Week 7:
Preparation: Chap 14: Aggregate Supply and the
Short-Run
Tradeoff between Inflation and
Unemployment.
Real world compares to basic model: Aggregate supply curve is upward sloping
rather than vertical.
Y = Y + (P – EP), with > 0, Y is output, Y is the natural level of output, P is
the
price level, EP is the excepted price level.
indicates how much output responds to unexpected changes in the price level;
1/ is the slope of the aggregate supply curve.
If the price level is higher than the excepted price level, output exceeds its
natural level. If the price level is lower than the expected price level, output falls
short of its natural level.
Long-run monetary neutrality and short-run monetary non-neutrality are
perfectly compatible.
2 goals of the policy makers: low inflation and low unemployment but can
conflict. Tradeoff between inflation and unemployment is referred as Phillips
curve.
What determines excepted inflation? Plausible assumption: people form their
expectations of inflation based on recently observed inflation => Adaptive
expectations.
If people expect prices to rise this year as the same rate as they did last year: Eπ
= π—1
Then Phillips curve equation would be: π = π-1 -
(u – un) +
So inflation depends on past inflation, cyclical unemployment, and a supply
shock.
Here, natural rate of unemployment is called non-accelerating inflation rate of
unemployment, or NAIRU.
π—1 implies that inflation has inertia (keeps moving unless something acts to stop
it).
Robert Solow : “Why is our money ever less valuable? Perhaps it is simply that
we have inflation because we expect inflation, and we expect inflation because
we’ve had it.”
(u – un) shows that cyclical unemployment – the deviation of unemployment
from its natural rate- exerts upward or downward pressure on inflation.
, Low unemployment pulls the inflation rate up, called demand-pull inflation –
because high aggregate demand is responsible for this type of inflation.
measures how responsive inflation is to cycle unemployment.
shows that inflation also rises and falls because of supply shocks. An adverse
supply shocks implies a positive value of and causes inflation to rise => cost-
push inflation – adverse supply shocks are typically events that push up the cost
of production.
Unemployment is at its natural rate for u = un, and then π = Eπ + => short run
Phillips curve.
Sacrifice ratio: the percentage of a year’s GDP that must be forgone to reduce
inflation by 1% point.
Cold turkey solution to inflation: for example, a rapid disinflation would lower
output by 10 percent for two years.
Because the expectation of inflation influences the short-run trade off between
inflation and unemployment, we assume that people have rational expectations:
people optimally use all the available information including information about
current government policies, to forecast the future.
Chap 15: A Dynamic Model of Aggregate Demand and
Aggregate Supply.
Robert Lucas: “As an advice-giving profession, we are in a way over our heads”.
Economists need to pay more attention to the issue of how people form
expectations of the future.
Traditional methods of policy evaluation – such as those that rely on
standard macroeconometric models – do not adequately take into account
the impact of policy on expectations.
Lucas Critique
Some economists argue that policy maker policymakers should learn to live with
inflation, rather than incur the large cost of reducing it.
Two lessons:
The narrow lesson: economists evaluating alternative policies need to
consider how policy affects expectations and behavior.
The broad lesson is that policy evaluation is hard, so economists engaged
in this task should be sure to show the requisite humility.
Lecture: The AD-AS model, the Phillips curve, and the
Lucas Critique.
The model of Aggregate Demand and Aggregate Supply (the AD-AS model):
Link between short run neoclassical business cycle theory and long run
classical theory:
o Combines the AD-curve with a short-run AS curve.
o Determines Pt and Yt in the short run.
Preparation: Chap 14: Aggregate Supply and the
Short-Run
Tradeoff between Inflation and
Unemployment.
Real world compares to basic model: Aggregate supply curve is upward sloping
rather than vertical.
Y = Y + (P – EP), with > 0, Y is output, Y is the natural level of output, P is
the
price level, EP is the excepted price level.
indicates how much output responds to unexpected changes in the price level;
1/ is the slope of the aggregate supply curve.
If the price level is higher than the excepted price level, output exceeds its
natural level. If the price level is lower than the expected price level, output falls
short of its natural level.
Long-run monetary neutrality and short-run monetary non-neutrality are
perfectly compatible.
2 goals of the policy makers: low inflation and low unemployment but can
conflict. Tradeoff between inflation and unemployment is referred as Phillips
curve.
What determines excepted inflation? Plausible assumption: people form their
expectations of inflation based on recently observed inflation => Adaptive
expectations.
If people expect prices to rise this year as the same rate as they did last year: Eπ
= π—1
Then Phillips curve equation would be: π = π-1 -
(u – un) +
So inflation depends on past inflation, cyclical unemployment, and a supply
shock.
Here, natural rate of unemployment is called non-accelerating inflation rate of
unemployment, or NAIRU.
π—1 implies that inflation has inertia (keeps moving unless something acts to stop
it).
Robert Solow : “Why is our money ever less valuable? Perhaps it is simply that
we have inflation because we expect inflation, and we expect inflation because
we’ve had it.”
(u – un) shows that cyclical unemployment – the deviation of unemployment
from its natural rate- exerts upward or downward pressure on inflation.
, Low unemployment pulls the inflation rate up, called demand-pull inflation –
because high aggregate demand is responsible for this type of inflation.
measures how responsive inflation is to cycle unemployment.
shows that inflation also rises and falls because of supply shocks. An adverse
supply shocks implies a positive value of and causes inflation to rise => cost-
push inflation – adverse supply shocks are typically events that push up the cost
of production.
Unemployment is at its natural rate for u = un, and then π = Eπ + => short run
Phillips curve.
Sacrifice ratio: the percentage of a year’s GDP that must be forgone to reduce
inflation by 1% point.
Cold turkey solution to inflation: for example, a rapid disinflation would lower
output by 10 percent for two years.
Because the expectation of inflation influences the short-run trade off between
inflation and unemployment, we assume that people have rational expectations:
people optimally use all the available information including information about
current government policies, to forecast the future.
Chap 15: A Dynamic Model of Aggregate Demand and
Aggregate Supply.
Robert Lucas: “As an advice-giving profession, we are in a way over our heads”.
Economists need to pay more attention to the issue of how people form
expectations of the future.
Traditional methods of policy evaluation – such as those that rely on
standard macroeconometric models – do not adequately take into account
the impact of policy on expectations.
Lucas Critique
Some economists argue that policy maker policymakers should learn to live with
inflation, rather than incur the large cost of reducing it.
Two lessons:
The narrow lesson: economists evaluating alternative policies need to
consider how policy affects expectations and behavior.
The broad lesson is that policy evaluation is hard, so economists engaged
in this task should be sure to show the requisite humility.
Lecture: The AD-AS model, the Phillips curve, and the
Lucas Critique.
The model of Aggregate Demand and Aggregate Supply (the AD-AS model):
Link between short run neoclassical business cycle theory and long run
classical theory:
o Combines the AD-curve with a short-run AS curve.
o Determines Pt and Yt in the short run.
