CHAPTER

14

Aggregate Supply and the

Short-Run Tradeoff Between
Inflation and Unemployment

2016 Worth Publishers, all rights reserved

 Summary & implications

P LRAS
Y Y (P EP)

P EP
Both models
SRAS of agg. supply
P EP
imply the
P EP relationship
summarized
Y by the SRAS
Y curve &
equation.

CHAPTER 14 Aggregate Supply 2

 Summary & implications

Suppose a positive SRAS equation: Y Y (P EP)

AD shock moves
P SRAS2
output above its LRAS
natural rate and SRAS1
P above the level
people had
P3 EP3
expected.
P2
Over time, AD2
EP2 P1 EP1
EP rises,
SRAS shifts up, AD1
and output returns Y
to its natural rate. Y2
Y3 Y1 Y
CHAPTER 14 Aggregate Supply 3
 Okuns law:

1% of unemployment = 2% of lost output.

OR

Where:
is potential output
is the nactual rate of unemployment

CHAPTER 14 Aggregate Supply 4

 Inflation, unemployment,
and the Phillips curve
The Phillips curve states that depends on
expected inflation, E
cyclical unemployment: the deviation of the
actual rate of unemployment from the natural rate
supply shocks, (Greek letter nu).

E (u u )
n

where > 0 is an exogenous constant.

CHAPTER 14 Aggregate Supply 5

 Deriving the Phillips curve from
SRAS
Y(1)
andY PYare
(Pin terms
EP ) of Logarithm

(2) P EP (1 )(Y Y )

(3) P EP (1 )(Y Y )

(4) (P P1) ( EP P1) (1 )(Y Y )

(5) E (1 )(Y Y )

(6) (1 )(Y Y ) (u u n ) Okuns law

(7) E (u u n )
CHAPTER 14 Aggregate Supply 6
 Comparing SRAS and the Phillips
curve
SRAS: Y Y (P EP )
Phillips curve: E (u u n )
SRAS curve:
Output is related to
unexpected movements in the price level.
Phillips curve:
Unemployment is related to
unexpected movements in the inflation rate.

CHAPTER 14 Aggregate Supply 7

 Adaptive expectations

Adaptive expectations: an approach that

assumes people form their expectations of future
inflation based on recently observed inflation.
A simple version:
Expected inflation = last years actual inflation
E 1

Then, Phillips curve eqn becomes

1 (u u n )

CHAPTER 14 Aggregate Supply 8

 Inflation inertia
1 (u u n )
In this form, the Phillips curve implies that
inflation has inertia:
In the absence of supply shocks or
cyclical unemployment, inflation will
continue indefinitely at its current rate.
Past inflation influences expectations of
current inflation, which in turn influences
the wages & prices that people set.

CHAPTER 14 Aggregate Supply 9

 Two causes of rising & falling inflation
1 (u u n )
cost-push inflation:
inflation resulting from supply shocks
Adverse supply shocks typically raise production
costs and induce firms to raise prices,
pushing inflation up.
demand-pull inflation:
inflation resulting from demand shocks
Positive shocks to aggregate demand cause
unemployment to fall below its natural rate,
which pulls the inflation rate up.
CHAPTER 14 Aggregate Supply 10
 Graphing the Phillips curve

In the short run, E (u u ) n

policymakers face
a tradeoff between
and u.
1 The short-run
E Phillips curve

n u
u

CHAPTER 14 Aggregate Supply 11

 Shifting the Phillips curve

People adjust E (u u )
n

their
expectations
over time,
so the tradeoff E 2
only holds in E 1
the short run.

E.g., an increase
u
in E shifts the u n

short-run P.C.
upward.
CHAPTER 14 Aggregate Supply 12
 The sacrifice ratio
To reduce inflation, policymakers can
contract agg. demand, causing
unemployment to rise above the natural rate.
The sacrifice ratio measures
the percentage of a years real GDP
that must be forgone to reduce inflation
by 1 percentage point.
A typical estimate of the ratio is 5.

CHAPTER 14 Aggregate Supply 13

 The sacrifice ratio

Example: To reduce inflation from 6 to 2 percent,

must sacrifice 20 percent of one years GDP:
GDP loss = (inflation reduction) (sacrifice ratio)
= 4 5
This loss could be incurred in one year or spread
over several, e.g., 5% loss for each of four years.
The cost of disinflation is lost GDP.
One could use Okuns law to translate this cost
into unemployment.

CHAPTER 14 Aggregate Supply 14

 Rational expectations

Ways of modeling the formation of expectations:

adaptive expectations:
People base their expectations of future inflation
on recently observed inflation.
rational expectations:
People base their expectations on all available
information, including information about current
and prospective future policies.

CHAPTER 14 Aggregate Supply 15

 Painless disinflation?
Proponents of rational expectations believe
that the sacrifice ratio may be very small:
Suppose u = un and = E = 6%,
and suppose the Fed announces that it will
do whatever is necessary to reduce inflation
from 6 to 2 percent as soon as possible.
If the announcement is credible,
then E will fall, perhaps by the full 4 points.
Then, can fall without an increase in u.
CHAPTER 14 Aggregate Supply 16
 Calculating the sacrifice ratio
for the Volcker disinflation

1981: = 9.7%
Total disinflation = 6.7%
1985: = 3.0%

year u un uu n
1982 9.5% 6.0% 3.5%
1983 9.5 6.0 3.5
1984 7.4 6.0 1.4
1985 7.1 6.0 1.1

Total 9.5%
CHAPTER 14 Aggregate Supply 17
 Calculating the sacrifice ratio
for the Volcker disinflation
From previous slide: Inflation fell by 6.7%,
total cyclical unemployment was 9.5%.
Okuns law:
1% of unemployment = 2% of lost output.

Thus, 9.5% cyclical unemployment

= 19.0% of a years real GDP.
Sacrifice ratio = (lost GDP)/(total disinflation)
= 19/6.7 = 2.8 percentage points of GDP were lost
for each 1 percentage point reduction in inflation.

CHAPTER 14 Aggregate Supply 18

 *Example
An economy is initially in equilibrium at the
natural level. The central bank increases the
money supply. Graphically illustrate and explain
short-run monetary nonneutrality and long-run
monetary neutrality using the ADAS model

CHAPTER 14 Aggregate Supply 19

 *Example
For each of the two models of short-run aggregate supply
(sticky price and imperfect information)
compare the following characteristics:

a. whether the market imperfection is located in the

goods market or the labour market

b. whether prices are flexible or fixed

c. whether the goods market and the labour market
clear instantly.

CHAPTER 14 Aggregate Supply 20

 *Example:

Assume that an economy is initially at the

natural rate of unemployment.

a. Use a Phillips curve diagram to illustrate graphically how

the inflation rate and unemployment rate change both in
the short run and in the long run to an unexpected
expansionary monetary policy.

b. Use a Phillips curve diagram to illustrate graphically how

the inflation rate and unemployment rate change both in
the short run and in the long run to the announcement of a
credible plan of expansionary monetary policy when people
have rational expectations.
CHAPTER 14 Aggregate Supply 21