to increase 5% but they actually increase 8%, they'll work more

So an increase in the price level that is higher than expected induces people to work more and thus increases the economy's output

Similarly, an increase in the price level that is lower than expected reduces output

Generalizing this example

Summary & implications

Y

P LRAS

Y

eP P( )eY Y P P

Producers often fooled

Producers rarely fooled

What shifts the curves?

Change in Pe

When P > Pe, expectations adjust and Pe rises over time

This increase in Pe shifts the SRAS curve up

When P < Pe, expectations adjust and Pe falls over time

This decrease in Pe shifts the SRAS curve down

Eventually, Y always returns to full employment

( )eY Y P P

( )eY Y P P

Imperfect Information - Misperceptions Theory and the Non-neutrality of Money

Monetary policy and the misperceptions theory Because of misperceptions, unanticipated

monetary policy has real effects; but anticipated monetary policy has no real effects because there are no misperceptions

An unanticipated increase in the money supply (same as Mankiw’s slide in the book)

Monetary policy and the misperceptions theory

Initial equilibrium where AD1 intersects SRAS1 and LRAS (point E) Unanticipated increase in money supply shifts AD

curve to AD2

The price level rises to P2 and output rises above its full-employment level, so money isn't neutral

As people get information about the true price level, their expectations change, and the SRAS curve shifts left to SRAS2, with output returning to its full-employment level

So, unanticipated monetary policy isn't neutral in the short run, but it is neutral in the long run

The Misperceptions Theory and the Nonneutrality of Money

Anticipated changes in the money supply If people anticipate the change in the money

supply and thus in the price level, they aren't fooled, there are no misperception, and the SRAS curve shifts immediately to its higher level

So anticipated monetary is neutral in both the short run and the long run

An anticipated increase in the money supply. Go directly from P1 to P3 - directly from point E to H.There is no SR equilibrium at point F as in the earlier slide.