Aggregate Supply. Sherif Khalifa. Sherif Khalifa () Aggregate Supply 1 / 16

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1 Sherif Khalifa Sherif Khalifa () 1 / 16

2 Firms do not instantly adjust the prices they charge in response to changes in demand. Prices are sometimes set by long term contracts between firms and customers. Firms hold prices steady to avoid annoying their customers with frequent prices changes. Once a firm has printed its catalogs and price lists, it is costly to alter prices. Firms base their prices on the costs of production, and wages evolve slowly over time. Sherif Khalifa () 2 / 16

3 Y : output Y : natural rate of output P: price level EP: expected price level The firms that adjust prices instantaneously p = P + a ( Y Y ) The firms that do not adjust prices in the short run p = EP + a ( EY EY ) p = EP Sherif Khalifa () 3 / 16

4 P = sep + (1 s) [ P + a ( Y Y )] P (1 s) P = sep + (1 s) [ P + a ( Y Y )] (1 s) P sp = sep + (1 s) [ a ( Y Y )] [ ] (1 s) a (Y ) P = EP + Y s P = EP + 1 ( ) Y Y α α (P EP) = ( Y Y ) Output deviates from its natural level when the price level deviates from the expected price level. The parameter α indicates how much output responds to unexpected changes in the price level. Sherif Khalifa () 4 / 16

5 P LRAS SRAS P 2 >EP P 1 =EP P 2 <EP Y 2 <Y 1 Y=Y 1 Y 2 >Y 1 Y Sherif Khalifa () 5 / 16

6 Definition The Phillips curve is a curve that shows the short run trade off between inflation and unemployment. Two closely watched indicators of economic performance are inflation and unemployment. Policy makers set their policies towards low inflation rates and low and unemployment rates. Economists reached the conclusion that the two objectives cannot be achieved simultaneously in the short run. If policymakers expand AD and move the economy up along the SRAS curve, they expand output and lower unemployment at the cost of higher inflation. If policymakers contract AD and move the economy down along the SRAS curve, they lower inflation at the cost of lower output and higher unemployment. Sherif Khalifa () 6 / 16

7 ( ) 1 (Y ) P = EP + Y α ( ) 1 (Y ) P = EP + Y + υ α ( ) 1 (Y ) (P P 1 ) = (EP P 1 ) + Y + υ α ( ) 1 (Y ) π = E π + Y + υ α ( ) 1 (Y ) Y = β (u u n ) α π = E π β (u u n ) + υ Inflation = Expected Inflation β (Cyclical Unemployment) + Supply Shock Sherif Khalifa () 7 / 16

8 The Phillips curve is the negative relationship between the unemployment rate and the inflation rate. High rates of growth in aggregate demand stimulate output and hence lower the unemployment rate. Such high rates of growth in demand also cause an increase in the inflation rate. Thus, the Phillips curve postulates a trade-off between inflation and unemployment. Lower rates of unemployment can be achieved but only at the expense of higher inflation rates. Sherif Khalifa () 8 / 16

9 Inflation Rate SRPC Unemployment Rate Sherif Khalifa () 9 / 16

10 Monetary growth does not influence the factors that determine the economy s unemployment rate. Long run unemployment is determined by power of unions, minimum wages, effi ciency wages, and job search. Regardless of the monetary policy pursued by the central bank, output and unemployment are at their natural rates in the long run. There is no long run trade off between inflation and unemployment. Sherif Khalifa () 10 / 16

11 Inflation Rate LRPC High Inflation Low Inflation Natural Rate of Unemployment Unemployment Rate Sherif Khalifa () 11 / 16

12 Inflation Rate LRPC U N SRPC Unemployment Rate Sherif Khalifa () 12 / 16

13 P LRAS 1 SRAS Π LRPC 1 1 A B B A C C AD 2 AD 3 AD 1 SRPC 1 Y N Y U N U Sherif Khalifa () 13 / 16

14 P LRAS 1 SRAS 2 SRAS 1 Π LRPC 1 D SRAS 3 D A A E SRPC 2 E AD 1 SRPC 3 SRPC 1 Y N Y U N U Sherif Khalifa () 14 / 16

15 P LRAS 1 SRAS Π LRPC 1 1 SRAS 2 B A A B C C SRPC 1 AD 2 AD 1 SRPC 2 YN Y U N U Sherif Khalifa () 15 / 16

16 Definition The sacrifice ratio is the number of percentage points of annual output lost in the process of decreasing inflation by 1 percentage point. Sacrifice ratio = % Y % π Sherif Khalifa () 16 / 16