Most economists analyze short-run fluctuations in aggregate income and the price level using the AD/AS model. Chapter 13 – Aggregate Supply and the Short-run Tradeoff Between Inflation and Unemployment – covers the three theories of aggregate supply that examine the frictions of macroeconomics. This chapter also covers why the Phillips-curve equation is a convenient way to analyze tradeoff between inflation and unemployment. I will explain these theories and also how the Phillips-curve equation works.
The three aggregate supply models are: sticky-price, sticky-wage, and imperfect-information. Although each of the three theories adheres to the same functional form, each one of them takes us through a different route, but each route ends up in the same place; the short-run aggregate supply equation form. The functional form is Y= ? + ? (P – P?), ?>0, where Y is output, ? is the natural level of output, P is the price level, and P? is the expected price level. ? indicates how much output responds to unexpected changes in P and 1/? is the slope of the AS curve.
The first model – The Sticky-Price Model – explains an upward sloping AS curve by assuming that some prices are sticky because firms do not instantly adjust the prices they charge in response to changes in the economy. Two of the reasons why firms hold prices steady are: firms have long-term contracts with customers, and in order not to annoy regular customer with frequent price changes. A way to conceptualize the relationship between price level and output in the sticky-price model is when the level of output is high, the demand for goods and services is also high.
Thus, when the firms set their sticky-prices, they set them high to account for the high demand. When firms set their prices high, the overall price level increases. Thus, a high level of output leads to a high level of demand, which leads to a high price level. When the price charged for goods and services is high, firms set their relatively sticky prices high. When some firms set their relatively sticky prices high, other firms follow suit. Thus, the overall price level increases. The second model – The Sticky-Wage Model – explains an upward sloping AS curve based on the labor market.
It shows what a sticky nominal wage implies for AS. Nominal wages are set by long-term contracts; therefore wages cannot adjust quickly to changes in economy. When the price level rises, the nominal wage remains fixed because this is solely based on the dollar amount of the wage. The real wage, on the other hand, falls because this is based on the purchasing power of the wage. When real wage falls, labor becomes cheaper. A higher price level means that a given wage is able to purchase fewer goods and services.
However, since the amount of output produced for each unit of labor is still the same, firms choose to hire more workers and increase revenues and profits. When firms hire more labor, output increases. Thus, when the price level rises, output increases because of sticky wages. The third model – The Imperfect-Information Model – explains an upward sloping AS curve based on the labor market as well. Unlike the sticky wage model, this model assumes that wages and prices are free to adjust and that the labor market clears.
The imperfect-information model attributes the positively sloped AS curve to misperceptions about prices. This model assumes that each individual supplier observes their own price closely but less closely the prices of all the goods they consume. If all prices in the economy (unobserved) increase including the supplier’s own price (observed) and the supplier expected it then P=P? and output remains unchanged. The perception is that the relative price for the supplier has not changed.
If all prices in the economy (unobserved) increase including the supplier’s own price (observed) and the supplier did not expect it then the supplier perceives mistakenly that the relative price of their own product has increased (P>P?). The supplier then produces more output. So, when actual prices exceed expected prices, suppliers raise their output. Another important topic of Chapter 13 is the Phillips Curve. The Phillips curve, as stated in the book, is a reflection of the short-run AS curve: as policymakers move the economy along the short-run AS curve, unemployment and inflation move in opposite direction.
This relative relationship between unemployment and inflation rate basically means that whenever unemployment is low, inflation tends to be high, and whenever unemployment is high, inflation tends to be low. The Phillips curve states that inflation rate depends on expected inflation, the cyclical unemployment, and supply shocks. These forces are expressed as: Inflation = Expected Inflation – B (cyclical unemployment rate) + Supply Shock; where B represents a number greater than zero that represents the sensitivity of inflation to unemployment.