AS and Phillips curve

Lecture 4

Mentor: Pham Xuan Truong

(truongpx@ftu.edu.vn)
Content
I Four models of aggregate supply
II Phillips curve
 Model Background
 Most economists analyze short-run fluctuations in aggregate
income and the price level using the AD/AS model.
 Earlier we introduced long-run AS as a vertical line which
implied perfect flexibility for prices.
 Our short-run AS curve was perfectly horizontal which implied
perfect rigidity for prices.
 Now to better reflect the real world in which some prices are
sticky and others are not. we will propose theories for a positively
sloped AS curve. This implies a tradeoff between inflation and
unemployment.
 All three models adhere to the following functional form of
aggregate supply. Y  Y   ( P  P )
e

where α>0, Y is output, Y is the natural rate of output, P is the

price level, and Pe is the expected price level.

 Model Background
This equation states that output deviates from its
natural rate when the price level deviates from the
expected price level. α indicates how much output
responds to unexpected changes in P and 1/α is the
slope of the AS curve.
Y  Y   (P  Pe )

• Although each of the three theories adheres to the

given functional form, each highlights a different
reason why unexpected movements in the price level
are associated with fluctuations in aggregate output.
I Four models of aggregate supply

(1) The sticky wage model

(2) The worker - misperception model
(3) The imperfect information model
(4) The sticky price model

(1) (2) Focus on labor market; (3) (4) Focus on goods

market
(1) (2) (3) From P change to Y change; (4) From Y change to
P change
(1) (4) price and wage are sticky; (2) (3)price and wage are
flexible
 (1) The Sticky Wage Model
 Many economists believe When the nominal wage is W/P

stuck, a rise in P from P0 to

that nominal wages are sticky
P1 lowers the real wage,
in the short run.
making labour cheaper.
W/P0
The lower real wage
induces firms to hire W/P1 DL
more labour.

L0 L1 L
The positive relationship
P between P and Y means n al Y
AS slopes upward. i tio ed
a dd hir ore
h e ur s m
T ab o ce t .
l du tpu Y1
o Y=F(L)
P1
pr ou
Y  Y   ( P  Pe ) Y0
P0

Y L0 L1 L
Y0 Y1
(1) The Sticky Wage Model
The downfall of the sticky wage model is that it
predicts a countercyclical relationship between the
real wage and output. Actual data suggests a
procyclical relationship, meaning that nominal wage
is not rigid as the model predicts
(2) The worker - misperception model
Unlike the sticky-wage model, this model developed by
Milton Friedman (1968) assumes that markets clear—
that is, all wages and prices are free to adjust to balance
supply and demand.
Additionally, the model presumes workers cannot
perceive correctly about the price and firms have no
accurate information about price
→ labor supply is based on actual real wage, labor
demand is based on expected real wage
(2) The worker - misperception model
+ If P > Pe → workers believe that nominal wage will be
adjusted quickly so that actual real wage can be higher
than expected real wage → labor supply increases
+ If P < Pe → workers believe that nominal wage will be
adjusted quickly so that actual real wage can be lower
than expected real wage → labor supply decreases
 (3) The imperfect information model
 Like worker – misperception model, all wages and prices are free
to adjust to balance supply and demand. In the model developed
by R.Lucas (1970), 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 the prices of their own goods
but not the prices of all goods they consume. Due to imperfect
information, they sometimes confuse changes in the overall price
level 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.
(3) The imperfect information model
(3) The imperfect information model
(4) The sticky price model
This model explains an upward sloping AS curve by
assuming that some prices are sticky because
1. firms have long term contracts with customers,
2. firms hold prices steady in order not to annoy
regular customers with frequent price changes,
and
3. for firms who have printed and distributed a
catalog or price list it is too costly to alter
prices.
(4) The sticky price model
(4) The sticky price model
(4) The sticky price model
 (4) The sticky price model
P  P e  [(1  s )a / s ](Y  Y )
So 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.
→ So, the overall price level depends on the expected
price level and on the level of output.
 (4) The sticky price model
Compare aggregate supply function of sticky price
  
model with traditional aggregate supply function )
Y Y ( P  P e

we have  s /[(1  s)a]

Implication
+ AS curve is steeper as more flexible price setting firm
(smaller s); AS curve is flatter as more fixed price
setting firm (larger s)
+ If there is no sticky price firm (s = 0) Y is always
equal to (AS is vertical curve). If there is no flexible
price firm (s = 1), P is always equal to (AS is
horizontal curve)
II Phillips curve
What is Phillips curve?
Phillips curve implies the relationship between unemployment
rate and inflation rate. The Phillips curve shows the trade-off
facing policy makers in terms of unemployment and inflation.

The Phillips curve in its modern form states that the inflation
rate depends on three forces:
1) Expected inflation
2) The deviation of unemployment from the natural rate, called
cyclical unemployment
3) Supply shocks
     (u  u )  v
e n
II Phillips curve
Building Phillips curve

→Phillips curve and the short run aggregate supply curve essentially
represent the same economic ideas.
II Phillips curve
Adaptive expectation and inflation inertia
II Phillips curve
Adaptive expectation and inflation inertia
 II Phillips curve
Two causes of raising and falling inflation

   1   (u  u n )  v

The second term shows that The third term shows that
cyclical unemployment exerts inflation also rises and falls
upward or downward pressure on with supply shocks. An
inflation. Low unemployment adverse supply shock would
pulls inflation up. This is called push production prices up.
demand-pull inflation because This type of inflation is
high AD is the cause. called cost-push inflation.

If u = un inflation will be unchanged, therefore un is also

called as non-acceleration inflation rate of
unemployment (NAIRU)
 II Phillips curve
Phillips curve in short run and long run
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un Unemployment, u
 II Phillips curve
Phillips curve in short run and long run

LRPC (u=un)

10% D E

5% B C

A SRPC ( e= 10%)
u un SRPC ( e= 5%)
Unemployment, u
SRPC (e = 0%)
 Rational expectations and the possibility of
painless disinflation
Rational expectations make the assumption that people optimally
use all the available information about current government policies,
to forecast the future. According to this theory, a change in
monetary or fiscal 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.

Proponents of rational expectations argue that the short-run Phillips

curve does not accurately represent the options that policymakers
have available. They believe that if policy makers are credibly
committed to reducing inflation, rational people will understand the
commitment and lower their expectations of inflation. Inflation can
then come down without a rise in unemployment and fall in output
 Hysteresis and the Challenge to the natural
rate hypothesis
Our entire discussion has been based on the natural rate hypothesis.
The hypothesis is summarized in the following statement:
Fluctuations in aggregate demand affect output and employment only
in the short run. In the long run, the economy returns to the levels of
output, employment, and unemployment described by the classical
model.
Recently, some economists have challenged the natural-rate
hypothesis by suggesting that aggregate demand may affect output
and employment even in the long run. They have pointed out a
number of mechanisms through which recessions might leave
permanent scars on the economy by altering the natural rate of
unemployment. Hysteresis is the term used to describe the long-
lasting influence of history on the natural rate.