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AGGREGATE DEMAND and AGGREGATE SUPPLY II. how to derive un upward sloping aggregate supply in the short-run: Sticky prices; Sticky wages; Lucas’ imperfect information model; The general AD-AS model ; the Phillips Curve . Lecture outline:. Three Models Of Aggregate Supply.
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AGGREGATE DEMAND and AGGREGATE SUPPLY II
how to derive un upward sloping aggregate supply in the short-run: • Sticky prices; • Sticky wages; • Lucas’ imperfect information model; • The general AD-AS model; • the Phillips Curve. Lecture outline:
Three Models Of Aggregate Supply Consider 3 stories that could give us this SRAS: The sticky-wage model The imperfect-information model The sticky-price model All three models imply:
Target real wage Expected price level The Sticky-wage Model Imperfection: Nominal wages are sticky in the short run,they adjust sluggishly (dueto labor contracts, social norms). Firms and workers set the nominal wage in advance based on the price level they expect to prevail. • 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:
The Sticky-wage Model • This model implies that the real wage should becounter-cyclical,should move in the opposite direction as output during business cycles: • In booms, when P typically rises, real wage should fall. • In recessions, when P typically falls, real wage should rise. • This prediction does not come true in the real world. It seems that real wages are pro-cyclical.
The StickyPrices Model • Reasons for sticky prices: • long-term contracts between firms and customers • menu costs • firms not wishing to annoy customers with frequent price changes • Assumption: • Firms set their own prices (e.g., as in monopolistic competition).
The StickyPrices Model Consider the pricing decision facing a typical firm.The firm’s desired price pdepends on two macroeconomic variables: The overall level of prices P. A higher price level implies that the firm’scosts are higher. Hence, the higher the overall price level, the more thefirm would like to charge for its product. The level of aggregate income Y. A higher level of income raises the demandfor the firm’s product. Because marginal cost increases at higher levelsof production, the greater the demand, the higher the firm’s desired price.
The StickyPrices Model Shift to the left the labor demand in the economy depicted in the following figure where we plot the equilibrium in thelabour market. The Ls is the labour supply and the Ld is the labour demand. On thevertical axis we have the real wage and on the horizontal axis the level of employment L.
The Lucas’ Imperfect-information Model Assumptions: • All wages and prices are perfectly flexible, all markets are 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 Lucas’ 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 does not know price level at the time she makes her production decision, so uses the expected price level, P e. • Suppose P rises but P e does not. • Supplier thinks her relative price has risen,so she produces more. • With many producers thinking this way, Y will rise whenever P rises above P e.
