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# Macroeconomic Theory EC 202

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This 9 page Class Notes was uploaded by Jayda Beahan Jr. on Saturday October 3, 2015. The Class Notes belongs to EC 202 at Boston College taught by Matteo Iacoviello in Fall. Since its upload, it has received 9 views. For similar materials see /class/218051/ec-202-boston-college in Economcs at Boston College.

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Date Created: 10/03/15

Aggregate Supply Ch13 I three models of aggregate supply in which output depends positively on the price level in the short run I the shortrun tradeoff between in ation and unemployment known as the Phillips curve CHAPTER 13 Aggregate sunny Slide n Three models of aggregate supply 1 The stickywage model 2 The imperfectinformation model 3 The stickyprice model All three models imply y 7aPiP CHAPTER 13 AggiegalE Sunniv siiuei The stickywage model I Firms and workers negotiate contracts and x the nominal wage before they know what the price level will turn out to be I The nominal wage W they set is the product of a target real wage or and the expected price level WldgtltPe W P 3 agtlt P P CHAPTER 13 AggiegalE Sunniv Slide 2 1 The stickywage model W P2 1 X P P If it turns out that th e unemployment and output are P P at their natural rats Real wage is less than is target 7 gt P9 so rms ire more workers and output riss above is natural rate Real wage exceeds is target so P lt P5 rms hire fewer workers and output falls below is natural rate CHAPIER 13 Aggregate sunpr slide a The cyclical behavior of the real wage Percentage Sticky Wimply that WP h l4 333 3923 should be countercyclical mquot 3 I Not true In the data I 1asal was 2 I l 339 1315333 1 I 1370 159539 2000 3 1558 I 13g 155 133239 I I l 1330 I 392 13m 73 5quot 1575 4 I I 153 I I I I I I I I 73 72 71 i 2 3 5 E 7 8 Percentage change in veal GDr CHAPIER 13 Aggregate Supply sildeA 2 The imperfectinformation model Assumptions all wages and prices perfectly flexible all markets clear each supplier produces one good consumes many goods each supplier knows the nominal price of the good she produces but does not know the overall price level CHAPIER 13 Aggregate sunpr slide 5 the nominal price of the good divided by the overall price level I Supplier doesn t know price level at the time she makes her production decision so uses the expected price level P5 I Suppose P rises but PE does not she produces mo With many producers thinking this way Y will rise whenever P rises above PE CHAPTER 13 Aggregate supply The imperfectinformation model I Supply of each good depends on its relative price Then supplier thinks her relative price has risen so slide 6 3 The stickyprice model I Reasons for sticky prices longterm contracB between firms and customers menu costs firms do not wish to annoy customers with frequent price changes I Assumption Firms set their own prices eg as in monopolistic competition Notation Vnatural level on CHAPTER 13 Aggregate Sunpr slide 7 The stickyprice model Suppose two types of firms 0 Flexpfirms p P aYV fraction 15 0 Sticky p firms p P5 fraction 5 o HenceP1sPaYVSF e oPPea1sYVs CHAPTER 13 Aggregate supply slide 8 The stickyprice model P PE yw S I High PE or High Y 2 High P Y Y autpe Stickyprice model procyclical real wage Suppose output falls T en Firms see a fall in demand for their products Sticky price rms reduce production and labor demand Shi in labor demand causes the ral wage to fall CHAPIER 13 AEEveuale supmv slide a Summarx amp implications P 45 Y7aPrPE P gt P2 SRAS E h f th ac o e P 7 PE three models of P lt PE 399 supply imply the relationship V summarized by the SRAS curve amp equation CHAPIER 13 Aggvegale Sunniv slide 1U Summary amp imp 39 SRAS equation Y YaP7 PE IfAD rises PgtP P M45 sms2 CHAPIER 13 Aggvegale Sunniv slide 11 Inflation Unemployment and the Phillips Curve The Phillips curve is a different way tn reinterpret the aggregate supply cune It stats that 1 depends on expected in ation 1fe cyclical unemployment the deviation ofthe actual rate ofunemployment from the natural rate supply shocks v where gt 0 is a parameter CHAPIER 13 AEEveoate supmv slide 12 Deriving the Phillips Curve from SRAS 1 y7apep2 m 2 P PE1aY77 3 P PE 1aY77 v 4 Pen P27R11aY77v 5 g e1ay77v 6 laxri ymueuquot 7 n 9 puuquot y Phillips Curve CHAPIER 13 912an Sunniv slide 13 How to form expectations 1 Adaptii So far we have not explained have expecmuons are formed Adaptive people form expectations based on immediam past Ire 171 I Then the PC becomes 1r nilipuiu v In ation inertia 9 Past in ation in uences expectations of current in ation which in turn in uences the wages amp prices that people set CHAPIER 13 AEEveoate supmv sme 14 Two causes ofrising amp falling inflation z zili ueu v I costpush inflation in ation resulting from supply shocks Adverse supply shocks raise production cosis and induce rms to raise prices I demandpull inflation in ation resulting from demand shoc Positive shocks to aggregate demand cause unemployment to fall below is natural rate CHAPIER 13 AEEveuale sunmv shoe 15 Graphing the Phillips curve A 1 771a lip rqn e v PlyW75 Carie CHAPIER 13 Aggvegaie Sunny shoe 16 Shifting the Philies curve 13 7 uru v A Eg an increase in if shifis the shortrun PC y upward n CHAPIER 13 Aggvegaie Sunny shoe 17 The sacri ce ratio I To reduce inflation policymakers can contract AD causing unemployment to rise I The sacrifice ratio measures AYA rr I SR GDP that must be foregone to reduce in ation by 1 typical estimate is 5 I If he ralia i5 5 then reducing in ation b y 4 requires a loss 0f4x5 20 afGDP eg GDP can fall 10 for two years CHAPIER 13 A vegaie sunpr slide 18 Forming expectations 2 Rational With rational expectations People base their expectations on all available information including information about current and prospective future policies How we believe people form egtltpectations is important for shaping economic policy Why do we care about adaptive vs rational CHAPIER 13 AggiegalE Sunpr slide 19 Painless disinflation I Proponents of rational expectations believe that the sacrifice ratio may be very small I Suppose u u 7 and 1 1re 6 and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible I If the announcement is credible then 19 will fall perhaps by the full 4 poinB I Then 1 can fall without an increase in u CHAPIER 13 A vegaie supin slide 2n I 1981 11 97 1985 11 30 Volcker disinflations Total disinflation 67 year II II quot 1quot 1982 95 5 0 35 1983 95 50 35 1984 74 50 14 1985 71 50 11 Totam CHAPIER 13 AEEveuale supmv slide 21 T h e sacrifice ratio for Volcker disinflation I Previous slide Duu Dnn 9567 4 IOkun s law Dyy Duu 2 I So Dyy Dnn 72 x 714 2800 I Sacrifice ratio 28 I percentage points of GDP were lost for each 1 percentage point reduction in inflation CHAPIER 13 AEEveuale Sunin slide 22 The natural rate thothesis Our analysis of the cosls ofdisin ation and of economic uctuations in the preceding chapters is based on the natural rate hypothesis In the SR AD changes can affect Y and L In the LR the economy behaves according to the classical model CHAPIER 13 AEEveuale sunin slide 23 An alternative hypothesis hysteresis I Hysteresis the longlasting in uence of history on variables such as the natural rate of unemployment I Negative shocks may increase ll so economy may not y recover The skills of cyclically unemployed workers deteriorate ile unemployed and they cannot nd a job when h ession ends Cyclically unemployed workers may lose their in uence esetting insiders em lo d e structurally unemployed when the recssion en CHAPIER 13 Aumeaale sunpr slide 24

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