UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and

Lam

UNIVERSITY OF NEW BRUNSWICK

FALL 2020

ECON 3023 FR01A

INTERMEDIATE MACROECONOMICS

INSTRUCTOR: DR. RAJENDRA CHAINI

TEXTBOOK : MACROECONOMICS CANADIAN EDITION (SIXTH EDITION)

AUTHORS : MANKIW, SCARTH AND LAM
ALTERNATE TEXTBOOK : MACROECONOMICS CANADIAN EDITION (FIFTH EDITION)
AUTHORS : N. GREGORY MANKIW AND WILLIAM M.. SCARTH
UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

CHAPTER 14

AGGREGATE SUPPLY
AND
THE SHORT RUN TRADEOFF BETWEEN
INFLATION AND UNEMPLOYMENT
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

AGGREGATE SUPPLY

 The model of Aggregate Demand, and Aggregate Supply or AD-AS model help analyze
the short run economic fluctuations
 The IS-LM model and the IS*-LM* (Mundell - Fleming) model help understand the
impact of economic shocks and the interventions through fiscal and monetary policies on
the AD curve.
 This chapter helps understand the factors that determine the slope and position of the
Aggregate Supply curve.
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THEORY OF AGGREGATE SUPPLY

 This chapter examines two models of AS, where some market imperfect conditions allow
the output of the economy to deviate from the natural level.
 The Sticky-Price Model
 The Imperfect-Information Model

 The short-run AS curve is upward sloping due the market imperfection instead of vertical
and thus, shift of the AD curve changes the output from the natural level resulting in
booms and busts of the business cycle.
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THEORY OF AGGREGATE SUPPLY

•Both
  models provide the same relationship between the output Y and natural level of output
Y = + α(P-EP), α>0 Where,
Y = Output, = Natural rate of Output
α = response of output to expected changes in the price level, 1/ α is the slope of the supply curve.
P = Price Level , EP = Expected Price level
The equation explains how the output level deviates from the natural level when the price level
deviates from the expected price level.
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE STICKY PRICE MODEL

• The Sticky Price Model reiterates the fact that firms try to stick to prices for a considerable
duration and do not adjust prices as expected in response to changes in demand.
• The reasons for Sticky prices may be
• Long-term contracts
• Avoiding discontents from customers from frequent changes in prices.
• Use of printed and catalogued price list that last long and hard to change
• Wage-dependent prices are changed less frequently as wages change at a much slower rate
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE STICKY PRICE MODEL

•  A Firm’s pricing decision depends on the following two variables:
 The overall price level P
 The level of Aggregate Output, Y As, marginal cost increases with level of output, greater the
demand, higher will be the firm’s desired price
The Desired Price, p can be expressed as :
p = P + a(Y- )

 Firms with flexible prices set their prices based on this equation, p = P + a(Y- )
 Firms with sticky prices will set tier prices as, p = EP + a(EY- E), E is the expected value
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE STICKY PRICE MODEL

• The
  sticky price model is p = EP + a(EY- E)
 Assuming, EY = E , i.e. expected output is same as natural level output, a(EY- E) = 0
The sticky price, p = EP, i.e. Firms with sticky prices will set their price based on the
changes they expect from other firms

 The overall price level of the economy will be the weighted average of the prices set by the
two groups; the firms with flexible prices and the firms with fixed prices
P = s EP + (1-s)[ P+ a(Y - )]
Assuming the share of firms with sticky price as, s and share of firms with flexible price as, (1-s)
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE STICKY PRICE MODEL

•   We have, Price level P = s EP + (1-s)[ P+ a(Y - )] i.e. sum of price levels set by the two groups
Or, P = s EP +[P+ a(Y - )]-s[ P+ a(Y - )]
Or, P = s EP + P+ a(Y - ) - sP - as(Y - )
Or, sP = s EP + a(Y - ) - as(Y - )
Or, sP = s EP + (1-s) [a(Y - )]
Dividing both sides by s we have, we have P = EP + [(1-s)a/s](Y - )
Assuming (1-s)a/s = 1/α or, s/ a(1-s) = α, P-EP = (1/ α)(Y - )
Or, α (P - EP) = Y - Or, Y = + α (P - EP)
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE IMPERFECT-INFORMATION MODEL

•    Assumes that markets clear the prices, i.e. prices adjust to balance the supply and demand
 Short-run and long-run aggregate supply differ due to misperception (temporary) about price levels
 Suppliers try to monitor prices of the goods they produce but have the inability to monitor prices of
all other large number of goods
 The inability to monitor all the prices create imperfection of the perception of changes in price level
compared to changes in relative prices
 The Imperfect-Information model suggest that when actual prices exceed the expected prices,
suppliers raise the output thus giving the same model for aggregate supply, Y = + α (P - EP)
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

SHORT RUN AGGREGATE ^ŚŽƌƚͲ

ZƵŶŐŐƌĞŐĂƚĞ^ƵƉƉůLJƵƌǀ Ğ
SUPPLY CURVE
160 Long Run Supply
 Y = + α (P-EP) 140
P>EP
P = EP + (1/ α)(Y- 120
z с нϮϬ;WͲ
ϭϬϬͿ
100 EP=P=100 Short Run Supply
Where, α = s/ [(1-s)a]
80
P<EP
Expected Price, EP = 100 60

α = 20 40

Long-run aggregate supply, 20

= 2000 0
Y = + α (P-100) 0 500 1000 1500 2000 2500 3000 3500

Or, P = 100 + (1/ 20)(Y- Short Run Supply Long Run Supply
UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

Alpha, α 20
Original Expected Price EP1, EP2 100
New Expected Price EP3 120
Natural level of Income, Y-bar 2000
Price, P = EP+(1/α)(Y-Y-)
Natural Income, Y-bar Income. Y Price, AS1, EP = 100 Price , AS2, EP = 120 AD1, P=200-0.05Y AD2, P=220-0.05Y
2000 0 0 20 200 220
2000 200 10 30 190 210
2000 400 20 40 180 200
2000 600 30 50 170 190
2000 800 40 60 160 180
2000 1000 50 70 150 170
2000 1200 60 80 140 160
2000 1400 70 90 130 150
2000 1600 80 100 120 140
2000 1800 90 110 110 130
2000 2000 100 120 100 120
2000 2200 110 130 90 110
2000 2400 120 140 80 100
2000 2600 130 150 70 90
2000 2800 140 160 60 80
2000 3000 150 170 50 70
UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

^ŚŽƌƚͲ
ZƵŶŐŐƌĞŐĂƚĞ^ƵƉƉůLJƵƌǀ Ğ
250
Shift if Aggregate Demand leading to short-run fluctuation

200
z с нϮϬ;WͲ
ϭϮϬͿ
P3= EP3
150 ϮϬϬϬ͕ϭϮϬ

z с нϮϬ;WͲ
ϭϬϬͿ
2200, 110 P2
100

ϮϬϬϬ͕ϭϬϬ
50
Original long-run
equilibrium, P1=EP1=EP2
0
0 500 1000 1500
 Y1 = Y32000
= Y2 2500 3000 3500

Short Run Supply Long Run Supply NEW Shifted Supply

AD1 AD2
UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

CHAPTER 14

14.2 INFLATION, UNEMPLOYMENT AND THE

PHILLIPS CURVE
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

IMPACT OF POLICY ACTIONS ON INFLATION AND UNEMPLOYMENT

 Policy makers use fiscal or monetary policies to expand aggregate demand

 The Expanded AD curve moves along the Short-Run AS curve to a point of higher output and higher
price level.
 Higher output means lower unemployment as more people are employed to produce higher output
 A higher price level compared to price level of the previous period indicates higher inflation
 Thus, movement of AD curve up along the Shor-Run Aggregate Supply Curve results in higher
inflation but reduced unemployment. Similarly, movement of the AD curve down the Short-Run
Aggregate Supply Curve results in lower inflation but higher rate of unemployment
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE PHILLIPS CURVE : TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT

DERIVING THE PHILLIPS CURVE FROM THE AGGREGATE SUPPLY CURVE

 The Phillips curve reflects and Short-Run Aggregate Supply Curve that also shows how inflation
and unemployment move in the opposite direction when the economy (through the AD curve)
moves along the Short-Run Aggregate Supply curve.
 Inflation rate depends on three forces:
 Expected Inflation
 Deviation of the unemployment rate from the natural rate of unemployment, known as Cyclical
Unemployment
 The Supply Shock
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE PHILLIPS CURVE EQUATION

Inflation = Expected Inflation – β × Cyclical Unemployment + Supply Shock

Or, π = Eπ - β × (u – u”) + ν
Where, , π = Inflation
Eπ = Expected Inflation
β = a parameter that measures the response of inflation to cyclical unemployment
(u – u”) = Cyclical Unemployment = Deviation of unemployment rate from its natural rate
ν = supply shock
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

DERIVING THE PHILLIPS CURVE

•   P = EP + (1/ α)(Y - )
Or, P = EP + (1/ α)(Y - ) + ν
Or, P – P-1 = (EP – P-1 ) + (1/ α)(Y - ) + ν
π = Eπ + (1/ α)(Y - ) + ν where, π = P – P-1 and Eπ = (EP – P-1 )
From the Okun’s law, Assuming (1/ α)(Y - ) = - β × (u – u”), we have
π = Eπ - β × (u – u”) + ν known as the Phillips curve
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

ADAPTIVE EXPECTATIONS AND INFLATION INTERTIA

 People make their expectations on inflation based on their observed past inflation
 This assumption is known as adaptive expectations, where,
Eπ = π-1 i.e., the inflation of the previous period
Thus the Phillips curve can be written as
π = π-1 - β × (u – u”) + ν
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

TWO CAUSES OF RISING AND FALLING OF INFLATION

 Demand-Pull Inflation derived from the cyclical unemployment

 Cost-Push Inflation derived from the supply shock

 Sacrifice Ratio : Percentage of a year’s real GDP that must be foregone to reduce inflation by one
percent point.
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE PHILLIPS CURVE (EXAMPLE EQUATION FROM HOOVER, 2015)

PHILLIPS CURVE The natural rate of
(Π-EΠ)= -0.73*(U-5.5) unemployment is
Inflation – Expected Inflation Natural rate of Unemployment 5.5%; 5.5% as at this
5 also known as NAIRU or Non- unemployment rate,
4
Accelerating Inflation Rate of i.e. u = 5.5, inflation
3
2 Unemployment is same as the
1
expected inflation. i.e.
0
-1 0 2 4 6 8 10 12 14 π = Eπ
5.5, 0
-2
-3
-4
-5
-6 Unemployment Rate
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE PHILLIPS CURVE (EXAMPLE EQUATION FROM HOOVER, 2015)

A: At Natural rate PHILLIPS CURVE C: At Natural rate of

of Unemployment
with π = Eπ =2 or
π- Eπ = 0 and u=u”
= 5.5 or (u-u”) = 0
B: π = 2.365, Eπ =2
and u = 5%
-1 0
Inflation
8 Unemployment with
7 π = Eπ =3 or π- Eπ =
6
0 and u=u” = 5.5% or
5
C (u-u”) = 0
4 5.5, 3
3 D
2 B
1 5.5, 2 D: π = 2.635, Eπ =3
0 A and u = 6%,
2 4 6 8 10 12 14

-2
Natural rate of
-3 Unemployment
-4 Unemployment Rate =5.5%