CHAPTER THREE

AGGREGATE DEMAND & AGGREGATE

SUPPLY

3.1 Aggregate Demand

3.1.1 Quantity-Adjustment vs Price-Adjustment
3.1.2 The IS-LM Model
3.1.2.1 The Goods Market and the IS Curve
3.1.2.2 The Money Market and the LM Curve
3.1.2.3 Equilibrium in Goods & Money Markets
3.1.2.4 Explaining Fluctuations with IS-LM Model
3.1.2.5 Interaction b/n Monetary & Fiscal Policies
3.1.3 Deriving the Aggregate Demand Curve
3.2 Aggregate Supply
3.2.1 Introduction to Aggregate Supply
3.2.2 Models of Aggregate Supply
3.2.2.1 The Sticky-wage Model
3.2.2.2 The Worker-Misperception Model
3.2.2.3 The Imperfect-Information Model
3.2.2.4 The Sticky-Price Model
3.2.3 Inflation, Unemp’t & the Phillips Curve
3.2.3.1 Deriving the Phillips Curve
3.2.3.2 Adaptive Expectations and Inflation Inertia
3.2.3.3 Rational Expectations & the Possibility of
Painless Disinflation
3.2.3.4 Hysteresis & the Challenge to the Natural-
Rate Hypothesis
3.1 Aggregate Demand
 3.1.1 Quantity-Adjustment vs Price-Adjustment
 The principal theme of classical price theory
is:
if there is an imbalance between supply &
demand in a competitive market, then prices
change to clear the market or establish eqlm.
 Real wage flexibility equilibrates the labor
sector & the real interest rate balances output
allocation b/n I & C goods.
 Together, the eqlm labor supply & capital
stock determine the eqlm output level.
 The Keynesian real sector model takes a
different approach.
 3.1.1 Quantity-Adjustment vs Price-Adjustment
The simplest Keynesian model abstracts
entirely from price changes.
The Keynesian model explains interactions b/n
demand for goods & services, and the financial
sector.
The basic theme of the approach is that, in the
short-run, quantity adjustments occur if there
is imbalance b/n supply & demand.
The Keynesian model is an application of the
quantity adjustment paradigm:
if there is imbalance b/n supply & demand, then
producers will change the quantity of output
produced.
 3.1.1 Quantity-Adjustment vs Price-Adjustment
 Clearly, both price & quantity adjustments
take place in reality.
 In the short run, a change in price is often a
costly & unreliable means of balancing sales
& production, esp. with a temporary
imbalance & a desire for rapid response.
 Thus, quantity adjustment is the primary
adjustment mechanism used to maintain
sales-production eqlm in the short run.
 In a modern economy with less emphasis on
manufacturing & greater emphasis on
services and with very rapid information
flows price changes do occur.
 3.1.1 Quantity-Adjustment vs Price-Adjustment
 Price changes are often made infrequently &
therefore the principal adjustments to supply
& demand imbalances in the short run are
quantity changes.
 The above conclusion relies upon two
characteristics of the product market:
1. it is presumed that goods can be held in
inventory (true for manufactured goods).
2. some degree of product differentiation.
 3.1.2 The IS-LM Model
 In the short run when P is fixed, shifts in AD
lead to changes in national income.
 The IS–LM model, a model of AD, aims at
showing what determines NI for any given
price level or what causes shifts in AD.
 The 2 parts of the model are IS & LM.
 IS stands for “Investment” & “Saving”, & the
IS curve represents what’s going on in the
market for goods & services.
 LM stands for “Liquidity” (demand for
money) & “Money” (supply of money), & the
LM curve represents what’s happening to the
supply of & demand for money.
 3.1.2 The IS-LM Model
 The interest rate links the two halves of the
IS–LM model since it influences both
investment & money demand.
 The IS–LM model shows how interactions b/n
these markets determine the position & slope
of the AD curve.
 3.1.2.1 The Goods Market and the IS Curve
 The IS curve plots the relationship b/n interest
rate & income level that arises in the market
for goods & services.
 As to Keynes, an economy’s total income in
the short run is determined largely by the
desire to spend by hhs, firms & gov’t.
 The more people want to spend, the more
goods & services firms can sell; the more
firms can sell, the more output they choose to
produce & the more resources they choose to
hire.
The Keynesian Cross & Income Determination
 To develop the IS curve we start with a basic
model called the Keynesian cross.
 3.1.2.1 The Goods Market and the IS Curve
 This model is the simplest interpretation of
Keynes’s theory of NI & is a building block
for the more realistic IS–LM model.
 The Keynesian cross begins by distinguish-ing
b/n actual & planned expenditure.
 AE is the amount hhs, firms & the gov’t spend
on goods & services, & equals GDP.
 An AE of say 10 billion Birr is translated to a
10 billion Birr value for GDP, giving rise to a
450 line relating AE & GDP.
AE

90

10

 0
 45
10 Y (= output, GDP)
90
 3.1.2.1 The Goods Market and the IS Curve
 PE is the amount hhs, firms & the gov’t would
like to spend on goods & services.
 For a closed economy (NX = 0), PE is the sum
of consumption, planned investment I & gov’t
purchases:
PE = C + I + G.
 To this equation, we add the following:
 The consumption function: C = C(Y − T);
 Assumption of fixed G & T (fiscal policy); &
 A simplifying assumption of exogenously fixed
planned investment.
 Combining these, we get: PE  C(Y T )  I  G
 PE is a function of income Y, planned
investment & fiscal policy variables.
PE
PE  C(Y T )  I  G

MPC
1

Y
 3.1.2.1 The Goods Market and the IS Curve
 Why would AE ever differ from PE?
 Answer: firms might engage in unplanned
inventory investment when their sales do not
meet their expectations.
 When firms sell less of their product than they
planned, their stock of inventories
automatically rises, and vice versa.
 Since unplanned changes in inventory are
counted as investment spending by firms, AE
can be > or < PE.
 AE = C(Y–T) + I + ∆inv + G while PE = C(Y–T)
+ I + G.
 AE > PE when ∆inv > 0; AE < PE when ∆inv
< 0; and, AE = PE when ∆inv = 0.
 3.1.2.1 The Goods Market and the IS Curve
Some NI Identities of the Closed Economy
1. Consumption and Saving Functions
C  C  cY d
S Y C
d

 Thus, the consumption function C  C  cY d

corresponds to the saving function S Yd C
which simplifies to S  C (1  c)Y d

2. Planned versus Actual Investment

 PE = C(Y–T)+I+G & AE = C(Y–T)+I+∆inv+G;
where I is planned investment (IPLANNED) & I +
∆inv is actual investment (IACTUAL).
 PE = AE is thus equivalent to planned
investment = actual investment.
 3.1.2.1 The Goods Market and the IS Curve
 Thus, it always holds that IACTUAL = IPLANNED +
undesired changes in inventories (∆inv).
 At equilibrium, IACTUAL = IPLANNED. This
requires that there is no undesired or
unplanned change in inventories (∆inv = 0).
 Thus, the eqlm condition PE = AE could be
stated as IACTUAL = IPLANNED or as ∆inv = 0.
3. Saving–Investment Identities
 The condition PE = AE = Y is the same as
saying that Y = C + I + G, which could be
rewritten in a number of ways.
 Subtracting taxes from both sides:
Y – T = C + I + G – T.
 3.1.2.1 The Goods Market and the IS Curve
 Y–T is disposable income, which is either
consumed or saved. So, Yd = C + I + (G –T).
 For a hypothetical economy with no gov’t (G
= T = 0), it follows that: Yd = C + I.
 Subtracting C from both sides yields:
Yd – C = C + I – C.
 The LHS of this identity is saving & the RHS
is planned investment. Thus, we have:
S=I
 For the case with gov’t, subtracting C from
both sides of Yd = C + I + (G – T):
Yd – C = I + (G – T).
 Moving (G – T) to the left we will have:
Yd – C + (T – G) = I.
 3.1.2.1 The Goods Market and the IS Curve
 Yd – C on the left is saving by the private
sector of the economy, SP.
 T – G is the difference between what gov’t
collects as taxes (net) & gov’t purchases. It is
saving by the public sector, SG.
 Thus, Yd–C+(T–G) = I reduces to SP+SG = I.
S (= SG + SP) = I.
 In sum, S = I is merely another way of stating
the basic equilibrium condition.
4. The Injection – Leakage Identity
 Another way of stating the eqlm condition
 The NI identity Y = C + I + G gives the
sources of national income.
 3.1.2.1 The Goods Market and the IS Curve
 Viewed from the income allocation side, the
income earned is shared among tax payments,
consumption & saving:
Y = T + C + S.
 Bringing the two sides together:
C + I + G = Y = T + C + S.
 In relation to the circular flow diagram, C, I
& G are injections/additions into the flow
while C, S & T are leakages/withdrawals from
the circle.
 Thus, injections = withdrawals at eqlm.
 C + I + G = T + C + S (or I + G = S + T) is
another way of representing the eqlm
condition.
 3.1.2.1 The Goods Market and the IS Curve
The Multiplier
The Keynesian cross shows how income Y is
determined for given levels of planned
investment I & fiscal policy variables G & T.
Now, we use it to show how Y changes when an
exogenous variable changes.
More specifically, we will consider how output
(or GDP) responds to changes in:
government purchases,
autonomous taxes,
autonomous spending (on C or I),
G & T by the same amount (the balanced
budget multiplier), and
the tax rate.
 3.1.2.1 The Goods Market and the IS Curve
The Government Purchases Multiplier (Y/G)
It tells us how much income rises in response
to a 1 Birr change in G.
Raising G by G (from G1 to G2) causes PE to
shift upward from PE1 to PE2 (by G).
 3.1.2.1 The Goods Market and the IS Curve
Consequently, eqlm moves from A to B.
An increase in G leads to an even greater
increase in Y, i.e., Y > G.
For the movement from A to B caused by G,
the Y is shown by arrows from Y1 to Y2 both
on the horizontal & vertical axes.
The vertical distance b/n Y1 to Y2 is the same
as the distance from Point B to C.
The resulting Y > the distance b/n the two PE
expenditure curves.
The government-purchases multiplier > 1.
Why does fiscal policy have a multiplied effect
on income?

3.1.2.1 The Goods Market and the IS Curve
The reason is that, according to the
consumption function C = C(Y − T), higher Y
causes higher C.
When an increase in G raises Y, it also raises
C, which further raises Y, which further raises
C, and so on.
Therefore, in this model, an increase in G
causes a greater increase in Y.
How big is the multiplier?
To answer this question, we trace through
each step of the change in income.

3.1.2.1 The Goods Market and the IS Curve

Round The Effect of G

on Consumption on Income
1 G
2 MPC x G MPC x G
3 MPC2 x G MPC2 x G
4 MPC3 x G MPC3 x G
… …
C = (MPC + MPC2 + Y = (1 + MPC + MPC2 +
SUM
MPC3 +…) x G MPC3 +…) x G

Y/G = 1 + MPC + MPC2 + MPC3 +…

Y/G = 1/(1 – MPC)
The larger MPC, the larger the multiplier.

3.1.2.1 The Goods Market and the IS Curve
With MPC = 0.8, the multiplier is 5;
For MPC = 0.9, the multiplier is 10.
Higher MPC implies that a larger fraction of
additional income is consumed, thereby
causing a larger induced increase in dd.
Mathematically,
Substituting the consumption function
C  C a  c(Y  T into
) the eqlm condition
Y  C  I  Gand rearranging:
1
Y  C a  cY  cT  I  G  Y  [Ca  cT  I  G ]
1 c
Taking derivatives:
1
dY  [dCa  cdT  dI  dG ]
1 c

3.1.2.1 The Goods Market and the IS Curve
From the final equation dY  1 [dCa  cdT  dI : dG ]
1 c
dY 1 dY 1 dY 1
  
dG 1  c dCa 1  c dI 1  c
dY c dY
 ?
dT 1  c dG
dG dT

1
dY dG  dT  [dCa  cdG  dI  dG ]
1 c
1
dY dG  dT  [dCa  (1  c)dG  dI ]
1 c
dY 1 c
dG  dT  1
dG 1 c

3.1.2.1 The Goods Market and the IS Curve
If tax is a (linear) function of income (T = tY):
Y  Ca  c(Y  tY )  I  G
dY  dCa  c[dY  d (tY )]  dI  dG
 dY  dCa  c[dY  (tdY  Ydt )]  dI  dG
 dY  dCa  cdY  ctdY  cYdt  dI  dG
 dY  cdY  ctdY  dCa  cYdt  dI  dG
 (1  c  ct )dY  dCa  cYdt  dI  dG
1
 dY  [dCa  cYdt  dI  dG ]
(1  c  ct )

3.1.2.1 The Goods Market and the IS Curve
If tax is a (linear) function of income (T = tY):
1
dY  [dCa  cYdt  dI  dG ]
(1  c  ct )
dY dY dY 1
  
dCa dI dG 1  c  ct
The tax rate multiplier:
dY  cY

dt 1  c  ct

3.1.2.1 The Goods Market and the IS Curve
Interest Rate, Investment and the IS Curve
The Keynesian cross makes a simplifying
assumption that planned investment is fixed.
But, planned investment depends on the
interest rate, r – i.e., I = I(r).
Since r is the cost of borrowing to finance
investment projects, a rise in r reduces I: the
investment function slopes downward.
To determine how income changes when
interest rate changes, we combine the
investment function with Keynesian-cross.


3.1.2.1 The Goods Market and the IS Curve
Using C = Ca+c(Y–T) & a linear investment
function (I = Ia–br) together with the eqlm
condition Y = C + I + G,
Y  Ca  c(Y  T )  I a  br  G
1
 r  [(1  c)Y  Ca  cT  I a  G ]
b
A higher r is associated with a lower level of
equilibrium Y, given the other variables.
The slope of the IS curve: dr  (1  c)

dY b
The slope of the IS curve depends on the
sensitivity of investment to changes in r (b) &
on MPC (c) or the multiplier.

3.1.2.1 The Goods Market and the IS Curve
If I is very sensitive to r, so that b is large, a given
 in r produces a large  in PE & thus shifts PE
curve up by a large amount.
A large shift in PE schedule produces a
correspondingly large  in eqlm income (Y).
If a given  in r produces a large  in Y, the IS
curve is very flat.
With b small & I not very sensitive to r, the IS
curve is relatively steep.
The larger MPC & the larger the multiplier, the
flatter the IS curve.
Larger multiplier: larger Y produced by a given
r, or smaller r needed for a given Y.
Points above & to the right of the IS curve signify
excess supply of goods, & vice versa.

3.1.2.1 The Goods Market and the IS Curve
In summary,
IS shows combinations of r & Y consistent with
eqlm in market for goods & services.
The IS curve is negatively sloped as a rise in r
reduces I & PE, thereby reducing eqlm Y.
To the right of the IS curve, there is excess supply
in the goods market, & vice versa.
The smaller the multiplier (MPC) & the less
sensitive I is to  in r, the steeper the IS curve.
The IS curve is drawn for a given fiscal policy.
s in fiscal policy that raise (reduce) demand for
goods shift IS curve to right (left).
IS curve is also shifted by s in autonomous
spending of private economic agents (Ca & Ia) .

3.1.2.2 The Money Market and the LM Curve
The money market is just one component of the
broader concept of asset markets.
Asset markets are markets where money, bonds,
stocks, houses & other forms of wealth are traded.
We simplify matters by grouping assets into two:
money & interest-bearing assets.
At a given time, an individual has to decide how
to allocate his/her financial wealth b/n two
alternatives – money & bond.
The more bonds held, the more interest received;
the more money held, the more likely the
individual is to have money available for making
a purchase.
Such decisions on the form in which to hold assets
are portfolio decisions.

3.1.2.2 The Money Market and the LM Curve
The portfolio decisions on how much money & on
how many bonds to hold are really the same
decision.
The LM curve plots the relationship b/n r & Y
that arises in the money market.
The theory of liquidity preference is the building
block for this relationship.
The Theory of Liquidity Preference
The theory explains how r is determined in the
short run; it posits that r adjusts to balance
supply of & demand for the economy’s most
liquid asset – money.
A. The supply of real money balances
If M stands for money stock & P for the price
level, M/P = supply of real money balances.

3.1.2.2 The Money Market and the LM Curve
The theory of liquidity preference assumes a fixed
supply of real money balances: M S M
( ) 
P P
M is an exogenous policy variable chosen by a
central bank (NBE in our case).
P is an exogenous variable in this model: we take
P as given (IS–LM explains the SR).
These imply that supply of real money balances is
fixed & does not depend on r.
B. The demand for real money balances
Demand for money is demand for real balances:
we hold money for what it can buy.
The higher P, the more nominal balances a person
has to hold to be able to purchase a given quantity
of goods.

3.1.2.2 The Money Market and the LM Curve
If P doubles, one has to hold twice as many
nominal balances to be able to buy the same
amount of goods.
The demand for real balances depends on real
income (Y) & the interest rate (r).
It depends on Y as people hold money to pay for
purchases, which depend on their Y.
r is one determinant of how much money people
choose to hold as it is the opportunity cost of
holding money: it is what you forgo by holding
money instead of interest-bearing assets like
bonds.
When r rises, people want to hold less of their
wealth in the form of money.

3.1.2.2 The Money Market and the LM Curve
On these grounds, the demand for real balances
rises with Y & decreases with r:
M d
( )  kY  hr
P
For a given level of Y, the quantity demanded of
M/P is a decreasing function of r.
Higher Y means larger demand for M/P, &
therefore shifts the (M/P)d curve to the right.
(M/P)S & (M/P)d determine what r prevails in the
economy (what r equilibrates the money market).

3.1.2.2 The Money Market and the LM Curve
Income, Money Demand, and the LM Curve
When Y is high, expenditure is high, so people
engage in more transactions that require the use
of money.
The higher Y, the higher (M/P)d will be, and the
higher the equilibrium r.
Therefore, a higher Y leads to a higher r.
The LM curve plots this positive relationship b/n
Y & r.

3.1.2.2 The Money Market and the LM Curve
For the money market to be in eqlm, demand has
to equal supply: M
 kY  hr
P 1 M
Solving for the interest rate: r  (kY  )
h P
Slope of the LM curve is given by: dr k

dY h
The LM curve is steep if (M/P)d is very responsive
to Y & less responsive to r.
A point to the right of the LM curve is a point of
excess (M/P)d: r is too low &/or Y too high.
A point to the left of the LM curve is a point of
excess (M/P)S: r is too high &/or Y too low.
The LM curve is drawn for a given (M/P)S: If
(M/P)S changes the LM curve shifts.

3.1.2.2 The Money Market and the LM Curve
In summary,
The LM curve shows combinations of r & Y
consistent with eqlm in the money market.
The LM curve is positively sloped: given MS, a
rise in Y raises the quantity of M demanded, &
has to be accompanied by an increase in r.
The greater the responsiveness of (M/P)d to Y &
the lower the responsiveness of (M/P)d to r, the
steeper the LM curve will be.
To the right of the LM curve, there is an excess
(M/P)d & to its left, there is an excess (M/P)S.
The LM curve is drawn for a given (M/P)S:
decreases in (M/P)S shift the LM curve upward;
increases in (M/P)S shift it downward.

3.1.2.3 Equilibrium in Goods & Money Markets
IS & LM together determine economy’s eqlm.
The model takes G, T, M & P as exogenous.
Given these variables, IS gives combinations of r
& Y that satisfy Y=C(Y–T)+I(r)+G, & LM
combinations of r & Y that satisfy M/P=L(r, Y).
The eqlm of the economy is the point at which the
IS curve & the LM curve cross.
At this point, AE = PE & (M/P)d = (M/P)S .

3.1.2.3 Equilibrium in Goods & Money Markets
To find eqlm r & eqlm Y algebraically, solve the
IS & the LM equations simultaneously.
1
IS : r  [(1  c)Y  Ca  cT  I a  G ].........(1)
b
1 M
LM : r  (kY  ) or Y  1 (hr  M ).........(2)
h P k P

 1 (1  c) M
r [ (hr  )  Ca  cT  I a  G ]
b k P

k (1  c) M
r [Ca  I a  G   cT ]
bk  (1  c)h k P

3.1.2.3 Equilibrium in Goods & Money Markets
1 M
Y  {hr  }
k P

1 hk (1  c) M M
Y { [Ca  I a  G   cT ]  }
k [bk  (1  c)h] k P P

1 hk bk M
Y { [Ca  I a  G  cT ]  ( )}
k [bk  (1  c)h] [bk  (1  c)h] P

h b M
Y [Ca  I a  G  cT  ( )]
bk  (1  c)h h P

3.1.2.4 Explaining Fluctuations with IS-LM Model
The intersection of the IS & the LM curves
determines level of national income (Y).
When one of these curves shifts, the short-run
eqlm changes & Y fluctuates.
Changes in Fiscal Policy
s in G or T influence PE & thereby shift the IS
curve.
Consider an increase in G.

Goods Market Money Market

G  PE 
Md  r 
Production & Y 
I  PE  Y

3.1.2.4 Explaining Fluctuations with IS-LM Model
The effect of fiscal policy (say, G) on Y in the IS-
LM model is weaker than the effect of the same
policy in the Keynesian Cross.
This is because of the crowding out effect.
Changes in Monetary Policy
 in MS influences (M/P)S & thereby shifts the LM
curve.
Consider an increase in MS.

Money Market Goods Market

I  PE 
M  r 
S
Production & Y 
MD  r

3.1.2.4 Explaining Fluctuations with IS-LM Model

k (1  c) M
From r  [Ca  I a  G  , cT ]
bk  (1  c)h k P
k (1  c) dM MdP
dr  [dCa  dI a  dG  cdT  [  2 ]
bk  (1  c)h k P P
dr dr dr k
   0
dCa dI a dG bk  (1  c)h
dr  ck
 0
dT bk  (1  c)h

dr  (1  c) P 1
 0
dM bk  (1  c)h

3.1.2.4 Explaining Fluctuations with IS-LM Model
h b M
From Y  [Ca  I a  G  cT  (, )]
bk  (1  c)h h P

h b dM MdP
dY  [dCa  dI a  dG  cdT  (  2 )]
(1  c)h  bk h P P

dY dY dY h
   0
dCa dI a dG (1  c)h  bk

dY  ch
 0
dT (1  c)h  bk

dY bP 1
 0
dM (1  c)h  bk

3.1.2.4 Explaining Fluctuations with IS-LM Model
Fiscal policy is more effective at influencing Y:
the flatter the LM curve – (M/P)d less sensitive
to Y &/or more sensitive to r, &
the larger the MPC (larger right- or left-ward
shift in IS curve) & the less sensitive I to r
(smaller crowding out effect).
Monetary policy is more effective at influencing
Y:
the flatter the IS curve – the larger the MPC &
the more sensitive I to r, &
the less sensitive (M/P)d to r (larger down- or
up-ward shift in LM curve) &/or the less
sensitive (M/P)d to Y.

3.1.2.5 Interaction b/n Monetary & Fiscal Policies
A change in monetary/fiscal policy may influence
the other, & the interdependence may alter the
impact of a policy change.
For example, suppose gov’t raises taxes.
The effect of this policy depends on how the
central bank responds to the tax raise.
The figure below shows three of the many possible
outcomes.

3.1.3 Deriving the Aggregate Demand Curve
r LM(P2)
LM(P1)

IS1

Y2 Y1 Y
P

P2

P1
AD
Y2 Y1 Y

3.1.3 Deriving the Aggregate Demand Curve
AD curve is drawn for given values of G, T, M &
P (exogenous variables in IS-LM model).
Events that shift the IS or LM curves (for a given
P) cause AD curve to shift.
A change in G, T, or MS will affect the eqlm Y for
every P & hence the position of AD curve.
Solving IS & LM equations simultaneously:
b -1 h
Y {MP  [Ca  cT  I a  G ]}
bk  h(1  c) b
The slope of AD is: Y b M
 [ 2]
P bk  h(1  c) P
P bk  h(1  c) P 2
 [ ]  0
Y b M
3.2 Aggregate Supply

3.2.1 Introduction to Aggregate Supply
The levels of eqlm output & price that prevail in
an economy depend on AD & AS.
AS describes the amount of output that producers
are willing & able to supply.
The AS curve implicit in IS-LM is based on the
notion of no supply constraints & pre-determined
prices in the short-run.
Whatever output level demanded will be
produced & the AS curve is horizontal.
There is sufficient excess capacity so that  AD 
production without  costs & prices.
At the opposite extreme to the horizontal AS
curve lies the vertical AS curve of classicals.
In this view, each market reaches an eqlm which
determines relative prices & quantity.

3.2.2 Models of Aggregate Supply
 The two AS curves are theoretical extremes, do
not depict the real world behavior.
 An upward sloping SRAS is more realistic.
 4 prominent models of SRAS.
The models differ in some details, but share a
common theme about what makes SRAS & LRAS
curves differ & a common end that SRAS curve is
upward sloping.
In all of them, some market imperfection causes Y
to deviate from the classical benchmark (the
natural rate, ). Y

3.2.2.1 The Sticky-wage Model
Why SRAS curve is upward sloping?
Due to sluggish adjustment of nominal wages.
Nominal wages are set by long-term contracts &
cannot adjust quickly.
Even without formal contracts, implicit agree-
ments b/n workers & firms or social norms &
notions of fairness may limit s in W.
So, nominal wages are sticky in the short run.
1) Workers & firms bargain & agree on nominal
wage (W) before they know what P will be.
They set W based on target real wage (ω) & on
expected price level (Pe): W P e

2) After W has been set & before L has been hired,

firms learn P; real wage will be W/P.

3.2.2.1 The Sticky-wage Model
e
W P

P P
Real wage (W/P) deviates from its target (ω) if P
differs from Pe:
If P > Pe, W/P < ω;
if P < Pe, W/P > ω.
3) Finally emp’t is determined by QL firms dd &
output by production function.
 Workers agree to provide as much L as firms
want at the preset wage.
 The firms’ hiring decisions is described by the
labor demand function: L = Ld(W/P).
 Output is determined by the production
function: Y = F(L).

3.2.2.1 The Sticky-wage Model
As W is sticky, an unexpected P moves W/P away
from ω & this influences the amounts of L hired
& Y produced.

The AS curve can be written as:

Y  Y   (P  P ) e
Output deviates from its natural level when P
deviates from Pe.

3.2.2.2 The Worker-Misperception Model
W can adjust freely & quickly to set Ls = Ld.
Unexpected P affects Ls as workers tempo rarily
confuse real & nominal wages.
The 2 components of the model: Ls & Ld.
Ld = Ld(W/P).
Ls = Ls(W/Pe).
Workers know W, but not P: when deciding how
much to work, they consider W/Pe:
W W P
e
  e
P P P
P/Pe = workers’ misperception of price level.
If P/Pe > 1, P is greater than what workers
expected & W/P < W/Pe.
 Ls = Ls[(W/P) X (P/Pe)].

3.2.2.2 The Worker-Misperception Model
Position of Ls curve & eqlm depend on P/Pe.
When P rises, economy’s reaction depends on
whether workers anticipate the change.
If they do, then Pe rises proportionately with P:
neither Ls nor Ld s; W rises proportionally with
Ps; W/P & emp’t remain the same.
If the P catches workers by surprise, Pe remains
the same when P rises.
The rise in P/Pe shifts Ls to right, lowering W/P &
raising the level of emp’t.
Hence, workers believe that P is lower & thus W/P
is higher than actually is the case.
This induces them to supply more labor.

3.2.2.2 The Worker-Misperception Model
Firms are assumed to be better informed than
workers & to recognize the fall in W/P: they hire
more L & produce more Y.
Deviations of P from Pe induce workers to  their
Ls & this s quantity of Y firms produce:
Y  Y   (P  P ) e

In the 2 models above (with an unchanging L d

curve) an unexpected rise in P lowers W/P & thus
raises quantities of L hired & Y produced: W/P is
countercyclical.
Yet real world data show a weak & opposite
correlation b/n W/P & Y; if W/P is cyclical, it is
slightly procyclical.
Most economists conclude that the 2 models
cannot fully explain AS: they advocate models in
which Ld shifts over the business cycle.

3.2.2.3 The Imperfect-Information Model
Markets clear, i.e., all wages & prices are free to
adjust.
The SRAS & LRAS curves differ because of
temporary misperceptions about prices.
Each supplier in the economy produces a single
good & consumes many goods.
As the number of goods is large, suppliers cannot
observe all prices at all times.
Due to imperfect information, they some-times
confuse s in overall P & in relative Ps.
This influences decisions about how much to ss &
leads to a positive r/p b/n P & Y in the SR.
Consider the decision facing a supplier – a wheat
farmer, for instance.
The amount of wheat she produces depends on
relative P of wheat: if RPW is high, she is
motivated to work hard & produce more.


Y  Y   (P  P )
e

3.2.2.4 The Sticky-Price Model
Firms do not instantly adjust their prices in
response to changes in demand.
Sometimes prices are set by long-term contracts
b/n firms & customers.
Even without formal agreements, firms may hold
prices steady in order not to annoy their
customers with frequent price changes.
Some prices are sticky because once a firm has
printed & distributed its catalog or price list, it is
costly to alter prices.
We first consider pricing decisions of individual
firms & then add up these decisions
Perfectly competitive firms are P-takers; to
consider how a firm sets P, we take firms with
some power over Ps.
Consider the decision facing a typical firm.

3.2.2.4 The Sticky-Price Model
The firm’s desired price p depends on two
macroeconomic variables:
Overall level of prices P – higher P implies
higher costs for the firm; the higher P, the more
the firm would like to charge.
Level of aggregate income Y – higher Y raises
demand for the firm’s product; as MC rises at
higher levels of production, the greater the
demand, the higher the p.
We write the firm’s desired price as:
p  P  a (Y  Y )
p depends on P & the level of output relative to
the natural rate.
a measures how much the desired price responds
to the level of Y.


e
p  P  a (Y  Y )
e e

pP e


P  sP  (1  s )[ P  a(Y  Y )]
e

sP  sP  (1  s )a (Y  Y )
e

P  P  (1  s )( a )(Y  Y )
e
s


Y  Y   (P  P )
e



     (u  u )  v
e n

P  P e  ( 1 )(Y  Y )



P  P e  ( 1 )(Y  Y )  v


P  P1  ( P e  P1 )  ( 1 )(Y  Y )  v


   e  ( 1 )(Y  Y )  v
( 1 )(Y  Y )    (u  u n )

     (u  u )  v
e n

3.2.3.2 Adaptive Expectations and Inflation Inertia
To make Phillips curve useful for analyzing the
choices facing policymakers, we need to say what
determines expected inflation.
A simple & often plausible assumption is that
people form their expectations of inflation based
on recently observed inflation.
This is called adaptive expectations.
Suppose people expect prices to rise this year at
the same rate as they did last year.
Then e equals last year’s inflation: e = -1.
In this case, we can write the Phillips curve as:
,
Inflation depends on past inflation, cyclical
unemp’t & supply shock.
The first term, -1, implies that inflation has
inertia.

3.2.3.2 Adaptive Expectations and Inflation Inertia
i.e., like an object moving through space,  keeps
going unless something acts to stop it.
In particular, if unemp’t is at the natural rate & if
there are no supply shocks, the continued rise in P
neither speeds up nor slows down.
This inertia arises because past  influences
expectations of future  & because these
expectations influence the wages & prices that
workers & firms set.
“We have inflation because we expect inflation, and we
expect inflation because we’ve had it.”
The 2nd & 3rd terms in Phillips curve equation
show 2 forces that can change inflation rate.
The 2nd term shows that cyclical unemp’t exerts
an up/down-ward pressure on inflation.
Low unemp’t pulls  up – demand-pull .
High unemp’t pulls  down.

3.2.3.2 Adaptive Expectations and Inflation Inertia
 measures how responsive  is to cyclical
unemp’t.
The 3rd term (v) shows that  also rises/falls
because of supply shocks.
An adverse supply shock, such as the rise in world
oil prices in 1970s, implies a positive value of v &
causes  to rise – cost-push .
A beneficial supply shock, such as the oil glut that
led to a fall in oil prices in the 1980s, makes v
negative and causes inflation to fall.
What options does the Phillips curve give to a
policymaker who can influence AD?
At any moment, e & supply shocks are beyond
the policymaker’s immediate control.
Yet, by changing AD, the policymaker can alter
output, unemp’t & .


3.2.3.2 Adaptive Expectations and Inflation Inertia
The combination of the level of unemp’t &  that
occurs depends on the e.
When economic agents begin to expect  to rise,
the short-run Phillips curve begins to shift,
thereby generating higher  at each unemp’t
level.
The short run Phillips curve shifts with e.
 corresponding to any given level of unemp’t
(output) therefore s over time as e s.
The higher the e, the higher the  corresponding
to any level of unemp’t/output.
This is one reason why it is possible for  &
unemp’t rate to rise together, or for  to rise
while the level of output falls.
The other important reason is that a supply shock
may hit the economy.

3.2.3.2 Adaptive Expectations and Inflation Inertia
On each short-run Phillips curve, e is constant &
except at points where Y = Yn , e will turn out to
be different from actual .
If  remains constant for any long period, firms
& workers will expect that rate to continue, & e
will become equal to actual .
The assumption that  = e distinguishes the
long-run from the short-run Phillips curve.
The long-run Phillips curve describes the r/p b/n
 & unemp’t/output when  = e.
With  = e, Phillips curve shows that Y = Yn.
Hence, the long-run Phillips curve is a vertical
line joining points on short-run Phillips curves at
which  = e.
In the long run, the level of unemp’t is
independent of .

3.2.3.2 Adaptive Expectations and Inflation Inertia
In the short run, with a given e, higher  is
accompanied by higher output; in the long run,
with =e, unemp’t is independent of .
Because people adjust their expectations of  over
time, the tradeoff b/n  & unemp’t holds only in
the short run.
The policymaker cannot keep  above e (& thus
unemp’t below its natural rate) forever.
Eventually, expectations adapt to whatever  the
policymaker has chosen.
In the long run, the classical dichotomy holds,
unemp’t returns to its natural rate, & there is no
tradeoff b/n  & unemp’t.
The Phillips curve shows that in the absence of a
positive supply shock, lowering  requires a
period of high unemp’t & reduced output.

3.2.3.2 Adaptive Expectations and Inflation Inertia
But by how much & for how long would unemp’t
need to rise above the natural rate?
Before deciding whether to reduce , policy-
makers must know how much output would be
lost during the transition to lower .
This cost can then be compared with the benefits
of lower inflation.
Much research has used the available data to
examine the Phillips curve quantitatively.
Results of such studies are often summarized in a
number called the sacrifice ratio, the percentage
of a year’s real GDP that must be forgone to
reduce  by 1 percentage point.
If the sacrifice ratio is estimated to be 5, for every
percentage point that  is to fall, 5% of one year’s
GDP must be sacrificed.

3.2.3.2 Adaptive Expectations and Inflation Inertia
The sacrifice ratio can also be expressed in terms
of unemp’t.
Okun’s law: a  of 1 percentage point in unemp’t
rate translates into a  of 2% in GDP.
So, reducing  by 1 percentage point requires 2.5
percentage points of cyclical unemp’t.
We can use the sacrifice ratio to estimate by how
much & for how long unemp’t must rise to reduce
.
If reducing  by 1 percentage point requires a
sacrifice of 5% of a year’s GDP, reducing  by 4
percentage points requires a sacrifice of 20% of a
year’s GDP, or equivalently, a sacrifice of 10
percentage points of cyclical unemp’t.
This disinflation may take various forms, each
totaling the sacrifice of 20% of a year’s GDP.

3.2.3.2 Adaptive Expectations and Inflation Inertia
For example, a rapid disinflation would lower
output by 10% for 2 years; a moderate
disinflation would lower output by 5% for 4
years; an even more gradual disinflation would
depress output by 2% for a decade.


3.2.3.3 Rational Expectations & the Possibility of Painless
Disinflation
Systematic mistakes – for instance, always under-
predicting  – are easily spotted.
According to the rational expectations hypothesis,
people correct such mistakes & change the way
they form expectations.
On average, rational expectations are correct
because people understand the environment in
which they operate.
Of course people make mistakes from time to
time, but they do not make systematic mistakes.
With expectations formed according to the
hypothesis of rationality, there is no trade-off
between unemp’t &  at all.
Unemp’t is equal to the natural rate plus a
deviation that is purely random.





3.2.3.3 Rational Expectations & the Possibility of Painless
Disinflation
That makes it impossible to set a policy that
makes unemp’t rate differ systematically from the
natural rate.
As long as expectations are an informed forecast
which utilize the actual structure of the economy,
unemp’t rate will differ from natural rate only if
there is a policy surprise: an effective policy must
be unanticipated.
Only by systematically fooling the public can
policymakers force unemp’t rate to deviate from
the natural eqlm.
There may be some reasons, though, why the
public may be fooled into making errors in
forecasting :
 economic agents may have an imperfect understanding
of the workings of the economy;
 their information may be limited.



3.2.3.3 Rational Expectations & the Possibility of Painless
Disinflation
Advocates of rational expectations argue that the
short-run Phillips curve does not accurately
represent the options that policymakers have
available.
They believe that if policymakers are credibly
committed to reducing , rational people will
understand the commitment & will quickly lower
their expectations of .
Inflation can then come down without a rise in
unemp’t & fall in output.
If people form their expectations rationally, then
 may have less inertia than it first appears.
Accordingly, traditional estimates of the sacrifice
ratio are not useful for evaluating the impact of
alternative policies.

3.2.3.3 Rational Expectations & the Possibility of Painless
Disinflation
Under a credible policy, the costs of reducing 
may be much lower than estimates of the sacrifice
ratio suggest.
In the most extreme case, one can imagine
reducing  without causing any recession.
A painless disinflation has two conditions:
1) the plan to reduce  must be announced before the
workers & firms who set wages & prices have formed
their expectations; &
2) workers & firms must believe the announcement;
otherwise, they will not reduce their expectations of
.
If both conditions are met, the announce-ment
will immediately shift the short-run tradeoff b/n
 & unemp’t downward, permitting a lower 
without higher unemp’t.

3.2.3.3 Rational Expectations & the Possibility of Painless
Disinflation
Although the rational-expectations approach
remains controversial, almost all economists agree
that expectations of  influence the short-run
tradeoff b/n  & unemp’t.
The credibility of a policy to reduce  is therefore
one determinant of how costly the policy will be.
Unfortunately, it is often difficult to predict
whether the public will view the announcement of
a new policy as credible.
The central role of expectations makes forecasting
the results of alternative policies far more
difficult.
To sum up,
 If expectations are backward-looking, wages & prices
will adjust slowly over time, so that the Phillips curve
has a negative slope.

3.2.3.3 Rational Expectations & the Possibility of Painless
Disinflation
 Under rational expectations, any anticipated  in AD is
incorporated in expectations of prices & wages, so that,
with respect to anticipated s in AD, Phillips curve is
vertical even in the short run.

3.2.3.4 Hysteresis & the Challenge to the Natural-Rate Hypothesis

Our discussion of fluctuations is based on the

assumption of the natural-rate hypothesis:
Fluctuations in AD affect output & emp’t only in the SR;
in the LR, the economy returns to levels of output, emp’t &
unemp’t described by the classical model.
The natural-rate hypothesis allows macro-
economists to study separately SR & LR
developments in the economy; It is one expression
of the classical dichotomy.
Recently, some economists have challenged the
natural-rate hypothesis by suggesting that AD
may affect output & emp’t even in the LR.
They have pointed out a number of mechanisms
through which recessions might leave permanent
scars on the economy by altering the natural rate
of unemp’t.

3.2.3.4 Hysteresis & the Challenge to the Natural-Rate Hypothesis
Hysteresis: term used to describe the long-lasting
influence of history on natural rate.
A recession can have permanent effects if it s the
people who become unemployed.
For instance, workers might lose valuable job
skills when unemployed, lowering their ability to
find a job even after the recession ends.
Alternatively, a long period of unemp’t may
change an individual’s attitude toward work &
reduce his desire to find emp’t.
In either case, the recession permanently inhibits
the process of job search & raises the amount of
frictional unemp’t.
Another way in which a recession can
permanently affect the economy is by changing
the process that determines wages.

3.2.3.4 Hysteresis & the Challenge to the Natural-Rate Hypothesis
Those who become unemployed may lose their
influence on the wage-setting process.
Unemployed workers may lose their status as
union members, for example.
More generally, some of the insiders in the wage-
setting process become outsiders.
If the smaller group of insiders cares more about
high real wages & less about high emp’t, then the
recession may permanently push real wages
further above the eqlm level & raise the amount
of structural unemp’t.
Hysteresis remains a controversial theory.
Some believe the theory helps explain persistently
high unemp’t coinciding with disinflation & even
after  is stabilized.
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3.2.3.4 Hysteresis & the Challenge to the Natural-Rate Hypothesis
Moreover, the increase in unemp’t tended to be
larger for countries that experienced the greatest
reductions in , such as Ireland, Italy, and Spain.
Yet there is still no consensus whether the
hysteresis phenomenon is significant, or why it
might be more pronounced in some countries than
in others.
If it is true, however, the theory is important,
because hysteresis greatly increases the cost of
recessions.
Put another way, hysteresis raises the sacrifice
ratio, because output is lost even after the period
of disinflation is over.