Macroeconomics

Lecture 34
 Review of the Previous
Lecture
• Interest Rate Differentials
– South East Asian Crisis
• Mundell Fleming and the AD Curve
 Topics Under Discussion
• Three Models of Aggregate Supply
 The sticky-wage model
 The imperfect-information model
 The sticky-price model
Three models of aggregate
supply
1. The sticky-wage model
2. The imperfect-information model
3. The sticky-price model
All three models imply:

Y  Y   (P  P ) e

agg. the expected

output price level
a positive
natural rate parameter the actual
of output price level
 The sticky-wage model
• Assumes that firms and workers negotiate
contracts and fix the nominal wage before they
know what the price level will turn out to be.
• The nominal wage, W, they set is the product of a
target real wage, , and the expected price level:

W  ω P e
W Pe
 ω
P P
 The sticky-wage model
W Pe
ω
P P
If it turns out that then
P P e unemployment and output are at
their natural rates

P P e Real wage is less than its target,

so firms hire more workers and
output rises above its natural rate
P P e Real wage exceeds its target, so
firms hire fewer workers and
output falls below its natural rate
 (a) Labor Demand (b) Production Function
Real wage, Income, output,Y
W/P
W/P 1 Y = F (L)
Y2
W/P 2
Y1
L = Ld( W/P )

4. . . . output,. .
L1 L2 Labor,L L1 L2 Labor,L
2. .. . reduces
the real wage 3. . . .which raises
for a given
employment, ..
nominal wage, ..
(c) Aggregate Supply
Price level,P
Y= Y + a ( P - P e )

P2
6. The aggregate
P1 supply curve
summarizes
these changes.
1. An increase
in the price Y1 Y2 Income, output,Y
level. .
5. . . . and income.
 The sticky-wage model
• Implies that the real wage should be counter-
cyclical , it should move in the opposite
direction as output over the course of
business cycles:
– In booms, when P typically rises, the real
wage should fall.
– In recessions, when P typically falls, the real
wage should rise.
• This prediction does not come true in the real
world:
 The cyclical behavior of the
Percentage
real wage
change in real 4 1972
wage
3
1998
1965
2
1960 1997
1999
1
1996 2000
1970 1984
0
1982 1993
1991 1992
-1
1990
-2 1975

-3 1979
1974

-4
1980
-5
-3 -2 -1 0 1 2 3 4 5 6 7 8
Percentage change in real GDP
The imperfect-information
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
 The imperfect-information
model
• Supply of each good depends on its relative
price: the nominal price of the good divided by
the overall price level. Supplier doesn’t know
price level at the time she makes her production
e
decision, so uses the expected price level, P .
• Suppose P rises but P e does not.
Then supplier thinks her relative price has risen,
so she produces more. With many producers
thinking this way, Y will rise whenever P rises
e
above P .
 The sticky-price model
• Reasons for sticky prices:
– long-term contracts between firms and
customers
– menu costs
– firms do not wish to annoy customers with
frequent price changes
• Assumption:
– Firms set their own prices
(e.g. as in monopolistic competition)
The sticky-price model
• An individual firm’s desired price is
p  P  a (Y Y )
where a > 0.
Suppose two types of firms:
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
before they know how P and Y will turn out:

p  P e  a (Y e Y e )
 The sticky-price model
p  P e  a (Y e Y e )
• Assume firms w/ sticky prices expect that output
will equal its natural rate. Then,
e
p P
• To derive the aggregate supply curve, we first find
an expression for the overall price level.
• Let s denote the fraction of firms with sticky prices.
Then, we can write the overall price level as
 The sticky-price model
P  s P e  (1  s )[P  a(Y Y )]

price set by sticky price set by flexible

price firms price firms

• Subtract (1s )P from both sides:

sP  s P e  (1  s )[a(Y Y )]
• Divide both sides by s :
 (1  s ) a 
P  P e
  (Y  Y )
 s 
 The sticky-price model
e  (1  s ) a 
e P  P    (Y  Y )
• High P  High P  s 
If firms expect high prices, then firms who must set
prices in advance will set them high. Other firms
respond by setting high prices.
• High Y  High P
When income is high, the demand for goods is high.
Firms with flexible prices set high prices. The greater
the fraction of flexible price firms, the smaller is s
and the bigger is the effect of Y on P.
 The sticky-price model
e  (1  s ) a 
P  P    (Y  Y )
 s 

• Finally, derive AS equation by solving for Y :

Y  Y   (P  P e ),

s
where  
(1  s )a
 The sticky-price model
In contrast to the sticky-wage model, the sticky-
price model implies a procyclical real wage:
Suppose aggregate output/income falls. Then,
 Firms see a fall in demand for their products.
 Firms with sticky prices reduce production, and
hence reduce their demand for labor.
 The leftward shift in labor demand causes the
real wage to fall.
 Summary
• Three Models of Aggregate Supply
 The sticky-wage model
 The imperfect-information model
 The sticky-price model
 Upcoming Topics
• Inflation, Unemployment and the Philips
Curve
– Causes of Inflation
– Sacrifice Ratio
– Rational Expectations
• Natural Rate Hypothesis