Chapter 13: AGGREGATE SUPPLY

While the IS-LM model is a useful and versatile model of the economy in the short run when prices are fixed, it only explains the aggregate demand side of the economy. In this chapter, four models of short-run aggregate supply are developed.

Aggregate Supply Models:

In chapter 8 the short-run aggregate supply curve, SRAS, was completely horizontal at a fixed price level while the long-run aggregate supply curve, LRAS, was completely vertical at the full employment (market clearing) rate of output. A more sophisticated analysis of the aggregate supply equation concludes that the SRAS curve is upward sloping.

The four different models used to explain an upward sloping SRAS curve are:

(1) the sticky-wage model, (2) the worker-misperception model, (3) the imperfect-information model, and (4) the sticky-price model. These models share certain features, not surprisingly, and all may contain some element of the truth.

The Sticky-Wage Model.

a. Focuses attention on wage-setting agreements made by firms and workers.

b. Nominal wages are set in advance and are not changed with every event that alters their employers’ profits.

c. The sticky-wage model starts with the presumption that when a firm and its workers sit down to bargain over the wage, they have in mind some target real wage upon which they will ultimately agree. The level of employment at this real wage is determined by demand (productivity) and supply conditions assumed to be at full employment.

d. When the price level rises, wages will be stuck at contract levels, so that real wages fall, making labor cheaper.

e. The lower real wages induces firms to hire more labor. This assumes that firms hire workers according to their labor demand function, ie. their marginal physical product.

f. The additional labor hired produces more output.

g. The positive relationship between the price level and the amount of output means that the aggregate supply curve is upward sloping.

h. The only point on the aggregate supply curve in which the real wage equals the targeted real wage occurs when the actual price level equals the expected price level.

The Worker-Misperception Model

a. Unlike the sticky-wage model, the worker-misperception model assumes that workers are free to equate supply and demand in the labor market, but that they temporarily confuse real and nominal wages.

b. Workers know their nominal wage, W, but they do not know the overall price level, P.

c. Their expected real wage equal to W/Pe determines how much they work, but if the actual price level rises and the expected price level remains the same, then the supply of labor function will shift to the right lowering the equilibrium real wage the employers pay.

d. Lower real wages increases employment and output.

e. Hence, higher prices that are not fully perceived by labor will increase the supply of labor, increase employment, increase output, and result in an upward sloping aggregate supply curve.

Case Study 1-1: The Cyclical Behavior of the Real Wage

In any model with an unchanging labor demand curve employment rises when the real wage falls. In the sticky-wage and worker-misperception models and unexpected increase in the price level lowers the real wage and increases employment and output. Therefore, real wages should be counter-cyclical, ie. fluctuate in the opposite direction from employment and output.

Figure 11-4 challenges this relationship by showing that the real wage is somewhat procyclical. Higher percentage change in real output are associated with a higher percentage change in real wages. This observation is inconsistent with the sticky-wage and worker-misperception models.

The explanation for this apparent contradiction lies in the fact that labor demand is not unchanging over the business cycle. Models which leave labor demand unchanged do not fully explain the relationship between the real wages and employment and output.

Shifts in labor demand over the cycle may arise because firms have sticky prices and cannot sell all they want at those prices. Or, alternatively technology shocks that alter labor productivity may shift the labor demand schedule (real business cycle theory.)

The Imperfect-Information Model

a. This model, like the worker-misperception model, assumes that the labor market clears, but unlike the worker-misperception model it does not assume that firms have better information than workers.

b. Since individual suppliers work in separate markets they cannot observe all prices at all times, even though they monitor closely the prices in their individual markets.

c. If there in an unexpected increase in the overall price level it may be erroneous assumed that relative prices in their industry are higher and workers and producers will work harder and produce more for a given increase in the overall price level.

d. The result is greater output and employment at a higher price level than would have occurred if the producers and workers had correctly recognized that their relative prices are unchanged.

The Sticky-Price Model

a. The sticky price model emphasizes that firms do not instantly adjust the prices they charge in response to changes in demand. Menu prices are changed at a cost to the firms, including the possibility of annoying their regular customers.

b. This ability to set prices implies that firms are operating in imperfectly competitive markets in which they have some market power.

c. Suppose that a firm’s desired price is denoted by p. This price depends upon two things. First, it depends upon the general price level. P. Second, it depends upon the level of demand in the economy, measured by the difference between current output and full employment output.

d. Now suppose that there are two types of firms in the economy. One fraction denoted by (1-s) has flexible prices and adjusts to current conditions. The other fraction, s, has sticky prices due to the cost of price setting or other reasons.

e. The firms that set their price in advance and keep it in place for some period of time (sticky portion) must set their price on the basis of expectations of future demand conditions. Their best forecast is for a level of demand at its long-run level, Y=Yn, such that shocks are random, ie. p = P*

f. The actual price level in the economy is the average of these two sets of prices:

(1) P = s P* + (1-s) (P + a(Y-Yn)) or (solving for P)

(2) P = P* + (a(1-s)/s) (Y-Yn)

g. This equation tells us, first, that if output is at its natural rate, the actual and expected price levels correspond. Second, if Y is greater than the natural rate, the actual price level will exceed the expected price level, so that the aggregate supply curve is upward sloping.

h. Solving equation (2) for output results in the familiar equation for SRAS where output is the natural rate plus alpha times the difference between the actual price level and the expected price level.

Case Study 11-2

Robert Lucas proposed the imperfect information model in which he noted that the slope of the aggregate supply curve should depend upon the variability of aggregate demand suppliers do not respond to the price level as if they were differences in relative prices. Since this would cause a decrease in the value of alpha (the weight applied to the difference between the actual and expected price level.), the aggregate supply curve would be steeper.

The same conclusion could be reached by the sticky-price model since when prices change frequently it becomes more costly to maintain sticky prices. Firms will not commit to prices in advance and will adjust more rapidly to price changes; hence, the value of alpha falls and the aggregate supply curve is steeper.

International data supports both models in that in countries with low average inflation the aggregate supply curve is flatter than in countries with high average inflation.

Summary and Implications

a. The four models used to explain an upward sloping SRAS curve can be classified according to two criteria: (1) Do the markets clear? (2) Does the market imperfection lie in the labor market or the in the goods market?

b. The sticky -wage and worker misperception models are based upon imperfections in the labor market. Markets clear in the worker misperception model but do not clear in the sticky wage model.

c. The imperfect information model and the sticky-price model are based upon imperfections in the goods market. Markets clear in the imperfect-information model by do not clear in the sticky-price model.

d. All four models can be expressed in the equation:

Y = Yn + a(P - P*) where Yn is the full employment rate of output, a is coefficient measuring the importance of forecast error between the actual price level, P, and the expected price level, P*.

e. If the price level is above the expected price level output exceeds the natural rate. If the price level is below the expected price level output falls short of the natural rate.

f. Figure 11-7 shows that the SRAC curve will eventually shift backward in response to unexpected shifts outward in AD, so that the LRAC curve is vertical at the natural rate of output.

Inflation, Unemployment, and the Phillips Curve

a. The modern Phillips Curve (that originally explained a negative relationship between the unemployment rate and the rate of wage inflation) postulates a negative relationship between the rate of inflation and the unemployment rate (because of the high correlation between wage inflation and price inflation).

b. The modern Phillips Curve includes the influence of expected inflation on the long-run versus short-run Phillips Curve based upon the worker-misperception model (market clearing with incorrectly forecast real wages in the short-run.)

c. The modern Phillips Curve includes the effects of supply shocks to aggregate supply that represent exogenous influences on prices (minimum wage, OPEC oil prices, government wage-price controls, etc.)

d. The Phillips Curve is merely a convenient way to express and analyze the aggregate supply curve.

The Short-Run Tradeoff Between Inflation and Unemployment

a. An unexpected increase in aggregate demand that results in higher prices than expected will result in higher real output and less unemployment. This results in a Phillips Curve in the short-run.

b. Because people adjust their expectations of inflation over time, this tradeoff between inflation and unemployment holds only in the short period.

c. Higher past inflation results in higher expected inflation that shifts the short-run aggregate supply curve backward, causing less output and employment with higher prices.

d. In the long-run there is no tradeoff between inflation and unemployment since output is independent from the price level along the LRAS curve.

Disinflation and the Sacrifice Ratio

a. Suppose the inflation rate is high at the natural rate of unemployment (the result of higher inflationary expectations based upon recent inflation rates.)

b. What is the cost of removing inflation in terms of short-run cyclical unemployment?

c. Research shows that the sacrifice ratio, the percentage of a years real GDP that most be foregone to reduce inflation by 1 percent, is about 5.

d. Okun’s Law says that a change of 1 percentage point in the unemployment rate translates into a change of 2 percent in GDP. Therefore, in order to reduce inflation by 1 percent cyclical unemployment would have to increase about 2.5 percent.

e. Since GDP is on the order of $5 trillion, the cost of bringing inflation down by 1 percent point is about $250 billion, or about $1,000 per head of the population.

Rational Expectations and Painless Disinflation

a. A short-run Phillips Curve takes place because the expected price lags the actual price. According to Friedman’s adaptive expectation, forecasting errors will not be random since they are an average of present and past inflation rates. When inflation is increasing, expected prices will be below actual prices. When inflation is decreasing expected prices will be above actual prices.

b. Rational expectations assumes that people optimally use all the information at their disposal to forecast the future. Forecasting errors will not be “autocorrelated” but random. Under these conditions the SRAC curve would not exist.

c. The only policy influence that would result in higher employment and output at a higher price level would be one that is not anticipated. In other words, announce policy changes have no effect on output. Also, with perfect information the sacrifice ratio would be significantly reduced or eliminated altogether. The rate of inflation would adjust suddenly and rapidly to current economic policy affecting aggregate demand. The key factor is how credible is current economic policy.

Case Study 12-4 The Sacrifice Ratio in Practice

The Volcker disinflation in the early 1980s permits an estimate of the sacrifice ratio. Between 1982 and 1985 inflation fell by 6.7 percentage points. Over the same period, unemployment was a total of 9.5 percentage point-years over the natural rate. Using Okun’s law this translates into about 19 percent of one year’s GDP, giving a sacrifice ratio of 2.8. This Relatively low level may reflect Volker’s perceived high credibility. Yet, not even Volker was able to engineer painless disinflation.

Recent Developments: New Keynesian Economics

Economists concerned with short-run economic fluctuations generally fall into two major schools of thought: New classical economists or New Keynesian economists. New classical economists advocate rapidly clearing markets with SRAC curves based upon the worker-misinformation and imperfect-information models. More recently they have turned to real-business theory which applies the tenants of the classical model--price flexibility and money neutrality--to explain economic fluctuations.

a. New Keynesian economists believe that market-clearing models cannot explain short-run fluctuations, so they advocate models with sticky wages and sticky prices. Aggregate demand is the primary determinant of income and output in the short-run.

b. Short-run stickiness of prices are the result of menu costs with aggregate demand externalities of price changes in which the firm does not derive the full benefit of its price change. Remember that for lower prices to increase output the LM curve must shift outward due to higher real money balances; but, the increase in demand created by higher real money balances affects aggregate demand rather than individual firm demand. This lower the incentive for an individual firm to lower its price.

c. Also if all firms do not change their price at once relative prices will change. In imperfect markets oligopolists are reluctant to change price if other do not follow suit.

d. The coordination between wages and prices also results in recessionary forces during which labor is temporarily hoarded or unsure about future union concessions or hiring costs. This hoarding of labor explains the procyclical change in labor productivity that would otherwise not be predicted if people were laid off in response to reduction in labor demand at higher real wages.

e. Hysteresis is a term used to describe long-lasting influences of history on the natural rate of unemployment. Keynesians have said that a recession can result in unemployed workers losing their status as insiders but rather become outsiders. A small group of insiders may be able to push and maintain real wages above the full employment real wage. This would increase the sacrifice ratio and make it more difficult to lower inflation through increases in unemployment. In Britain, the unemployment rate remained high even after inflation had been reduced suggesting that recession might have permanently raised the natural rate of unemployment.