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MACROECONOMICS:
THEORY AND POLICY
Anindya S. Chakrabarti
Indian Institute of Management, Ahmedabad
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Recap
• Discussed IS-LM model.

• Discussed fiscal and monetary policies.

• Different effects on interest rate and output.

• Demand side story.

• Need to introduce a supply side story.

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Aggregate Supply:
Wages, Prices,
and Unemployment
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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

• The price-output relationship is based upon links between wages,

prices, employment, and output

 link between unemployment and inflation = Phillips Curve

• Translate between unemployment and output, inflation and price

changes
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Introduction
• Introduce role of price and inflation expectations, and the
“rational expectations revolution”

• NOTE: theory of AS is the least settled area in macro

• Don’t fully understand why W and P are slow to adjust, but offer several
theories

• All modern models differ in starting point, but reach the same
conclusion: SRAS is flat, LRAS is vertical
Inflation and Unemployment
• U.S. unemployment from 1959 to [Insert Figure 6.1 here]
2005
• Several periods of high
unemployment: early 1960s, mid
1970’s, early-mid 1980’s, and early
1990s
• Several periods of low
unemployment: late 1960’s, early
2000
• Phillips curve (PC) shows the
relationship between
unemployment and inflation
• Although GDP is linked to
unemployment, it is easier to work
with the PC than the AS when
discussing unemployment

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The Phillips Curve
• In 1958 A.W. Phillips [Insert Figure 6.2 here]
published a study of wage
behavior in the U.K.
between 1861 and 1957
• There is an inverse relationship
between the rate of
unemployment and the rate of
increase in money wages

From a policymaker’s
perspective, there is a tradeoff
between wage inflation and
unemployment

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The Policy Tradeoff
• PC quickly became a [Insert Figure 6-3 here]
cornerstone of macroeconomic
policy analysis since it
suggests that policy makers
could choose different
combinations of u and  rates
• Can choose low u if willing to
accept high  (late 1960’s)
• Can maintain low  by having
high u (early 1960’s)
• In reality the tradeoff between
u and  is a short run
phenomenon
• In the LR the tradeoff disappears
as AS becomes vertical

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 The Inflation Expectations-Augmented
Phillips Curve
• Figure shows the behavior [Insert Figure 6-4 here]
of  and u in the US since
1960  does not fit the
simple PC story

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Two models (Mankiw’s book)

• In previous chapters, we assumed the price level P was
“stuck” in the short run.
• This implies a horizontal SRAS curve.

• Now, we consider two prominent models of aggregate

supply in the short run:
• Sticky-price model
• Sticky wage model
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SRAS curve
 Other things equal, Y and P are positively related, so the
SRAS curve is upward sloping.

agg. expected
output price level
natural rate a positive actual
of output parameter price level
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The sticky-price 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).
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The sticky-price model

• An individual firm’s desired price is:

p  P  a(Y  Y )
where a > 0.
Suppose two types of firms:
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price before
they know how P and Y will turn out:

p  EP  a( EY  EY )
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The sticky-price model

P  s[ EP ]  (1  s)[ P  a(Y  Y )]
price set by
sticky-price firms price set by
flexible-price firms

(1 s )a
P  EP  (Y  Y )
s
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SRAS curve
• Finally, derive AS equation by solving for Y:

Y  Y   (P  EP ),
s
where    0
(1  s ) a
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Sticky wage model

• Recall that from profit maximization
W
MPL 
P
• Also when L increases, MPL decreases.

• Suppose P increases, W is sticky. Then W/P decreases.

• Therefore, MPL decreases.

• Therefore, L increases and hence output increases.

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Deriving the Phillips curve from SRAS

(1) Y  Y   (P  EP )
(2) P  EP  (1  )(Y  Y )
(3) P  EP  (1  )(Y  Y )  

(4) (P  P1 )  ( EP  P1 )  (1  ) (Y  Y )  

(5)   E  (1  )(Y Y )  
(6) (1  )(Y Y )    (u  un )

(7)   E   (u  u n )  
Supply Shocks
• A supply shock is a [Insert Figure 6-10 here]
disturbance in the economy
whose first impact is a shift
in the AS curve
• An adverse supply shock is one
that shifts AS inwards
• As AS shifts to AS’, equilibrium
shifts from E to E’ and prices
increase while output falls
• The u at E’ forces wages and
prices down until return to E,
but process is slow

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Supply Shocks
• Figure shows the impact of [Insert Figure 6-10 here]
AD policy after an adverse
supply shock
• Suppose G increases (to AD’):
• Economy could move to E* if
increase enough
• Such shifts are
“accommodating policies”
since accommodate the fall in
the real wage at the existing
nominal wage
• Added inflation, although
reduce u from AS shock

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