AGGREGATE DEMAND and

AGGREGATE SUPPLY II

how to derive un upward sloping aggregate supply in the short-run:

Sticky prices; Sticky wages; Lucas’ imperfect information model; The general AD-AS model; the Phillips Curve.

Lecture outline:

Three Models Of Aggregate SupplyConsider 3 stories that could give us this SRAS:

The sticky-wage modelThe imperfect-information model

The sticky-price modelAll three models imply:

The Sticky-wage ModelImperfection:

Nominal wages are sticky in the short run, they adjust sluggishly (due to labor contracts, social norms).

Firms and workers set the nominal wage in advance based on the price level they expect to prevail.

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 (W) they set is the product of a target real wage and the expected price level:

eW ω P

eW PωP P

Target real

wageExpected price level

The Sticky-wage Model

The Sticky-wage Model

The Sticky-wage Model

The Sticky-wage Model This 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. It seems that real wages are pro-cyclical.

The Sticky Prices Model Reasons for sticky prices:

long-term contracts between firms and customers menu costs firms not wishing to annoy customers with

frequent price changes Assumption:

Firms set their own prices (e.g., as in monopolistic competition).

The Sticky Prices ModelConsider the pricing decision facing a typical firm.

The firm’s desired price p depends on two macroeconomic variables:

The overall level of prices P. A higher price level implies that the firm’s costs are higher. Hence, the higher the overall price level, the more the firm would like to charge for its product.

The level of aggregate income Y. A higher level of income raises the demand for the firm’s product. Because marginal cost increases at

higher levels of production, the greater the demand, the higher the firm’s desired price.

The Sticky Prices Model

The Sticky Prices Model

The Sticky Prices Model

The Sticky Prices Model

The Sticky Prices Model

The Sticky Prices Model

The Sticky Prices Model

Shift to the left the labor demand in the economy depicted in the following figure where we plot the

equilibrium in the labour market. The Ls is the labour supply and the Ld is the labour demand. On the vertical

axis we have the real wage and on the horizontal axis the level of employment L.

The Lucas’ Imperfect-information Model

Assumptions: All wages and prices are perfectly flexible, all

markets are clear. Each supplier produces one good, consumes

many goods. Each supplier knows the nominal price of the

good she produces, but does not know the overall price level.

The Lucas’ Imperfect-information Model

Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level.

Supplier does not know price level at the time she makes her production decision, so uses the expected price level, P e.

Suppose P rises but P e does not. Supplier thinks her relative price has risen, so she

produces more. With many producers thinking this way, Y will

rise whenever P rises above P e.

Summary of the AD-AS Model

Inflation, Unemployment, and the Phillips Curve

The Phillips Curve and SRAS

Graphing the Phillips Curve