Macroeconomics II. Explaining AS - Sticky Wage Model, Lucas Model, Sticky Price Model, Phillips Curve

Transcription

1 Macroeconomics II Explaining AS - Sticky Wage Model, Lucas Model, Sticky Price Model, Phillips Curve Vahagn Jerbashian Ch. 13 from Mankiw (2010, 2003) Spring 2018

2 Where we are and where we are heading to Macroeconomics I discusses the IS-LM Model which characterizes the Aggregate Demand curve We will discuss now in detail 3 theories which offer characterizations for the Aggregate Supply curve, in short/medium run: Sticky Wage Model; Lucas Model, and Sticky Price Model

3 Aggregate Demand curve The Aggregate Demand curve Y (P) is given by two equations Y = C (Y T ) + I (r) + G M = L (Y, r) P Unknowns in these equations are interest rate r and Aggregate Demand Y (P) Aggregate Demand curve is downward sloping since higher P implies lower real money balances To solve for Y and P another equation is needed: Aggregate Supply curve

4 Theories for SRAS and Phillips Curve Till now an extreme assumption was usually maintained: all prices are fixed We relax that assumption and obtain upward sloping supply curve in short-run There are competing explanations for that relation and we will go through 3 of them The positive relation between SRAS and price levels will imply short run trade-off between inflation and output (and employment) Phillips Curve summarizes this relation: P ( Inflation ) SRAS E U

5 SRAS and LRAS Consider a more realistic case, in between the two extreme assumptions we considered before

6 Three theories for SRAS The following theories disagree on the causes of positive relation between SRAS and P Sticky Wage Model; Lucas (or Imperfect Information) Model; and Sticky Price Model however, the implication of these theories is approximately the same, i.e.,

7 Sticky Wage Model for SRAS Assumptions Ex ante, the price level is not observable. The employment contracts are signed prior to learning the price level, i.e., Implications the employees agree to work at expected nominal wage W = ϖp e, where ϖ is a target real wage. Real wage W /P decreases when the realized price P is higher than the expected price P e When W /P firms hire more workers U and Y In simplest case Y = Ȳ + α(p P e ) Real wage is counter cyclical (i.e., W /P Y ), which is not confirmed in data

8 Lucas (Imperfect Information) Model for SRAS Assumptions Supply of each good depends on its relative price: the nominal price of the good p divided by the overall price level P Supplier doesn t know overall price level P at the time s/he makes the production decision y, so s/he uses the expected price level, P e Implications Supplier estimates the relative price with p/p e Suppose all prices P,if s/he 1. did not expect that P e = const p y 2. expected that P e p = const y = const If in the economy there are suppliers which follow 1 P Y.In the simplest case Y = Ȳ + α(p P e )

9 Sticky Price Model for SRAS Assumptions Firms set prices (imperfect competition). Firm s desired price is p = P + a (Y Ȳ ), where a > 0. There are two types of firms 1. s percent of firms have flexible prices and set the prices according to p = P + a (Y Ȳ ) 2. 1 s percent of firms have sticky prices and set the prices before they know how P and Y will turn out These firms set their prices according to their expectations: p = P e + a (Y e Ȳ ). These firms expect the output to be at the natural level, i.e., Y e = Ȳ p = P e.

10 Sticky Price Model for SRAS - Implications In order to derive the SRAS, derive the overall price level P = sp + (1 s) p = s [P + a (Y Ȳ )] + (1 s) P e P = P e s + a 1 s (Y Ȳ ) Y = Ȳ s (P P e ) a s If firms expect high prices they ll set high prices, which will confirm their expectations (self fulfilling prophecy) If demand firms with sticky prices increase the production pay higher wages s we get closer to long run implications since prices become more flexible

11 Theories for SRAS - Summary and implications Suppose a positive AD shock moves output above its natural rate and P above the level people had expected (point B) Over time, P e rises, SRAS shifts up, and output returns to its natural rate.(point C)

12 Phillips Curve - the trade-off between output and inflation

13 Derivations of Phillips Curve SRAS : Y = Ȳ + α (P P e ) P = P e + 1 α (Y Ȳ ) Assume supply shocks υ which change the prices (e.g., oil price shock) - υ is called cost push shock - P = P e + 1 α (Y Ȳ ) + υ

14 Derivations of Phillips Curve - Output Let the prices be in logarithms and subtract from both sides the last periods prices P P 1 = P e P α (Y Ȳ ) + υ π = π e + 1 (Y Ȳ ) + υ : Phillips Curve with output α

15 Derivations of Phillips Curve - Unemployment Use Okun s law 1 (Y Ȳ ) = β (u ū), β > 0 α where u is the unemployment rate and ū is it s natural level π = π e β (u ū) + υ : Phillips Curve with unemployment

16 Phillips Curve and SRAS Phillips Curve and SRAS represent essentially the same relationships Both show a link between real and nominal variables that causes the classical dichotomy (the theoretical separation of real and nominal variables) to break down in the short run SRAS curve is more convenient when studying output and the price level Phillips Curve is more convenient when studying unemployment and inflation

17 Phillips Curve - NAIRU To make the Phillips Curve more useful, we need to say what determines expected inflation Lets assume that people form their expectations of inflation based on recently observed inflation π e = π 1 This assumption is called adaptive expectations π = π 1 β (u ū) + υ When the Phillips curve is written in this form, it is sometimes called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU

18 Phillips Curve - NAIRU The term π 1 in π = π 1 β (u ū) + υ implies that inflation has inertia - it keeps going until something acts to stop it In the model of AD/AS, inflation inertia is represented as persistent upward shifts in AS and AD curves AS: If prices are rising quickly people would expect them to continue rising quickly since SRAS depends on the expected price level it will shift upwards AD: AD must also shift upward to confirm the expectations of inflation - Most often, the continued rise in AD is due to persistent growth in the money supply

19 Phillips Curve - NAIRU Because the position of the SRAS will shift upward overtime, it will continue to shift upward until something changes inflation expectations e.g., if the CB suddenly reduces money growth, AD would stabilize, and the upward shift in AS would cause a recession The high unemployment in the recession would reduce inflation and expected inflation, causing inflation inertia to subside

20 2 causes of rising and falling inflation In π = π 1 β (u ū) + υ the 2nd term shows that cyclical unemployment (u ū) exerts pressure on inflation Low u ū pulls the inflation rate up This is called demand-pull inflation because high aggregate demand is responsible for this type of inflation High u ū pulls the inflation rate down The parameter β measures how responsive inflation is to cyclical unemployment

21 2 causes of rising and falling inflation In π = π 1 β (u ū) + υ the 3rd term shows that inflation also rises and falls because of supply shocks υ An adverse supply shock, such as the rise in world oil prices in the 1970s, implies a positive υ and causes inflation to rise This is called cost-push inflation because adverse supply shocks are typically events that push up the costs of production A beneficial supply shock, such as the oil glut that led to a fall in oil prices in the 1980s, makes υ negative and causes inflation to fall

22 The trade-off between inflation and unemployment At any point in time, a policymaker who controls AD can choose a combination of π and u on this short-run Phillips Curve e.g., the policymaker can expand AD to lower u and raise π or can depress AD to raise u and lower π

23 The trade-off between inflation and unemployment Because people adjust their expectations of inflation over time, the (current) trade-off between π and u holds only in the short-run The policymaker cannot keep π > π e (and thus u < ū) forever Eventually, π e adapts to whatever π the policymaker has chosen In the long-run, the classical dichotomy holds (u = ū) and there is no trade-off between π and u

24 RE and the possibility of painless disinflation Rational expectations (RE) make the assumption that people optimally use all the available information about current government policies, to forecast the future Therefore, a change in government policy will change expectations, and an evaluation of any policy change must incorporate this effect on expectations If people do form their expectations rationally, then inflation may have less inertia than it first appears

25 RE and the possibility of painless disinflation Proponents of rational expectations argue that the short-run Phillips curve does not accurately represent the options that policymakers have They believe that if policy makers are credibly committed to reducing inflation, rational people will understand that and lower their expectations of inflation Inflation can then come down without a rise in unemployment and fall in output

26 Natural-Rate Hypothesis Our entire discussion has been based on the natural rate hypothesis, which is summarized in the following statement: Fluctuations in AD affect Y and 1 u only in the short-run. In the long-run, the economy returns to the levels of Y and 1 u described by the classical model

27 Hysteresis and the challenge to the Natural-Rate Hypothesis Recently, several economists have challenged this hypothesis They have pointed out a number of mechanisms through which recessions might leave long-run effect on the economy by altering the natural rate of unemployment, e.g., during long unemployment workers might lose valuable job skills which can lower their ability to find a job even after the recession ends; alternatively, long unemployment may change an individual s attitude toward work and reduce his/her desire to find job Hysteresis is the term used to describe the long-lasting influence of history on the natural rate (history dependence)