Worth: Mankiw Economics 5e CHAPTER THIRTEEN Aggregate Supply There is ahvays a temporary tradeoff befween inflation and unemploy from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation Milton friedman Most economists analyze short-run fluctuations in aggregate income and the price level using the model of aggregate demand and aggregate supply. In the IS-LM modek hapters, we examined aggregate demand in some detail. The IS-LM model-together with its open-economy cousin the Mundell-Fleming model-shows how changes in monetary and fiscal policy and shocks to the money and goods markets shift the aggregate demand curve. In this chapter, we turn our attention to aggregate supply and develop theories that explain the po- sition and slope of the aggregate supply curve. When we introduced the aggregate supply curve in Chapter 9, we established that aggregate supply behaves differently in the short run than in the long run. In the long run, prices are flexible, and the aggregate supply curve is vertical.When the aggregate supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the output of the economy remains at its natural rate By con- trast, in the short run, prices are sticky, and the aggregate supply curve is not ver tical. In this case, shifts in aggregate demand do cause fluctuations in output. In Chapter 9 we took a simplified view of price stickiness by drawing the short-run aggregate supply curve as a horizontal line, representing the extreme situation in which all prices are fixed. Our task now is to refine this understanding of short- run aggregate supply Unfortunately, one fact makes this task more difficult: economists disagree about how best to explain aggregate supply. As a result, this chapter begins by presenting three prominent models of the short-run aggregate supply curve. Among economists, each of these models has some prominent adherents(as well as some prominent critics), and you can decide for yourself which you find most plausible. Although these models differ in some significant details, they are also elated in an important way: they share a common theme about what makes the User JoENA: Job EFFo1429: 6264_ch13: Pg 347: 25876#/eps at 100sl Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 347:25876#/eps at 100% *25876* Mon, Feb 18, 2002 12:56 AM Most economists analyze short-run fluctuations in aggregate income and the price level using the model of aggregate demand and aggregate supply. In the previous three chapters, we examined aggregate demand in some detail. The IS–LM model—together with its open-economy cousin the Mundell–Fleming model—shows how changes in monetary and fiscal policy and shocks to the money and goods markets shift the aggregate demand curve. In this chapter, we turn our attention to aggregate supply and develop theories that explain the position and slope of the aggregate supply curve. When we introduced the aggregate supply curve in Chapter 9, we established that aggregate supply behaves differently in the short run than in the long run. In the long run, prices are flexible, and the aggregate supply curve is vertical.When the aggregate supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the output of the economy remains at its natural rate. By contrast, in the short run, prices are sticky, and the aggregate supply curve is not vertical. In this case, shifts in aggregate demand do cause fluctuations in output. In Chapter 9 we took a simplified view of price stickiness by drawing the short-run aggregate supply curve as a horizontal line, representing the extreme situation in which all prices are fixed. Our task now is to refine this understanding of shortrun aggregate supply. Unfortunately, one fact makes this task more difficult: economists disagree about how best to explain aggregate supply. As a result, this chapter begins by presenting three prominent models of the short-run aggregate supply curve. Among economists, each of these models has some prominent adherents (as well as some prominent critics), and you can decide for yourself which you find most plausible. Although these models differ in some significant details, they are also related in an important way: they share a common theme about what makes the | 347 Aggregate Supply 13 CHAPTER There is always a temporary tradeoff between inflation and unemployment; there is no permanent tradeoff. The temporary tradeoff comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation. — Milton Friedman THIRTEEN
Worth: Mankiw Economics 5e 348 PART IV Business Cycle Theory: The Economy in the Short Run short-run and long-run aggregate supply curves differ and a common conclusion chat the short-run aggregate supply curve is upward sloping After examining the models, we examine an implication of the short-run gregate supply curve. We show that this curve implies a tradeoff between two measures of economic performance--inflation and unemployment. According to this tradeoff, to reduce the rate of inflation policymakers must temporarily raise unemployment, and to reduce unemployment they must accept higher inflation. As the quotation at the beginning of the chapter suggests, the tradeoff between infation and unemployment is only temporary. One goal of this chapter is to ex- plain why policymakers face such a tradeoff in the short run and, just as impor- tant, why they do not face it in the long run. 13-7 Three Models of Aggregate Supply When classes in physics study balls rolling down inclined planes, they often begin by assuming away the existence of friction. This assumption makes the problem simpler and is useful in many circumstances, but no good engineer would ever take this assumption as a literal description of how the world works. similarly, this book began with classical macroeconomic theory, but it would be a mistake to assume that this model is always true. Our job now is to look more deeply into the“ frictions” of macroeconomics. We do this by examining three prominent models of aggregate supply, roughly in the order of their development. In all the models, some market im- perfection(that is, some type of friction) causes the output of the economy to deviate from the classical benchmark. As a result, the short-run aggregate sup- ply curve is upward sloping, rather than vertical, and shifts in the aggregate demand curve cause the level of output to deviate temporarily from the nat- ural rate. These temporary deviations represent the booms and busts of the business cycle Although each of the three models takes us down a different theoretical route each route ends up in the same place. That final destination is a short-run aggre- gate supply equation of the form >0 where Y is output, Y is the natural rate of output, P is the price level, and pe is the expected price level. This equation states that output deviates from its natural rate when the price level deviates from the expected price level. The parameter o indicates how much output responds to unexpected changes in the price level; 1/a is the slope of the aggregate supply curve. Each of the three models tells a different story about what lies behind this short-run aggregate supply equation. In other words, each highlights a particular reason why unexpected movements in the price level are associated with fluctu ations in aggregate output. User JoENA: Job EFFo1429: 6264_ch13: Pg 348: 27755 #/eps at 100smml Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 348:27755#/eps at 100% *27755* Mon, Feb 18, 2002 12:56 AM short-run and long-run aggregate supply curves differ and a common conclusion that the short-run aggregate supply curve is upward sloping. After examining the models, we examine an implication of the short-run aggregate supply curve. We show that this curve implies a tradeoff between two measures of economic performance—inflation and unemployment.According to this tradeoff, to reduce the rate of inflation policymakers must temporarily raise unemployment, and to reduce unemployment they must accept higher inflation. As the quotation at the beginning of the chapter suggests, the tradeoff between inflation and unemployment is only temporary. One goal of this chapter is to explain why policymakers face such a tradeoff in the short run and, just as important, why they do not face it in the long run. 13-1 Three Models of Aggregate Supply When classes in physics study balls rolling down inclined planes, they often begin by assuming away the existence of friction.This assumption makes the problem simpler and is useful in many circumstances, but no good engineer would ever take this assumption as a literal description of how the world works. Similarly, this book began with classical macroeconomic theory, but it would be a mistake to assume that this model is always true. Our job now is to look more deeply into the “frictions” of macroeconomics. We do this by examining three prominent models of aggregate supply, roughly in the order of their development. In all the models, some market imperfection (that is, some type of friction) causes the output of the economy to deviate from the classical benchmark.As a result, the short-run aggregate supply curve is upward sloping, rather than vertical, and shifts in the aggregate demand curve cause the level of output to deviate temporarily from the natural rate. These temporary deviations represent the booms and busts of the business cycle. Although each of the three models takes us down a different theoretical route, each route ends up in the same place.That final destination is a short-run aggregate supply equation of the form Y =Y − + a(P − Pe ), a > 0 where Y is output, Y − is the natural rate of output, P is the price level, and Pe is the expected price level.This equation states that output deviates from its natural rate when the price level deviates from the expected price level.The parameter a indicates how much output responds to unexpected changes in the price level; 1/a is the slope of the aggregate supply curve. Each of the three models tells a different story about what lies behind this short-run aggregate supply equation. In other words, each highlights a particular reason why unexpected movements in the price level are associated with fluctuations in aggregate output. 348 | PART IV Business Cycle Theory: The Economy in the Short Run
Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 349 The Sticky-Wage Model To explain why the short-run aggregate supply curve is upward sloping, many economists stress the sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term contracts, so wages cannot adjust quickly when economic conditions change. Even in industries not covered by form contracts, implicit agreements between workers and firms may limit wage changes. Wages may also depend on social norms and notions of fairness that evolve slowly. For these reasons, many economists believe that nominal wages are sticky in the short run The sticky-wage model shows what a sticky nominal wage implies for ag- gregate supply To preview the model, consider what happens to the amount of tput produced when the price level rises: 1. When the nominal wage is stuck, a rise in the price level lowers the real wage, naking labor cheaper 2. The lower real wage induces firms to hire more labor 3. The additional labor hired produces more output This positive relationship between the price level and the amount of output means that the aggregate supply curve slopes upward during the time when the nominal wage cannot adjust To develop this story of aggregate supply more formally, assume that workers and firms bargain over and agree on the nominal wage before they know what the price level will be when their agreement takes effect. The bargaining par- ties--the workers and the firms--have in mind a target real wage. The target may be the real wage that equilibrates labor supply and demand. More likely, the tar- get real wage is higher than the equilibrium real wage: as discussed in Chapter 6, union power and efficiency-wage considerations tend to keep real wages above the level that brings supply and demand into balance The workers and firms set the nominal wage W based on the target real wage wo and on their expectation of the price level Pe. The nominal wage they set is Nominal Wage Target Real Wage X Expected Price Level After the nominal wage has been set and before labor has been hired firms learn the actual price level P. The real wage turns out to be W/P (P/P Real Wage Target Real Wage x Expected Price Level Actual Price level This equation shows that the real wage deviates from its target if the actual price level differs from the expected price level. When the actual price level is greater than expected, the real wage is less than its target; when the actual price level is less than expected the real wage is greater than its target. User JoENA: Job EFFo1429: 6264_ch13: Pg 349: 27756#/eps at 100smml Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 349:27756#/eps at 100% *27756* Mon, Feb 18, 2002 12:56 AM The Sticky-Wage Model To explain why the short-run aggregate supply curve is upward sloping, many economists stress the sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term contracts, so wages cannot adjust quickly when economic conditions change. Even in industries not covered by formal contracts, implicit agreements between workers and firms may limit wage changes. Wages may also depend on social norms and notions of fairness that evolve slowly. For these reasons, many economists believe that nominal wages are sticky in the short run. The sticky-wage model shows what a sticky nominal wage implies for aggregate supply.To preview the model, consider what happens to the amount of output produced when the price level rises: 1. When the nominal wage is stuck, a rise in the price level lowers the real wage, making labor cheaper. 2. The lower real wage induces firms to hire more labor. 3. The additional labor hired produces more output. This positive relationship between the price level and the amount of output means that the aggregate supply curve slopes upward during the time when the nominal wage cannot adjust. To develop this story of aggregate supply more formally, assume that workers and firms bargain over and agree on the nominal wage before they know what the price level will be when their agreement takes effect. The bargaining parties—the workers and the firms—have in mind a target real wage.The target may be the real wage that equilibrates labor supply and demand. More likely, the target real wage is higher than the equilibrium real wage: as discussed in Chapter 6, union power and efficiency-wage considerations tend to keep real wages above the level that brings supply and demand into balance. The workers and firms set the nominal wage W based on the target real wage q and on their expectation of the price level Pe .The nominal wage they set is W = q × Pe Nominal Wage = Target Real Wage × Expected Price Level. After the nominal wage has been set and before labor has been hired, firms learn the actual price level P.The real wage turns out to be W/P = q × (Pe /P) Real Wage = Target Real Wage × . This equation shows that the real wage deviates from its target if the actual price level differs from the expected price level.When the actual price level is greater than expected, the real wage is less than its target; when the actual price level is less than expected, the real wage is greater than its target. Expected Price Level Actual Price Level CHAPTER 13 Aggregate Supply | 349
Worth: Mankiw Economics 5e 350 PART IV Business Cycle Theory: The Economy in the Short Run The final assumption of the sticky-wage model is that employment is deter- by the qu labor that firms demand. In other words, the bargain between the workers and the firms does not determine the level of employment in advance; instead, the workers ag sNe describe the firms' hiring decisions by the gree to provide as much labor as the firms wish to buy at the predetermined wage. We L=Ld(W/P), hich states that the lower the real wage, the more labor firms hire. The labor demand curve is shown in panel(a)of Figure 13-1. Output is determined by the Y=F(L, which states that the more labor is hired, the more output is produced. This is shown in panel(b)of Figure 13-1 Panel (c)of Figure 13-1 shows the resulting aggregate supply curve. Be ause the nominal wage is sticky, an unexpected change in the price level (a) Labor Demand (b)Production Function Real wage Income, output, Y W/P Y2 2 Labor. L Labor. L 3.. which raises (c) Aggregate Supply The Sticky-Wage Model Panel (a) Price level. P shows the labor demand curve. Because Y=Y+ a(P-Pe) the nominal wage Wis stuck, an in in the price level from P, to P2 reduces the real wage from W/P, to W/P2.The P2 6. The aggregate lower real wage raises the quantity of abor demanded from L1 to L2. Panel (b) shows the production function. An nese ch increase in the quantity of labor fror 1. An increase L, to L2 raises output from Y, to Y2 in the price Y,Income,output,Y Panel(c)shows the aggregate supply curve summarizing this relationship 5... and income between the price level and output.An increase in the price level from P, to P raises output from Y, to Y2 User JoENA: Job EFFo1429: 6264_ch13: Pg 350: 27757#/eps at 100sm Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 350:27757#/eps at 100% *27757* Mon, Feb 18, 2002 12:56 AM The final assumption of the sticky-wage model is that employment is determined by the quantity of labor that firms demand. In other words, the bargain between the workers and the firms does not determine the level of employment in advance; instead, the workers agree to provide as much labor as the firms wish to buy at the predetermined wage.We describe the firms’ hiring decisions by the labor demand function L = Ld (W/P), which states that the lower the real wage, the more labor firms hire.The labor demand curve is shown in panel (a) of Figure 13-1. Output is determined by the production function Y = F(L), which states that the more labor is hired, the more output is produced.This is shown in panel (b) of Figure 13-1. Panel (c) of Figure 13-1 shows the resulting aggregate supply curve. Because the nominal wage is sticky, an unexpected change in the price level 350 | PART IV Business Cycle Theory: The Economy in the Short Run figure 13-1 Real wage, W/P Income, output, Y Price level, P Income, output, Y Labor, L Labor, L W/P1 W/P2 L Ld(W/P) L2 L1 Y2 Y1 Y F(L) L2 L1 P2 P1 Y Y a(P Pe ) Y2 Y1 1. An increase in the price level . . . 3. . . .which raises employment, . . . 4. . . . output, . . . 5. . . . and income. 2. . . . reduces the real wage for a given nominal wage, . . . 6. The aggregate supply curve summarizes these changes. (a) Labor Demand (b) Production Function (c) Aggregate Supply The Sticky-Wage Model Panel (a) shows the labor demand curve. Because the nominal wage W is stuck, an increase in the price level from P1 to P2 reduces the real wage from W/P1 to W/P2. The lower real wage raises the quantity of labor demanded from L1 to L2. Panel (b) shows the production function. An increase in the quantity of labor from L1 to L2 raises output from Y1 to Y2. Panel (c) shows the aggregate supply curve summarizing this relationship between the price level and output. An increase in the price level from P1 to P2 raises output from Y1 to Y2.
Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 351 moves the real wage away from the target real wage, and this change in the real wage influences the amounts of labor hired and output produced. The aggre gate supply curve can be written as Y=Y Output deviates from its natural level when the price level deviates from the ex pected price level CASE STUDY The Cyclical Behavior of the Real Wage In any model with an unchanging labor demand curve, such as the model we just discussed, employment rises when the real wage falls. In the sticky-wage del, an unexpected rise in the price level lowers the real wage and thereby raises the quantity of labor hired and the amount of output produced. Thus, the eal wage should be countercyclical: it should fluctuate in the opposite direction from employment and output. Keynes himself wrote in The General Theory that an increase in employment can only occur to the accompaniment of a decline in the rate of real wages. The earliest attacks on The General Theory came from economists challenging Keynes's prediction. Figure 13-2 is a scatterplot of the percentage change in real compensation per hour and the percentage change in real GDP using annual data for the U.S. economy from 1960 to 2000. If Keynes's prediction were cor- rect, the dots in this figure would show a downward-sloping pattern, indicating a negative relationship. Yet the figure shows only a weak correlation between the real wage and output, and it is the opphdy procyclical: the real wage tends to rise osite of what Keynes predicted. That is, if he real wage is cyclical at all when output rises Abnormally high labor costs cannot explain the low employ ment and output observed in recessions How should we interpret this evidence? Most economists conclude that the in which the labor demand curve shifts over the bis apply. They advocate models sticky-wage model cannot fully explain aggregate Usiness cycle. These shifts may arise because firms have sticky prices and cannot sell all they want at those prices; we discuss this possibility later. Alternatively, the labor demand curve may shift because of shocks to technology, which alter labor productivity. The theor we discuss in Chapter 19, called the theory of real business cycles, gives a promi- nent role to technology shocks as a source of economic fluctuations For the sticky-wage model, see Jo Anna Gray, Wage Indexation: A Macroeconomic Ap- proach, "Journal of Monetary Economics 2(April 1976): 221-235; and Stanley Fischer, ""Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule, "Joumal of Political Econ y85( February1977:191-205 For some of the recent work on the cyclical behavior of the real wage, see Scott Sumner and Stephen Silver, "Real Wages, Employment, and the Phillips Curve, " Journal of Political Economy 97 (une 1989): 706-720; and Gary Solon, Robert Barsky, and Jonathan A. Parker, "Measuring the Cyclicality of Real Wages: How Important Is Composition Bias? "Quarterly Journal of Economics 109 User JoENA: Job EFFo1429: 6264_ch13: Pg 351: 27758#/eps at 100sm Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 351:27758#/eps at 100% *27758* Mon, Feb 18, 2002 12:56 AM moves the real wage away from the target real wage, and this change in the real wage influences the amounts of labor hired and output produced.The aggregate supply curve can be written as Y =Y − + a(P − Pe ). Output deviates from its natural level when the price level deviates from the expected price level.1 CHAPTER 13 Aggregate Supply | 351 1 For more on the sticky-wage model, see Jo Anna Gray,“Wage Indexation:A Macroeconomic Approach,’’ Journal of Monetary Economics 2 (April 1976): 221–235; and Stanley Fischer, “Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule,’’ Journal of Political Economy 85 (February 1977): 191–205. 2 For some of the recent work on the cyclical behavior of the real wage, see Scott Sumner and Stephen Silver, “Real Wages, Employment, and the Phillips Curve,’’ Journal of Political Economy 97 ( June 1989): 706–720; and Gary Solon, Robert Barsky, and Jonathan A. Parker, “Measuring the Cyclicality of Real Wages: How Important Is Composition Bias?’’Quarterly Journal of Economics 109 (February 1994): 1–25. CASE STUDY The Cyclical Behavior of the Real Wage In any model with an unchanging labor demand curve, such as the model we just discussed, employment rises when the real wage falls. In the sticky-wage model, an unexpected rise in the price level lowers the real wage and thereby raises the quantity of labor hired and the amount of output produced.Thus, the real wage should be countercyclical: it should fluctuate in the opposite direction from employment and output. Keynes himself wrote in The General Theory that “an increase in employment can only occur to the accompaniment of a decline in the rate of real wages.’’ The earliest attacks on The General Theory came from economists challenging Keynes’s prediction. Figure 13-2 is a scatterplot of the percentage change in real compensation per hour and the percentage change in real GDP using annual data for the U.S. economy from 1960 to 2000. If Keynes’s prediction were correct, the dots in this figure would show a downward-sloping pattern, indicating a negative relationship.Yet the figure shows only a weak correlation between the real wage and output, and it is the opposite of what Keynes predicted.That is, if the real wage is cyclical at all, it is slightly procyclical: the real wage tends to rise when output rises.Abnormally high labor costs cannot explain the low employment and output observed in recessions. How should we interpret this evidence? Most economists conclude that the sticky-wage model cannot fully explain aggregate supply.They advocate models in which the labor demand curve shifts over the business cycle.These shifts may arise because firms have sticky prices and cannot sell all they want at those prices; we discuss this possibility later.Alternatively, the labor demand curve may shift because of shocks to technology, which alter labor productivity.The theory we discuss in Chapter 19, called the theory of real business cycles, gives a prominent role to technology shocks as a source of economic fluctuations.2
Worth: Mankiw Economics 5e 352 PART IV Business Cycle Theory: The Economy in the Short Run figure 13-2 Percentage hange in real 4 1972留 1998■ ■1965 996■ a1970 1984m 1982 1993■ 1990■ 1975■ 1979■ 1974■ Percentage change in real GDP The Cyclical Behavior of the Real Wage This scatterplot shows the percentage change in ith the sticky-wage mode, age is somewhat procyclical. This observation is inconsistent direction That is. the real wa Source: U.S. Department of Commerce and U.S. Department of Labor. The Imperfect-Information Model curve is called the imperfect-information model. Unlike the sticky-wage model, this model assumes that markets clear--that is, all wages and prices are free to adjust to balance supply and demand. In this model, the short-run and long-run aggregate supply curves differ because of temporary misperceptions about prices The imperfect-information model assumes that each supplier in the economy produces a single good and consumes many goods. Because the number of goods is so large, suppliers cannot observe all prices at all times. They monitor closely the prices of what they produce but less closely the prices of all the goods they consume. Because of imperfect information, they sometimes confuse changes in he overall level of prices with changes in relative prices. This confusion influ- ences decisions about how much to supply, and it leads to a positive relationship between the price level and output in the short run Consider the decision facing a single supplier- a wheat farmer, for instance. Because the farmer earns income from selling wheat and uses this income to buy pods and services, the amount of wheat she chooses to produce depends on the User JoENA: Job EFFo1429: 6264_ch13: Pg 352: 27759#/eps at 100sl Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 352:27759#/eps at 100% *27759* Mon, Feb 18, 2002 12:56 AM The Imperfect-Information Model The second explanation for the upward slope of the short-run aggregate supply curve is called the imperfect-information model. Unlike the sticky-wage model, this model assumes that markets clear—that is, all wages and prices are free to adjust to balance supply and demand. In this model, the short-run and long-run aggregate supply curves differ because of temporary misperceptions about prices. The imperfect-information model assumes that each supplier in the economy produces a single good and consumes many goods. Because the number of goods is so large, suppliers cannot observe all prices at all times.They monitor closely the prices of what they produce but less closely the prices of all the goods they consume. Because of imperfect information, they sometimes confuse changes in the overall level of prices with changes in relative prices.This confusion influences decisions about how much to supply, and it leads to a positive relationship between the price level and output in the short run. Consider the decision facing a single supplier—a wheat farmer, for instance. Because the farmer earns income from selling wheat and uses this income to buy goods and services, the amount of wheat she chooses to produce depends on the 352 | PART IV Business Cycle Theory: The Economy in the Short Run figure 13-2 Percentage change in real wage Percentage change in real GDP 1982 1975 1993 1992 1960 1996 1999 1997 1998 1979 1970 1980 1991 1974 1990 1984 2000 1972 1965 3 2 10 1 2 3 7 8 4 5 6 4 3 2 1 0 1 2 3 4 5 The Cyclical Behavior of the Real Wage This scatterplot shows the percentage change in real GDP and the percentage change in the real wage (measured here as real private hourly earnings). As output fluctuates, the real wage typically moves in the same direction. That is, the real wage is somewhat procyclical. This observation is inconsistent with the sticky-wage model. Source: U.S. Department of Commerce and U.S. Department of Labor
Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 353 price of wheat relative to the prices of other goods and services in the economy. If the relative price of wheat is high, the farmer is motivated to work hard and produce more wheat, because the reward is great. If the relative price of wheat is low, she prefers to enjoy more leisure and produce less wheat. Unfortunately, when the farmer makes her production decision, she does not know the relative price of wheat. As a wheat producer, she monitors the wheat market closely and always knows the nominal price of wheat. But she does not know the prices of all the other goods in the economy. She must, therefore, esti- mate the relative price of wheat using the nominal price of wheat and her ex- pectation of the overall price level Consider how the farmer responds if all prices in the economy, including the price of wheat, increase. One possibility is that she expected this change in prices.When she observes an increase in the price of wheat, her estimate of its relative price is unchanged. She does not work any harder The other possibility is that the farmer did not expect the price level o Increase (or to increase by this much). When she observes the increase in the price of wheat, she is not sure whether other prices have risen(in which case wheat's relative price is unchanged) or whether only the price of wheat has risen(in which case its rela tive price is higher). The rational inference is that some of each has happened. In other words, the farmer infers from the increase in the nominal price of wheat that its relative price has risen somewhat. She works harder and produces more Our wheat farmer is not unique. When the price level rises unexpectedly, all uppliers in the economy observe increases in the prices of the goods they pro- duce. They all infer, rationally but mistakenly, that the relative prices of the goods hey produce have risen. They work harder and produce more To sum up, the imperfect-information model says that when actual prices ex ceed expected prices, suppliers raise their output. The model implies an aggre- gate supply curve that is now familiar Y=Y Output deviates from the natural rate when the price level deviates from the ex- level The Sticky-Price Model Our third explanation for the upward-sloping short-run aggregate supply curve is called the sticky-price model. This model emphasizes that firms do not in- stantly adjust the prices they charge in response to changes in demand. Some times prices are set by long-term contracts between firms and customers. Even 3 Two economists who have emphasized the role of imperfect information for understanding the short-run effects of monetary policy are the Nobel Prize winners Milton Friedman and Lucas. See Milton Friedman, The Role of Monetary Policy, American Economic Revie 58 1968: 1-17; and Robert E. Lucas, ]r, " Understanding Business Cycles "Stabilization of the and International Economy, vol 5 of Carnegie-Rochester Conference on Public Policy (Amsterdam: North-Holland, 1977) User JoENA: Job EFFo1429: 6264_ch13: Pg 353: 27760#/eps at 100s Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 353:27760#/eps at 100% *27760* Mon, Feb 18, 2002 12:56 AM price of wheat relative to the prices of other goods and services in the economy. If the relative price of wheat is high, the farmer is motivated to work hard and produce more wheat, because the reward is great. If the relative price of wheat is low, she prefers to enjoy more leisure and produce less wheat. Unfortunately, when the farmer makes her production decision, she does not know the relative price of wheat. As a wheat producer, she monitors the wheat market closely and always knows the nominal price of wheat. But she does not know the prices of all the other goods in the economy. She must, therefore, estimate the relative price of wheat using the nominal price of wheat and her expectation of the overall price level. Consider how the farmer responds if all prices in the economy, including the price of wheat, increase. One possibility is that she expected this change in prices.When she observes an increase in the price of wheat, her estimate of its relative price is unchanged. She does not work any harder. The other possibility is that the farmer did not expect the price level to increase (or to increase by this much).When she observes the increase in the price of wheat, she is not sure whether other prices have risen (in which case wheat’s relative price is unchanged) or whether only the price of wheat has risen (in which case its relative price is higher).The rational inference is that some of each has happened. In other words, the farmer infers from the increase in the nominal price of wheat that its relative price has risen somewhat. She works harder and produces more. Our wheat farmer is not unique.When the price level rises unexpectedly, all suppliers in the economy observe increases in the prices of the goods they produce.They all infer, rationally but mistakenly, that the relative prices of the goods they produce have risen.They work harder and produce more. To sum up, the imperfect-information model says that when actual prices exceed expected prices, suppliers raise their output.The model implies an aggregate supply curve that is now familiar: Y =Y − + a(P − Pe ). Output deviates from the natural rate when the price level deviates from the expected price level.3 The Sticky-Price Model Our third explanation for the upward-sloping short-run aggregate supply curve is called the sticky-price model.This model emphasizes that firms do not instantly adjust the prices they charge in response to changes in demand. Sometimes prices are set by long-term contracts between firms and customers. Even CHAPTER 13 Aggregate Supply | 353 3 Two economists who have emphasized the role of imperfect information for understanding the short-run effects of monetary policy are the Nobel Prize winners Milton Friedman and Robert Lucas. See Milton Friedman,“The Role of Monetary Policy,’’American Economic Review 58 (March 1968): 1–17; and Robert E. Lucas, Jr.,“Understanding Business Cycles,’’ Stabilization of the Domestic and International Economy, vol. 5 of Carnegie-Rochester Conference on Public Policy (Amsterdam: North-Holland, 1977)
Worth: Mankiw Economics 5e 354 PART IV Business Cycle Theory: The Economy in the Short Run without formal agreements, firms may hold prices steady in order not to annoy heir regular customers with frequent price changes. Some prices are sticky be cause of the way markets are structured: once a firm has printed and distributed its catalog or price list, it is costly to alter prices. To see how sticky prices can help explain an upward-sloping aggregate supply urve, we first consider the pricing decisions of individual firms and then add to- gether the decisions of many firms to explain the behavior of the economy as a whole. Notice that this model encourages us to depart from the assumption of perfect competition, which we have used since Chapter 3. Perfectly competitive firms are price takers rather than price setters. If we want to consider how firms set prices, it is natural to assume that these firms have at least some monopoly control over the prices they charge. Consider the pricing decision facing a typical firm. The firms desired price p depends on two macroeconomic variables The overall level of prices P. A higher price level implies that the firms costs are higher. Hence, the higher the overall price level, the more the firm would like to charge for its product. The level of aggregate income Y. A higher level of income raises the de- mand for the firms product. Because marginal cost increases at higher levels f production, the greater the demand, the higher the firms desired price We write the firm's desired price as p=P+a(r-r This equation says that the desired price p depends on the overall level of prices P and on the level of aggregate output relative to the natural rate Y-Y. The pa- rameter a(which is greater than zero) measures how much the firms desired price responds to the level of aggregate output low assume that there are two types of firms. Some have flexible prices: they always set their prices according to this equation. Others have sticky prices: they announce their prices in advance based on what they expect economic condi- tions to be. Firms with sticky prices set prices according to pe +a(y-y where, as before, a superscript"e"represents the expected value of a variable. For simplicity, assume that these firms expect output to be at its natural rate, so that he last term, a(r-y), is zero. Then these firms set the price That is, firms with sticky prices set their prices based on what they expect othe firms to chars 4 Mathematical note: The firm cares most about its relative price, which is the ratio of its nominal price level, then this equation states that the desired relative price depends on the deviation of out- User JoENA: Job EFFo1429: 6264_ch13: Pg 354: 27761#/eps at 100s Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 354:27761#/eps at 100% *27761* Mon, Feb 18, 2002 12:56 AM without formal agreements, firms may hold prices steady in order not to annoy their regular customers with frequent price changes. Some prices are sticky because of the way markets are structured: once a firm has printed and distributed its catalog or price list, it is costly to alter prices. To see how sticky prices can help explain an upward-sloping aggregate supply curve, we first consider the pricing decisions of individual firms and then add together the decisions of many firms to explain the behavior of the economy as a whole. Notice that this model encourages us to depart from the assumption of perfect competition, which we have used since Chapter 3. Perfectly competitive firms are price takers rather than price setters. If we want to consider how firms set prices, it is natural to assume that these firms have at least some monopoly control over the prices they charge. Consider the pricing decision facing a typical firm.The firm’s desired price p depends on two macroeconomic variables: ➤ The overall level of prices P. A higher price level implies that the firm’s costs are higher. Hence, the higher the overall price level, the more the firm would like to charge for its product. ➤ The level of aggregate income Y. A higher level of income raises the demand for the firm’s product. Because marginal cost increases at higher levels of production, the greater the demand, the higher the firm’s desired price. We write the firm’s desired price as p = P + a(Y −Y −). This equation says that the desired price p depends on the overall level of prices P and on the level of aggregate output relative to the natural rate Y −Y −.The parameter a (which is greater than zero) measures how much the firm’s desired price responds to the level of aggregate output.4 Now assume that there are two types of firms. Some have flexible prices: they always set their prices according to this equation. Others have sticky prices: they announce their prices in advance based on what they expect economic conditions to be. Firms with sticky prices set prices according to p = Pe + a(Ye −Y −e ), where, as before, a superscript “e’’ represents the expected value of a variable. For simplicity, assume that these firms expect output to be at its natural rate, so that the last term, a(Ye −Y −e ), is zero.Then these firms set the price p = Pe . That is, firms with sticky prices set their prices based on what they expect other firms to charge. 354 | PART IV Business Cycle Theory: The Economy in the Short Run 4 Mathematical note: The firm cares most about its relative price, which is the ratio of its nominal price to the overall price level. If we interpret p and P as the logarithms of the firm’s price and the price level, then this equation states that the desired relative price depends on the deviation of output from the natural rate
Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 355 We can use the pricing rules of the two groups of firms to derive the aggre gate supply equation. To do this, we find the overall price level in the economy which is the weighted average of the prices set by the two groups. If s is the frac tion of firms with sticky prices and 1-s the fraction with fexible prices, then the overall price level is P (1-s[P+a(Y-Y) The first term is the price of the sticky-price firms weighted by their fraction in the economy, and the second term is the price of the fexible-price firms weighted by their fraction. Now subtract(1-s)P from both sides of this equation to obtain :p=sp +(1 -sla(y-Y)I Divide both sides by s to solve for the overall price level: P=PC+[(1-s)a/(Y-Y) The two terms in this equation are explained as follows: When firms expect a high price level, they expect high costs. Those firms that fix prices in advance set their prices high. These high prices cause the other firms to set high prices also. Hence, a high expected price level P leads to a high actual price level P. When output is high, the demand for goods is high. Those firms with fexible prices set their prices high, which leads to a high price level.The effect of output on the price level depends on the proportion of firms with fexible prices. Hence, the overall price level depends on the expected price level and on the level of output. Algebraic rearrangement puts this aggregate pricing equation into a more fa lilian form: Y=Y+a( where a= s/(1-s)a. Like the other models, the sticky-price model says that the deviation of output from the natural rate is positively associated with the de- viation of the price level from the expected price level Although the sticky-price model emphasizes the goods market, consider briefly what is happening in the labor market. If a firms price is stuck in the short run, then a reduction in aggregate demand reduces the amount that the firm is able to sell. The firm responds to the drop in sales by reducing its produc- tion and its demand for labor. Note the contrast to the sticky-wage model: the firm here does not move along a fixed labor demand curve. Instead, fluctuations in output are associated with shifts in the labor demand curve.Because ofthese in the same directon. Thus, the real wage can be procyclical wage can all move shifts in labor demand, employment, production, and the real For a more advanced development of the sticky-price model, see Julio Rotemberg, "Monopolis- tic Price Adjustment and Aggregate Output, "Review of Economic Studies 49(1982): 517-53 User JoENA: Job EFFo1429: 6264_ch13: Pg 355: 27762#/eps at 100s Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 355:27762#/eps at 100% *27762* Mon, Feb 18, 2002 12:56 AM We can use the pricing rules of the two groups of firms to derive the aggregate supply equation.To do this, we find the overall price level in the economy, which is the weighted average of the prices set by the two groups. If s is the fraction of firms with sticky prices and 1 − s the fraction with flexible prices, then the overall price level is P = sPe + (1 − s)[P + a(Y −Y −)]. The first term is the price of the sticky-price firms weighted by their fraction in the economy, and the second term is the price of the flexible-price firms weighted by their fraction. Now subtract (1 − s)P from both sides of this equation to obtain sP = sPe + (1 − s)[a(Y −Y −)]. Divide both sides by s to solve for the overall price level: P = Pe + [(1 − s)a/s](Y −Y −)]. The two terms in this equation are explained as follows: ➤ When firms expect a high price level, they expect high costs.Those firms that fix prices in advance set their prices high.These high prices cause the other firms to set high prices also. Hence, a high expected price level Pe leads to a high actual price level P. ➤ When output is high, the demand for goods is high.Those firms with flexible prices set their prices high, which leads to a high price level.The effect of output on the price level depends on the proportion of firms with flexible prices. Hence, the overall price level depends on the expected price level and on the level of output. Algebraic rearrangement puts this aggregate pricing equation into a more familiar form: Y =Y − + a(P − Pe ), where a = s/[(1 − s)a]. Like the other models, the sticky-price model says that the deviation of output from the natural rate is positively associated with the deviation of the price level from the expected price level. Although the sticky-price model emphasizes the goods market, consider briefly what is happening in the labor market. If a firm’s price is stuck in the short run, then a reduction in aggregate demand reduces the amount that the firm is able to sell.The firm responds to the drop in sales by reducing its production and its demand for labor. Note the contrast to the sticky-wage model: the firm here does not move along a fixed labor demand curve. Instead, fluctuations in output are associated with shifts in the labor demand curve. Because of these shifts in labor demand, employment, production, and the real wage can all move in the same direction.Thus, the real wage can be procyclical.5 CHAPTER 13 Aggregate Supply | 355 5 For a more advanced development of the sticky-price model, see Julio Rotemberg,“Monopolistic Price Adjustment and Aggregate Output,’’Review of Economic Studies 49 (1982): 517–531
Worth: Mankiw Economics 5e 356 PART IV Business Cycle Theory: The Economy in the Short Run International Differences in the Aggregate Supply Curve Although all countries experience economic fluctuations, these fluctuations are not exactly the same everywhere. International differences are intriguing puzzles in themselves, and they often provide a way to test alternative economic theories Examining international differences has been especially fruitful in research on aggregate supply When economist Robert Lucas proposed the imperfect-information model, he derived a surprising interaction between aggregate demand and aggregate supply: according to his model, the slope of the aggregate supply curve should depend on the volatility of aggregate demand. In countries where aggregate demand fluctuates widely, the aggregate price level fluctuates widely as well. Because most movements in prices in these countries do not represent movements in relative prices, suppliers should have learned not to respond much to unexpected changes in the price level Therefore, the aggregate supply curve should be relatively steep(that is, a will be small). Conversely, in countries where aggregate demand is relatively stable, suppliers should have learned that most price changes are relative price changes. Accordingly in these countries, suppliers should be more responsive to unexpected price changes, making the aggregate supply curve relatively fat(that is, a will be large Lucas tested this prediction by examining international data on output and prices. He found that changes in aggregate demand have the biggest effect on output in those countries where aggregate demand and prices are most stable Lucas concluded that the e evidence supports the imperfect-information model The sticky-price model also makes predictions about the slope of the short- run aggregate supply curve. In particular, it predicts that the average rate of infla tion should influence the slope of the short-run aggregate supply curve. When the average rate of inflation is high, it is very costly for firms to keep prices fixed for long intervals. Thus, firms adjust prices more frequently. More frequent price adjustment in turn allows the overall price level to respond more quickly to shocks to aggregate demand. Hence, a high rate of infation should make the short-run aggregate supply curve steeper. International data support this prediction of the sticky-price model. In coun- tries with low average inflation, the short-run aggregate supply curve is relatively fat: fluctuations in aggregate demand have large effects on output and are slowly reflected in prices. High-inflation countries have steep short-run aggregate sup- ply curves. In other words, high inflation appears to erode the frictions that cause to be stick Note that the sticky-price model can also explain Lucas's finding that coun- tries with variable aggregate demand have steep aggregate supply curves. If the price level is highly variable, few firms will commit to prices in advance (s will be small). Hence, the aggregate supply curve will be steep(a will be small bRobert E. Lucas, Jr, "Some International Evidence on Output-Inflation Tradeoffs, "American Eco- 7Laurence Ball, N. Gregory Mankiw, and David Romer, "The New Key Economics and the Output-Inflation Tradeoff, " Brookings Papers on Economic Activity(1988: 1 ) 1-6 User JoENA: Job EFFo1429: 6264_ch13: Pg 356: 27763#/eps at 100sl l Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 356:27763#/eps at 100% *27763* Mon, Feb 18, 2002 12:56 AM 356 | PART IV Business Cycle Theory: The Economy in the Short Run CASE STUDY International Differences in the Aggregate Supply Curve Although all countries experience economic fluctuations, these fluctuations are not exactly the same everywhere. International differences are intriguing puzzles in themselves, and they often provide a way to test alternative economic theories. Examining international differences has been especially fruitful in research on aggregate supply. When economist Robert Lucas proposed the imperfect-information model, he derived a surprising interaction between aggregate demand and aggregate supply: according to his model, the slope of the aggregate supply curve should depend on the volatility of aggregate demand. In countries where aggregate demand fluctuates widely, the aggregate price level fluctuates widely as well. Because most movements in prices in these countries do not represent movements in relative prices, suppliers should have learned not to respond much to unexpected changes in the price level. Therefore, the aggregate supply curve should be relatively steep (that is, a will be small).Conversely,in countries where aggregate demand is relatively stable,suppliers should have learned that most price changes are relative price changes.Accordingly, in these countries, suppliers should be more responsive to unexpected price changes, making the aggregate supply curve relatively flat (that is,a will be large). Lucas tested this prediction by examining international data on output and prices. He found that changes in aggregate demand have the biggest effect on output in those countries where aggregate demand and prices are most stable. Lucas concluded that the evidence supports the imperfect-information model.6 The sticky-price model also makes predictions about the slope of the shortrun aggregate supply curve. In particular, it predicts that the average rate of inflation should influence the slope of the short-run aggregate supply curve.When the average rate of inflation is high, it is very costly for firms to keep prices fixed for long intervals.Thus, firms adjust prices more frequently. More frequent price adjustment in turn allows the overall price level to respond more quickly to shocks to aggregate demand. Hence, a high rate of inflation should make the short-run aggregate supply curve steeper. International data support this prediction of the sticky-price model. In countries with low average inflation, the short-run aggregate supply curve is relatively flat: fluctuations in aggregate demand have large effects on output and are slowly reflected in prices. High-inflation countries have steep short-run aggregate supply curves. In other words, high inflation appears to erode the frictions that cause prices to be sticky.7 Note that the sticky-price model can also explain Lucas’s finding that countries with variable aggregate demand have steep aggregate supply curves. If the price level is highly variable, few firms will commit to prices in advance (s will be small). Hence, the aggregate supply curve will be steep (a will be small). 6 Robert E. Lucas, Jr.,“Some International Evidence on Output-Inflation Tradeoffs,’’American Economic Review 63 ( June 1973): 326–334. 7 Laurence Ball, N. Gregory Mankiw, and David Romer,“The New Keynesian Economics and the Output-Inflation Tradeoff,’’ Brookings Papers on Economic Activity (1988:1): 1–65
