10.

Aggregate Supply and Equilibrium

1. The Phillips Curve

a) Price Setting by Firms

Firms set nominal prices with a markup over marginal cost:

𝑃=𝑃 ∗ 𝜇 ∗ ℳ𝐶
%

Since production costs are often predetermined, the price is set

according to the expected price level

□ predetermined labour contracts

□ menu cost

Assuming a constant markup, we get the following equation for

inflation (derivation at the end):

Phillips Curve/Aggregate Supply:

𝜋= π +𝛼 𝑦

ECON 102 Page 1

 b) Factors that Impact the Phillips Curve

(1) Movements along the Phillips Curve

𝜋 = π + 𝜶(𝒚 − 𝒚 )

𝜋 𝑃𝐶

𝜋∗

0 𝑦
low demand high demand
𝑦<𝑦 𝑦>𝑦

• low production • high production

• low labour demand • high labour demand
• low (real) wage pressure • high (real) wage pressure
• slack in production • hitting capacity constraints
• low cost pressure • high cost pressure

 low inflation/deflation  high inflation

Note: Movements along the PC are business cycle fluctuations

Demand-Pull Inflation

ECON 102 Page 2

 (2) Movements of the Philips Curve

𝜋 = 𝝅𝒆 + 𝛼(𝑦 − 𝑦 )

𝜋 𝑃𝐶

𝜋∗

0 𝑦
higher than expected inflation
π < π∗
• Expected input price increases
○ droughts
○ supply chain interruptions
○ increase in oil prices
○ wages
• Currency depreciation
○ foreign inputs become more
expensive (indirect)
○ foreign goods become more
expensive (direct)
• High Inflation
○ (Nominal) wage increases
• Central Bank loses credibility
lower than expected inflation
𝜋 > π∗
• Expected input price fall
○ advances in technology/
high productivity growth
• Currency appreciation
○ foreign inputs become
cheaper (indirect)
○ foreign goods become
cheaper (direct)
Cost-Push Inflation

ECON 102 Page 3

Note 1: Phillips Curve in the Book

𝑢𝑛𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 𝜋 − 𝜋 = 𝛼(𝑦 − 𝑦 )

𝜋−𝜋

if 𝑦 = 𝑦 (𝑦 = 0) then π = π∗

When the output gap is closed the best expectation for inflation
is the CB's inflation target π∗ (if the CB is credible)

ECON 102 Page 4

Note 2: The Classic Phillips Curve

Phillips Curve Okun's Rule of Thumb

𝜋 = 𝜋 + 𝛼𝑦 𝑦 = −𝛾 (𝑢 − 𝑢 )

α
𝜋 = 𝜋 − 𝛽(𝑢 − 𝑢 ) 𝛽 = ⎯⎯
𝛾

ECON 102 Page 5

2. The IS-MP-PC Model

a) Interaction of Demand and Supply

CB Policy Rate (𝒓𝑶𝑹 )

IS-MP 
𝑟 [Financial Frictions (𝛾)]

𝑟∗ 𝑀𝑃 
Real Interest rate (𝑟)

𝐼𝑆 [Demand Shocks]
𝑦 
PC Aggregate Spending
𝜋 
𝑃𝐶
Output Gap (𝒚)

π∗ 
[Supply Shocks (π )]

0 𝑦 Production Cost (𝑴𝑪)

Inflation (𝝅)

ECON 102 Page 6

 b) Macroeconomic Shocks

(1) Financial Shocks

ECON 102 Page 7

(2) Spending/Demand Shocks

ECON 102 Page 8

(3) Supply Shocks

ECON 102 Page 9

 3. The AS-AD Model

a) Endogenous monetary policy

Monetary Policy Rule IS-MP

𝑟=𝑟 +𝛾 𝑀𝑃𝑅 𝑟

𝑀𝑃
𝑟∗

𝐼𝑆
π∗ 𝜋 𝑦
AS-AD
𝐴𝑆/𝑃𝐶
𝜋 𝜋

π∗

45° 𝐴𝐷
𝜋 0 𝑦

Notes: • CB needs to adjust policy rate for financial

frictions
• CB indirectly controls demand
• the PC becomes Aggregate Supply (AS)

ECON 102 Page 10

 b) Demand Shocks

Monetary Policy Rule IS-MP

𝑟 𝑟
𝑀𝑃𝑅

𝑟∗ 𝑀𝑃

𝐼𝑆
π∗ 𝜋 𝑦
AS-AD
𝐴𝑆/𝑃𝐶
𝜋 𝜋

π∗

45° 𝐴𝐷
𝜋 0 𝑦

 Monetary Policy feedback dampens business cycle

fluctuations

ECON 102 Page 11

 c) Supply Shocks

𝐴𝑆/𝑃𝐶
𝜋

π∗

𝐴𝐷

0 𝑦

► Stagflation
 CB can't fight inflation without making
recession worse

ECON 102 Page 12

Appendix: Derivation of the Aggregate Supply Function

𝑃 = 𝑃 ∗ 𝜇 ∗ 𝑀𝐶

𝑃 = 𝑃 ∗ 𝜇 ∗ 𝑀𝐶

take logs: 𝑝 = 𝑝 + 𝜇 + 𝑚𝑐

same true for previous period: 𝑝 =𝑝 + 𝜇 + 𝑚𝑐

so: π =𝑝 −𝑝 = π + 𝑚𝑐 − 𝑚𝑐 = π + Δ𝑚𝑐

the change in marginal cost is proportional to the output gap.

Δ𝑚𝑐 = 𝛼𝑦

This is more complicated to show, but it basically comes from

increasing marginal cost and wage pressures in the labour market.
Wages increase faster when unemployment is low and increase
slower/stagnate when unemployment is high

𝜋 = π + 𝛼𝑦

ECON 102 Page 13