1. SRAS and Phillips Curve

Mankiw - Ch.15

What does an increase in AD have on the SRAS curve?

shifts in AD only affect output in Sr and only effect price in Lr

How us price level, P weighted?

How much is consumed

What are the 2 different types of frictions?

1. Sticky prices - some fraction of prices are fixed and the remainder are flexible (P can change in SR but not entirely)

2. Imperfect information -  the general price level is not perfectly observed (better to be able to explain where something comes from)

When is sticky prices not realistic?

The possible exception of a deep recession/depression.

What is the equation for SRAS?

What is the equation for Price level?

What does the line for SRAS look like?

Upward sloping?

What is the key friction that leads to the Sticky-Price Model?

Firms don’t immediately adjust their prices following a change in demand for their g/s

Why does the key friction for the Sticky-Price Model arise?

• long term agreements with customers -e.g. contracts

• menu costs - costly for firms to change prices - time + effect + money cost → don’t change

• sticky wages - labour is an important F.o.P - firms cant decrease wages → don’t decrease prices

What is an individuals Firm’s ‘desired’ price (p)?

What they would like to set if they could

firms would set the price p if they were able to adjust continuously

What are the 2 groups of firms?

Firms with flexible prices - always set desired price:

• p = P +a(Y-Y¬)

Firms with sticky prices - set price in advance

• p = EP + a(EY -EY¬)

• based on expectations

• assume EY = EY¬, then p = EP f

Why are there 2 groups of firms

Not all able to change prices at the same time

What is the equation for the General price level? When you have sticky vs flexible firms?

weighted average of the prices set by the 2 groups of firms

What happens when you rearrange the General Price level and what does it imply

1/alpha = (1-s/s)a >0, therefore AS has to be upward sloping, and (1-s/s) needs to be positive

What does the equation for General price level imply and what model does it show?

What is the equation for Y?

What is Model 2 and what are its assumptions?

Imperfect-Information Model

generates upward sloping SRAS curve but bc of information friction

Assumptions:

• Prices are fully flexible - no sticky prices

• Each supplier produces a single good but also consumes goods produced by other suppliers

• Key friction: there are many good - suppliers are unable to perfectly observe all prices at all times

• they know the price of the good they produce but it is too costly to monitor the prices of all other goods

What is the suppliers problem?

Suppliers choose how much to produce based on relative prices

P_i - price of good i produced by supplier i:

• supplier i sells its product for the price P_i and uses this income to buy goods from other suppliers

• if P_i/P is high then supplier i is motivated to work harder and supply more goods to the market

• information problem (the key friction): supplier i knows P_i but observes P imperfectly

What is the function for supply_i?

Supply_i = f(P_i/P)

What happens to Supply_i if all prices rise by x%?

• P must also increase by x% but supplier i cannot perfectly observe P

• Supplier i simply observes an increase in P_i by x%

Should supplier i increase output?

• no its relative price has not changed. however, with imperfect information supplier i could misinterpret the rise in P_i as an increase in P_i/P

• All commodities increase by P so relatively not better off incentive to work harder has changed

What is the role of expectations in imperfect information

Supply_i = f(P_i/EP)

in previous example - supplier i doesn’t increase if the price was expected,

if price was unexpected then supplier i will increase output

Why do all suppliers have the same problem?

If P increase unexpectedly, ceteris paribus, Y increase in respond.

If P >PEP suppliers mistakenly interpret a rise in ‘own price’ as a rise in relative prices and increases production

the extent to which they responds depends on α

if α is larger then SRAS will be flatter

What happens in countries were AD fluctuates a lot using imperfect information model relate to 1/α

• P will also fluctuate a lot

• Suppliers should realise/learn that unexpected changes in own price (P_i) are unlikely to signal a change in relative price (P_i/P)

• they should not alter their output level upon observing an unexpected change in P_i

• Y should not respond to P ≠EP, α should be small, SRAS curve should be steep

If countries have more stable AD then SRAS should be flatter

What does the SRAS look like for different α?

How does Y = Y¬ + α(P-EP) apply in the model?

What does an ADAS curve look like if P>EP?

What does inflation depend on?

• expected inflation

• cyclical unemployment

• Supply shocks(e.g. oil prices)

What is the modern form of the Philips curve? or the unemployment version?

What happens to inflation if unemployment increases?

What happens to inflation if there is a supply shock?

How do you derive the Phillips curve?

What is the relationship between output and unemployment?

negative and statsitical

can rewrite (1-α)(Y-Y¬) = B(u-uⁿ)

What is the difference between the modern and old phillips curve

Now uses price inflation instead of wage inflation 0 fairly closely correlated - conceptually different but statistically not

• now features expectations (based on Friedman (1968) and Phelps (1967)

• now inc supply shocks - influenced by shocks of 1970s

What are the 2 types of inflation and what are they

‘Demand-pull’ inflation

• a decline in cyclical unemployment (u-uⁿ) places upward pressure on the rate of inflation

• strong econ → decrease unemp → increase inflation

‘Cost-push’ inflation

• v> 0 for an adverse shock

What is the theoretical implication of the philips curve?

classical dichotomy breaks down in SR

• classical dichotomy - nominal and real variables don’t depend on each other

• real variables do depend upon nominal variables

Upward sloping SRAS - output depends upon unexpected changes in the price level

Phillips curve: unemployment depends upon unexpected change sin the rate of inflation

What is the policy implication of the Phillips curve? show a diagram

Why is the Phillips Curve important?

If gov wants to bring down inflation

According to the Phillips curve, this requires higher unemployment for a time

useful for policymakers when deciding whether or not to embark upon disinflationary policy

• how much output to sacrifice to bring down inflation

• role to quantify the sacrifice

• quantify the trade off - related to trade off from Phillips curve

What is the sacrifice ratio

% of annual GDP required to bring inflation down by 1 percentage point

What happens if you include inflation expectations onto the Phillips curve? - Modern Phillips curve

How do you prove that unemployment reaches the natural level of unemployment

What happens in the Long run?

output and unemployment are at their ‘natural level’ bc the LRAS is vertical

‘classical dichotomy’ is restored

What does uⁿ depend on

‘supply-side factors’

• eg. pop growth or quality of the workforce

• tend to be longer term

What can be shown from the empirical application. US Datat 1960-2019?

There is no produced phillips curve

there is an approx line of best fit, somewhat downward sloping, looks curved not linear but shows negative relationship btw inflation and unemployment in 60s

70s - increase in expected inflation due to inability to react to shocks

80s - conscious decision → decrease inflation → phillips curve starts to shift down

What is the natural rate hypothesis?

the rate of unemployment may depart from uⁿ in the short run but returns to uⁿ in the LR

• should come back how it started

Why do some economists disagree with the natural rate hypothesis?

they believe uⁿ can increase with the rate of unemployment - permanent ‘scars’ - but there is no consensus on this

• stretched too for it doesnt come back

• bad recession → unemployment duration increase

Example: hysteresis

• ppl who have been out of work for an extended period of time become less employable - lost skills

• higher SR unemp → higher Lr unemp

• we dont have it in our model

What is adaptive expectations and how can we use it?