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