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 2
 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

e
Y  Y   (P  P )
agg. the expected
output price level
a positive
natural rate parameter the actual
of output price level slide 3
 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:
W  ω P e

slide 4
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 5
 (a) Labor Demand (b) Production Function
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 given
employment,. .
nominal wage, ..
(c) Aggregate Supply
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, output,
slide 6 Y
level. .
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 7
 SUMMARY & IMPLICATIONS
P LRAS
Y  Y   (P  P e )

P Pe
SRAS
e EACH OF THE
P P THREE MODELS
OF AGG. SUPPLY
P Pe IMPLY THE
RELATIONSHIP
Y
SUMMARIZED BY
Y THE SRAS CURVE
& EQUATION
slide 8
 SUMMARY & IMPLICATIONS
SUPPOSE A SRAS equation: Y  Y   (P  P e )
POSITIVE AD
SHOCK MOVES P LRAS
OUTPUT ABOVE ITS
NATURAL RATE SRAS1
AND P ABOVE THE
LEVEL PEOPLE
HAD EXPECTED.

Over time, P2e  P1  P1e

P e rises,
AD1
SRAS shifts up, Y
and output returns
to its natural rate. Y 3  Y1  Y slide 9
 INFLATION, UNEMPLOYMENT,
AND THE PHILLIPS CURVE
THE PHILLIPS CURVE STATES THAT 
DEPENDS ON

where  > 0 is an exogenous constant.

slide
10
 DERIVING THE PHILLIPS CURVE
FROM
e
SRAS
(1) Y  Y   (P  P )
(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
11
 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
12
 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
13
 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
14
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
15
 GRAPHING THE PHILLIPS CURVE

IN THE SHORT 
RUN,
POLICYMAKERS
FACE A TRADE-OFF 
BETWEEN _____. 1 The short-run
e  Phillips Curve

u
n
u
slide
16
 SHIFTING THE PHILLIPS CURVE
PEOPLE
ADJUST THEIR 
EXPECTATIONS
OVER TIME, SO
THE TRADEOFF
ONLY HOLDS
IN THE SHORT  1e  
RUN.

E.g., an increase
in e shifts the u
n
short-run P.C. u
upward. slide
17