MACROECONOMIC

ENVIRONMENT
10. Aggregate Supply : Wages,
Prices, Unemployment And
Inflation
 Introduction
• Develop the AS side of the economy and examine the dynamic
adjustment process that carries us from the short run to the long
run.

• Aggregate supply (AS) behaves differently in the short run than

in the long run.

• In the long run, prices are flexible, and the AS curve is vertical.

• By contrast, in the short run, prices are sticky, and the AS curve
is not vertical.

• Earlier, we took a simplified view of price stickiness by drawing

the short-run AS curve as a horizontal line, representing the
extreme situation in which all prices are fixed.

• So, now we want to refine our understanding of short-run AS (i.e

allow for and explain an upward sloping SRAS).
 Y = Y* + (P-Pe) where 
Expected
price level
positive constant:
Output
Natural an indicator of Actual price level
rate of output how much
output responds to
unexpected changes in the
price level.
This equation states that output deviates from its natural rate when the
price level deviates from the expected price level. The parameter 
indicates how much output responds to unexpected changes in the price
level, 1/ is the slope of the aggregate supply curve.
• The Sticky Wage Model

• In this model, some market imperfection

causes the short-run AS curve to be
upward sloping, rather than horizontal, and
shifts in the AD curve cause the level of
output to deviate temporarily from the
natural rate.
 Sticky Wage Model
• Sticky nominal wages.

1) When the nominal wage is stuck, a rise in the price level

lowers the real wage, making labor cheaper.

2) The lower real wage induces firms to hire more labor.

3) The additional labor hired produces more output.

4) Money illusion of workers

• This positive relationship between the price level and the

amount of output means the AS curve slopes upward
during the time when the nominal wage cannot adjust.
 SRAS (Pe=P2)
P LRAS*
SRAS (Pe=P0) Y = Y + (P-Pe)
P2 B
P1 A' Start at point A; the economy is at full
P0 employment Y and the actual price level is P 0.
A
AD' Here the actual price level equals the expected
price level. Now let’s suppose that the price
AD level increases to P1.

Y Y' Output
Since P1 (the actual price level) is now greater than P e (the expected price level) Y
will rise above the natural rate, and we slide along the SRAS (Pe=P0) curve to A' .
The starting SRAS (Pe=P0) curve is defined by the presence of fixed expectations (in
this case at P0). Similarly, every SRAS is defined as such. So in terms of the SRAS
equation, when P rises to P1, holding Pe constant at P0, Y must rise.

Y = Y + (P-Pe)
 SRAS (Pe=P2)
P LRAS*
B
SRAS (Pe=P0) Y = Y + (P-Pe)
P2
P1 A' The “long-run” will be defined when the
P0 expected price level equals the actual price
A
AD' level. So, as price level expectations
adjust, PeP2, we’ll end up on a new
AD short-run aggregate supply curve, SRAS
(Pe=P2) at point B.
Y Y' Output
Thus, we are back at LRAS, a situation characterized by perfect information where
the actual price level (now P2) equals the expected price level (also, P 2).

In terms of the SRAS equation, we can see that as Pe catches up with P, that entire
“expectations gap” disappears and we end up on the long run aggregate supply
curve at full employment where Y = Y.

Y = Y + (P-Pe)
 The Phillips Curve
• The Phillips curve shows the relationship between inflation
and unemployment in the SR.

• The Phillips-curve equation and the short-run aggregate

supply equation represent essentially the same
macroeconomic ideas. Both show the classical belief to break
down in the short run.

• The Phillips curve and the aggregate supply curve are two
sides of the same coin. The aggregate supply curve is more
convenient when studying output and the price level,
whereas the Phillips curve is more convenient when
studying unemployment and inflation.
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 In reality the tradeoff between u and π is

a short run phenomenon. In the LR the
tradeoff disappears as AS (and Ph.C)
becomes vertical.

u* Unemployment, u (%)

Simple PhC Equation: π = - β(u – u*); where β=0.5

 Inflation Expectations Augmented
Phillips Curve
• Edmund Phelps and Milton Friedman argued that well-informed,
rational employers and workers would pay attention only to real
wages—the inflation-adjusted purchasing power of money
wages.

• In their view, real wages would adjust to make the supply of labor
equal to the demand for labor, and the unemployment rate would
then stand at a level uniquely associated with that real wage—the
“natural rate” of unemployment.

• Both Friedman and Phelps argued that the government could not
permanently trade higher inflation for lower unemployment (i.e
SRPC will keep shifting up or down as per change in
expectations of inflation) .

• Imagine that unemployment is at the natural rate. The real wage

is constant: workers who expect a given rate of price inflation
insist that their wages increase at the same rate to prevent the
erosion of their purchasing power.
Inflation Expectations Augmented Phillips Curve
• Now, imagine that the government uses expansionary monetary/ fiscal
policy in an attempt to lower unemployment below its natural rate.

• The resulting increase in demand encourages firms to raise their prices

faster than workers had anticipated. With higher revenues, firms are
willing to employ more workers at the old wage rates and even to raise
those rates somewhat.

• For a short time, workers suffer from money illusion: they see that their
money wages have risen and willingly supply more labor. Thus, the
unemployment rate falls. They do not realize right away that their
purchasing power has fallen because prices have risen more rapidly
than they expected.

• But, over time, as workers come to anticipate higher rates of price

inflation, they supply less labor and insist on increases in wages that
keep up with inflation. The real wage is restored to its old level, and the
unemployment rate returns to the natural rate. But the price inflation
and wage inflation brought on by expansionary policies continue at the
new, higher rates.
Inflation Expectations Augmented Phillips Curve
• Friedman’s and Phelps’s analyses provide a distinction between the “short-
run” and “long-run” Phillips curves.

• So long as the average (expected) rate of inflation remains fairly constant

inflation and unemployment will be inversely related.

• But if the average rate of inflation changes, as it will when policymakers

persistently try to push unemployment below the natural rate, after a period of
adjustment, unemployment will return to the natural rate.

• That is, once workers’ expectations of price inflation have had time to adjust,
the natural rate of unemployment is compatible with any rate of inflation. The
long-run Phillips curve could be shown as a vertical line at the natural rate.

• The original curve would then apply only to brief, transitional periods and
would shift with any persistent change in the average rate of inflation.

• These long-run and short-run relations can be combined in a single

“expectations-augmented” Phillips curve. The more quickly workers’
expectations of price inflation adapt to changes in the actual rate of inflation,
the more quickly unemployment will return to the natural rate, and the less
successful the government will be in reducing unemployment through
monetary and fiscal policies.
Inflation Expectations Augmented Phillips Curve

Inflation-Expectations
Augmented PC equation:
π = πe – β(u – u*)

The modern PC intersects the natural rate of u at the level of expected inflation.
The height of the SRPC depends upon πe .
Changes in expectations shifts the curve up and down.
When high AD moves the economy up and to the left along the SRPC, π results.
If persists, people adjust their expectations upwards, and move to higher SRPC.
The Phillips curve in its modern form states that the inflation rate
depends on three forces:
1) Expected inflation
2) The deviation of unemployment from the natural rate, called
cyclical unemployment
3) Supply shocks

These three forces are expressed in the following equation:

 = e  ) + 
Expected
Inflation
Inflation   Cyclical Supply
Unemploymen Shock
• The second and third terms in the Phillips-curve equation show
the two forces that can change the rate of inflation.

• The second term, (u-u*), shows that cyclical unemployment

exerts downward pressure on inflation. Low unemployment pulls
the inflation rate up. This is called demand-pull inflation because
high aggregate demand is responsible for this type of inflation.
High unemployment pulls the inflation rate down. The parameter 
measures how responsive inflation is to cyclical unemployment.

• The third term,  shows that inflation also rises and falls because
of supply shocks. An adverse supply shock, such as the rise in
world oil prices in the 70’s, implies a positive value of  and causes
inflation to rise. This is called cost-push inflation.
 Let’s start at point A, a point of price stability (=0%) and full employment (u=u*).
Remember, each short-run Phillips curve is defined by the presence of fixed expectations.
Suppose there is an increase in the rate of growth of the money supply causing LM and AD to shift out
resulting in an unexpected increase in inflation. The Phillips curve equation  = e – (u-u*) + v implies
that the change in inflation misperceptions causes unemployment to decline. So, the economy moves to a
point above full employment at point B.
As long as this inflation misperception exists, the economy will
 LRPC (u=u*) remain below its natural rate u* at u'.
When the economic agents realize the new level of inflation, they
10% D E will end up on a new short-run Phillips curve where expected
inflation equals the new rate of inflation (5%) at point C, where
actual inflation (5%) equals expected inflation (5%).
If the monetary authorities opt to obtain a lower u again,
then they will increase the money supply such that  is
5% B C 10%, for example. The economy moves to point D, where
actual inflation is 10% but, e is 5%.
When expectations adjust, the
economy will land on a new SRPC, at
A SRPC ( =10%) point E, where both  and e equal
e

10%.
u' u* SRPC ( =5%)
e

Unemployment, u
SRPC (e=0%)
 Adaptive Expectations
• What determines expected inflation. A simple but practical assumption
is that people form their expectations of inflation based on recently
observed inflation. This assumption is called adaptive expectations. So,
expected inflation e equals last year’s inflation -1. In this case, we can
write the Phillips curve as:
 = -1  ) + 
which states that inflation depends on past inflation, cyclical
unemployment, and a supply shock.

• u* is called the Non-Accelerating Inflation Rate of Unemployment, or

NAIRU. The term -1 (or πe ) implies that inflation has inertia-- meaning
that it keeps going until something acts to stop it.
• Rational expectations make the assumption that people
optimally use all the available information about current
government policies, to forecast the future.

• According to this theory, a change in monetary or fiscal policy

will change expectations, and an evaluation of any policy change
must incorporate this effect on expectations. If people do form
their expectations rationally, then inflation may have less inertia
than it first appears.

• Proponents of rational expectations argue that the short-run

Phillips curve does not accurately represent the options that
policymakers have available.
• They believe that if policy makers are credibly
committed to reducing inflation, rational people will
understand the commitment and lower their
expectations of inflation. Inflation can then come down
without a rise in unemployment and fall in output.

• Robert Lucas modified the model to allow for rational

expectations.
 Exercise 1
Use the following data to measure USA’s balance on
merchandise trade; balance on current account;
balance on capital account and balance of payments.
There is no change in reserve assets held by govt and
official agencies.
1) USA exports goods valued at $19,650.
2) USA imports merchandise valued at $21,758.
3) US citizens receive interest income of $3621 from
foreign investments.
4) Interest income of $1394 is paid on foreign- owned
assets in USA.
5) US citizens travel expenditures equal $1919.
6) Foreign travel in USA is $1750.
7) US unilateral transfers are $2388.
8) US capital outflow is $4174.
9) US capital inflow is $6612.
 Exercise 2
The following transactions occurred in respect of India’s trade with
rest of the world during 2007. (All figures are in crores).

a)Oil worth Rs10,000 was exported.

b)Perfume worth Rs5,000 was imported.
c)Foreign tourists spent Rs3000 in India.
d)India donated Rs 1000 to developing countries.
e)Dividends from overseas companies equal to Rs 500 were received.
f)Overseas shares worth Rs150 were purchased.
g)Deposits worth Rs70 were made by transfers from foreign currency
accounts.
h)There was a balancing item of +Rs20.
i)A Rs 4000 loan from IMF was repaid.

Find (in Rs) India’s

i)visible trade balance; ii)balance of trade(goods & services);
iii)current account surplus or deficit; iv)BOPs; v)change in
official reserves.
 Exercise 3
Suppose C=47.50+0.85(Y-Tn); Tn=100; G=100;
I=100-5i; NX=50-0.1Y; M/P=100; L=0.20Y-10i.
iF=5%, and there is capital mobility.
a) Find equilibrium income and the roi.

b) Is there BOP equilibrium? What is the balance

on current account and capital account at
equilibrium income found in part (a)?

c) What effect will a Rs10 increase in govt

spending have on equilibrium income? On BOP
equilibrium?