AD-AS

A NEW AND IMPROVED SHORT RUN AS

P CURVE
__________

Consider a more realistic case, in between the two extreme assumptions we

considered before. slide 1
THREE MODELS OF AGGREGATE SUPPLY
CONSIDER 3 STORIES THAT COULD GIVE US THIS SRAS:
1. THE STICKY-WAGE MODEL
2. THE IMPERFECT-INFORMATION MODEL
3. THE STICKY-PRICE MODEL

Y  Y   (P  P ) e

agg. the expected

output price level
a positive
natural rate parameter the actual
of output price level slide 2
 THE STICKY-WAGE MODEL
• ASSUMES THAT FIRMS AND WORKERS NEGOTIATE
CONTRACTS AND FIX THE NOMINAL WAGE.
• THE NOMINAL WAGE, W, THEY SET IS THE PRODUCT
OF A TARGET REAL WAGE, , AND THE EXPECTED
PRICE LEVEL:
e
W  ω P

slide 3
 THE STICKY-WAGE MODEL
W Pe
ω
P P

Pe = P unemployment and output are

at their natural rates
Real wage is less than its target,
Pe <P
so firms hire more workers and
output rises above its natural rate

Pe >P
Real wage exceeds its target, so
firms hire fewer workers and
output falls below its natural rate
slide 4
 (a) Labor De mand (b) Production Fun ction
Real wage, Income, output, Y
W/P
W/P 1 Y 5 F(L)
Y2
W/P 2
Y1
L 5 Ld(W/P )

4. . .. output,. .

2. .. . reduces L1 L2 Labor, L L1 L2 Labor, L

the real wage 3. . ..which raises
for a giv en
employment,. .
nominal wage,. .
(c) Aggregate S upply
Price level, P Y 5 Y 1 a (P 2 Pe )

P2
6. The aggregate
P1 supply curve
summarizes
these changes.
1. An increase
in the price Y1 Y2 Income,slideoutput,
5 Y
lev el. .
5. . .. and income.
 THE STICKY-WAGE MODEL
• IMPLIES THAT THE REAL WAGE SHOULD BE _______
______, __________________________
_________ OVER THE COURSE OF BUSINESS
CYCLES:
• IN BOOMS, WHEN P TYPICALLY RISES, THE REAL
WAGE SHOULD FALL.
• IN RECESSIONS, WHEN P TYPICALLY FALLS, THE
REAL WAGE SHOULD RISE.

slide 6
 SUMMARY & IMPLICATIONS
P LRAS
Y  Y   (P  P e )

P Pe
SRAS
e
EACH OF THE
P P THREE MODELS OF
AGG. SUPPLY IMPLY
P Pe
THE RELATIONSHIP
SUMMARIZED BY
Y
Y THE SRAS CURVE
& EQUATION
slide 7
 SUMMARY & IMPLICATIONS
SUPPOSE A POSITIVE SRAS equation: Y  Y   (P  P e )
AD SHOCK MOVES
OUTPUT ABOVE ITS P LRAS
NATURAL RATE
AND P ABOVE THE SRAS1
LEVEL PEOPLE
HAD EXPECTED.

Over time, P e
 P  P e
e 2 1 1
P rises,
SRAS shifts up, AD1
Y
and output returns
to its natural rate.
Y 3  Y1  Y slide 8
 INFLATION, UNEMPLOYMENT,
AND THE PHILLIPS CURVE
THE PHILLIPS CURVE STATES THAT  DEPENDS ON

   e   (u  u n )  

where  > 0 is an exogenous constant.

slide 9
 DERIVING THE PHILLIPS CURVE FROM SRAS
(1) Y  Y   (P  P e )
(2) P 

(3) P  P e  (1  )(Y Y )  

(4) (P  ___ )  ( P e  ___ )  (1  )(Y Y )  

(5)    e  (1  )(Y Y )  

(6) (1  )(Y Y )  

(7)    e   (u  u n )   slide
10
 THE PHILLIPS CURVE AND SRAS
SRAS: Y  Y   (P  P e )
Phillips curve:    e   (u  u n )  
• SRAS CURVE:
OUTPUT IS RELATED TO _________________
_________________.
• PHILLIPS CURVE:
UNEMPLOYMENT IS RELATED TO ___________
_________________.

slide
11
 ADAPTIVE EXPECTATIONS
• ADAPTIVE EXPECTATIONS: AN APPROACH THAT
ASSUMES PEOPLE FORM THEIR EXPECTATIONS OF
FUTURE INFLATION BASED ON _______________
_________________.
• A SIMPLE EXAMPLE:
EXPECTED INFLATION = LAST YEAR’S ACTUAL INFLATION

 e  ___
 Then, the P.C. becomes
  ___   (u  u n )  
slide
12
 INFLATION INERTIA
n
   1   (u  u )  
• IN THIS FORM, THE PHILLIPS CURVE IMPLIES THAT
INFLATION HAS INERTIA:
• IN THE ABSENCE OF SUPPLY SHOCKS OR CYCLICAL UNEMPLOYMENT,
INFLATION WILL ________
____________________.
• PAST INFLATION INFLUENCES EXPECTATIONS OF CURRENT
INFLATION, WHICH IN TURN INFLUENCES THE WAGES & PRICES THAT
PEOPLE SET.

slide
13
 TWO CAUSES OF RISING & FALLING
INFLATIONn
   1   (u  u )  
• _______________: INFLATION RESULTING FROM
SUPPLY SHOCKS.
ADVERSE SUPPLY SHOCKS TYPICALLY RAISE
PRODUCTION COSTS AND INDUCE FIRMS TO RAISE
PRICES, “PUSHING” INFLATION UP.
• _______________: INFLATION RESULTING FROM
DEMAND SHOCKS.
POSITIVE SHOCKS TO AGGREGATE DEMAND CAUSE
UNEMPLOYMENT TO FALL BELOW ITS NATURAL RATE,
WHICH “PULLS” THE INFLATION RATE UP. slide
14
 GRAPHING THE PHILLIPS CURVE
   e   (u  u n )  
IN THE SHORT 
RUN, POLICYMAKERS
FACE A TRADE-OFF
BETWEEN _____. 
1 The short-run
 e  Phillips Curve

n u
u
slide
15
 SHIFTING THE PHILLIPS CURVE
PEOPLE ADJUST    e   (u  u n )  
THEIR 
EXPECTATIONS
OVER TIME, SO
THE TRADEOFF
ONLY HOLDS IN
THE SHORT RUN.  1e  

E.g., an increase
in e shifts the u
n
short-run P.C. u
upward. slide
16