AS UE

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# 🌟 **Chapter 13 Summary Notes


Aggregate Supply & the Short-Run Tradeoff Between Inflation and Unemployment**

*(Mankiw, 7th ed.)*


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## **1. Why Aggregate Supply Matters**


In the **long run**, prices are flexible β†’ **AS curve is vertical** β†’ output stays at its natural level.

In the **short run**, some prices are sticky β†’ **AS curve slopes upward** β†’ output fluctuates when AD shifts.



Two models explain short-run AS:


* **Sticky-Price Model**

* **Imperfect-Information Model**

Both lead to the same conclusion:

πŸ‘‰ *Output deviates from its natural level when actual prices differ from expected prices.*



General AS form:

**Y – YΜ„ = a(P – Pᡉ)**, where a > 0.


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# **2. The Phillips Curve**


The Phillips Curve translates AS behavior into inflation-unemployment terms.


### **Modern Phillips Curve Equation:**


**Ο€ = πᡉ – b(u – uβ‚™) + v**



Where:


* **Ο€** = inflation

* **πᡉ** = expected inflation

* **u – uβ‚™** = cyclical unemployment

* **v** = supply shock

* **b** = responsiveness of inflation to unemployment


Key ideas:


* Higher unemployment β†’ pulls inflation **down** (demand-pull effects).

* Supply shocks β†’ push inflation **up or down** (cost-push effects).



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# **3. Adaptive Expectations & Inflation Inertia**


If people expect the future based on last year’s inflation β†’ **adaptive expectations**.


Thus:

**πᡉ = π₋₁** β†’ inflation has **inertia** β€” it continues unless something disrupts it.



Inflation inertia happens because:


* Workers/firms base wage-price decisions on past inflation.

* Expected inflation shifts short-run AS upward over time.



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# **4. Demand-Pull vs. Cost-Push Inflation**


### **Demand-Pull Inflation**


High aggregate demand β†’ low unemployment β†’ inflation rises.



### **Cost-Push Inflation**


Adverse supply shock (e.g., oil price hike) β†’ costs rise β†’ inflation rises.

Favorable shock β†’ inflation falls.



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# **5. The Short-Run Tradeoff (The Phillips Curve Graph)**


In the **short run**, policymakers can choose a point on the short-run Phillips curve:


* **Lower unemployment β†’ higher inflation**

* **Higher unemployment β†’ lower inflation**



The position of the curve depends on **expected inflation**:


* Higher expected inflation β†’ curve shifts upward β†’ worse tradeoff

* Lower expected inflation β†’ curve shifts downward



In the **long run**, expectations adjust β†’ curve becomes vertical at **uβ‚™** β†’ **no tradeoff**.



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# **6. Disinflation & the Sacrifice Ratio**


**Disinflation** = reducing inflation.

The Phillips curve implies:

πŸ‘‰ Lowering inflation requires **higher unemployment and lower output** (in the absence of shocks).



**Sacrifice Ratio** = % of a year’s GDP that must be lost to reduce inflation by 1%.


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# **7. Rational Expectations & Painless Disinflation**


Some economists argue that if people believe the policy, inflation can fall **without** unemployment rising:


Requirements:


1. Policy to reduce inflation is **announced early**

2. Policy is **credible**



If both are met β†’ expectations drop quickly β†’ short-run Phillips curve shifts down β†’ **β€œpainless disinflation.”**


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# **8. Historical Evidence (U.S. Case Study)**


* **1960s:** Low unemployment β†’ demand-pull inflation.

* **1970s:** Oil shocks β†’ cost-push inflation (stagflation).

* **1980s:** Tight monetary policy β†’ high unemployment β†’ inflation fell.



These periods illustrate:


* Both **demand-pull** and **cost-push** forces

* Short-run vs. long-run differences

* Role of expectations


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# **9. Hysteresis**


Idea:

A recession might increase the **natural rate of unemployment** (uβ‚™) permanently because:


* Long-term unemployed lose skills

* Firms’ hiring behavior changes



Thus, temporary high unemployment may cause lasting damage.


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# **πŸ”₯ Quick Quiz Guide (What They Usually Ask)**


If you see a surprise quiz, expect these types of questions:


### **Concept IDs**


* Sticky vs flexible prices

* Natural rate of unemployment

* Demand-pull vs cost-push inflation

* Adaptive vs rational expectations

* Sacrifice ratio

* Stagflation


### **Graphs**


* Short-run Phillips curve shifts

* AD–AS shifts with supply shocks

* Long-run Phillips curve (vertical)


### **Short Explanations**


* Why short-run tradeoff disappears long-run

* How expectations determine inflation

* Why disinflation can be costly or painless