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,Feb18,200212:56User 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 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 inflation 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 flat: 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 prices to be sticky.7 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). 6 Robert E. Lucas, Jr.,“Some International Evidence on Output-Inflation Tradeoffs,’’American Eco￾nomic 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