The document discusses several economic models that can explain the short-run tradeoff between inflation and unemployment: 1) The sticky-price model where prices adjust slowly, creating a temporary tradeoff as output responds to unexpected price changes. 2) The imperfect-information model where suppliers make temporary mistakes about prices due to imperfect information. 3) The Phillips curve models the relationship between inflation, expected inflation, unemployment, and supply shocks.

1. Chapter Thirteen 1
CHAPTER 14
Aggregate Supply and the
Short-Run Tradeoff Between
Inflation and Unemployment
Daw Chan Myae July
18.07.21

2. Chapter Thirteen 2
After examining the basic theory of the short-run aggregate
supply curve,we establish a key implication. We show that
this curve implies a trade-off between two measures of
economic performance– inflation and unemployment. This
trade-off, called the Phillips curve, tells us that to
reduce the rate of inflation policymakers must
temporarily raise unemployment, and to
reduce unemployment, they must accept
higher inflation. But, this tradeoff is
policymakers face such a tradeoff in the short run and, why
just as importantly, they do not face it in the long run.
Inflation, p
Unemployment, u
only temporary. One goal
of this module is to help
explain how and why
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3. Chapter Thirteen 3
Let’s now look into a few prominent models of aggregate supply:
Sticky-price, which is most widely accepted, and an alternative theory
Imperfect-information.
In all the models, some market imperfection causes the output of the
economy to deviate from its natural level. As a result, the
short-run aggregate supply curve is upward sloping, rather than
vertical, and shifts in the aggregate demand curve cause the level of
output to deviate temporarily from its natural level. These temporary
deviations represent the booms and busts of the business cycle.
Although these models takes us down a different theoretical
route, each route ends up in the same place. That final destination is a
short-run aggregate supply equation of the form…
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4. Chapter Thirteen 4
Y = Y + a(P-EP) where a > 0
Output
Actual price level
positive constant:
an indicator of
how much
output responds
to unexpected
changes in the
price level.
Natural
rate of output
Expected
price level
This equation states that output deviates from its natural level when the
price level deviates from the expected price level. The parameter a
indicates how much output responds to unexpected changes in the price
level, 1/a is the slope of the aggregate supply curve.

5. Chapter Thirteen 5
Our first explanation for the upward-sloping short-run aggregate supply
curve is called the sticky-price model. This model emphasizes that firms
do not instantly adjust the prices they charge in response to changes in
demand. Sometimes prices are set by long-term contracts between firms
and consumers.
To see how sticky prices can help explain an upward-sloping aggregate
supply curve, first consider the pricing decisions of individual firms
and then aggregate the decisions of many firms to explain the economy
as a whole. We will have to relax the assumption of perfect competition
whereby firms are price-takers. Now they will be price-setters.
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6. Chapter Thirteen 6
Consider the pricing decision faced by a typical firm. The firm’s
desired price p depends on two macroeconomic variables:
1) The overall level of prices P. A higher price level implies that the
firm’s costs are higher. Hence, the higher the overall price level, the
more the firm will like to charge for its product.
2) The level of aggregate income Y. A higher level of income raises the
demand for the firm’s product. Because marginal cost increases at
higher levels of production, the greater the demand, the higher the
firm’s desired price.
The firm’s desired price is:
p = P + a(Y-Y)
This equations states that the desired price p depends on the overall
level of prices P and on the level of aggregate demand relative to its
natural rate Y-Y. The parameter a (which is greater than 0) measures
how much the firm’s desired price responds to the level of aggregate
output.

7. Chapter Thirteen 7
Now assume that there are two types of firms. Some have flexible prices:
they always set their prices according to this equation. Others have sticky
prices: they announce their prices in advance based on what they expect
economic conditions to be. Firms with sticky prices set prices according to
p = EP + a(EY - EY),
where the capitalized “E” represents the expected value of a variable. For
simplicity, assume these firms expect output to be at its natural rate, so
the last term a(EY - EY), drops out. Then these firms set price so
that p = EP. That is, firms with sticky prices set their prices based on what
they expect other firms to charge.
We can use the pricing rules of the two groups of firms to derive the
aggregate supply equation. To do this, we find the overall price level in the
economy as the weighted average of the prices set by the two groups.
After some manipulation, the overall price level is:
P = EP + [(1-s)a/s](Y-Y)]
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8. Chapter Thirteen 8
The third explanation for the upward slope of the short-run aggregate
supply curve is called the imperfect-information model. Unlike the
sticky-wage model, this model assumes that markets clear—that is, all
wages and prices are free to adjust to balance supply and demand. In this
model, 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.
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9. Chapter Thirteen 9
P = EP + [(1-s)a/s](Y-Y)]
The two terms in this equation are explained as follows:
1) 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 E leads to a high actual price level P.
2) 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. Hence, the overall price level depends on the
expected price level and on the level of output. Algebraic rearrangement
puts this aggregate pricing equation into a more familiar form:
where a = s/[(1-s)a]. Like the other models, the sticky-price model says
that the deviation of output from the natural rate is positively associated
with the deviation of the price level from the expected price level.
Y = Y + a(P-EP)
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10. Chapter Thirteen 10
Start at point A; the economy is at full employment Y and the
actual price level is P0. Here the actual price level equals the
expected price level. Now let’s suppose we increase the price
level to P1.
Since P (the actual price level) is now greater than Pe (the
expected price level) Y will rise above the natural rate, and we
slide along the SRAS (Pe=P0) curve to A' .
Remember that our new SRAS (Pe=P0) curve is defined by the
presence of fixed expectations (in this case at P0). So in terms
of the SRAS equation, when P rises to P1, holding Pe constant
at P0, Y must rise.
The “long-run” will be defined when the expected price level equals the actual price level. So, as price level
expectations adjust, EPP2, we’ll end up on a new short-run aggregate supply curve, SRAS (EP=P2) at point
B.
Hooray! We made it back to LRAS, a situation characterized by perfect information where the actual price
level (now P2) equals the expected price level (also, P2).
Y = Y + a (P-EP)
Y = Y + a (P-EP)
Y = Y + a (P-EP)
In terms of the SRAS equation, we can see that as EP catches up with P, that entire “expectations gap”
disappears and we end up on the long run aggregate supply curve at full employment where Y = Y.
SRAS (EP=P2)
B
P2
A'
Y'
SRAS (EP=P0)
P
Output
A
P0
LRAS*
Y
AD
AD'
P1

11. Chapter Thirteen 11
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
These three forces are expressed in the following equation:
p = Ep - b(m-mn) + n
Inflation b  Cyclical
unemployment
Supply
shocks
Expected
inflation

12. Chapter Thirteen 12
The Phillips curve equation and the short-run aggregate supply equation
represent essentially the same macroeconomic ideas. Both equations
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.
The Phillips curve and the aggregate supply curve are two sides of the
same coin. The aggregate supply curve is more convenient when
studying output and the price level, whereas the Phillips curve
is more convenient when studying unemployment and inflation.
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13. Chapter Thirteen 13
To make the Phillips curve useful for analyzing the choices facing
policymakers, we need to say what determines expected inflation. A
simple often plausible assumption is that people form their expectations
of inflation based on recently observed inflation. This assumption is
called adaptive expectations. So, expected inflation Ep equals last year’s
inflation p-1. In this case, we can write the Phillips curve as:
which states that inflation depends on past inflation, cyclical
unemployment, and a supply shock.
p = p-1 - b(m-mn) + n
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14. Chapter Thirteen 14
The second and third terms in the Phillips-curve equation show the
two forces that can change the rate of inflation.
The second term, b(u-un),shows that cyclical unemployment exerts
downward pressure on inflation. Low unemployment pulls the
inflation rate up. This is called demand-pull inflation .
The third term, n shows that inflation also rises and falls because of
supply shocks. An adverse supply shock, such as the rise in world oil
prices in the 70s, implies a positive value of n and causes inflation
to rise. This is called cost-push inflation.
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15. Chapter Thirteen 15
un
Inflation, p
Unemployment, u
Ep + n
In the short run, inflation and unemployment
are negatively related. At any point in time, a
policymaker who controls aggregate demand
can choose a combination of inflation and
unemployment on this short-run Phillips
curve.
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16. Chapter Thirteen 16
un

Unemployment, u
LRPC (u=un)
5%
10%
SRPC (E = 0%)
SRPC (E = 10%)
SRPC (E = 5%)
D
B C
E
Suppose there is an increase in the rate of growth of the money supply causing LM and AD to shift out,
resulting in an unexpected increase in inflation. The Phillips curve equation  = E – b(u-un) + v
implies that the change in inflation misperceptions causes unemployment to decline. So, the economy
moves to a point above full employment at point B.
A
As long as this inflation misperception exists, the economy will
remain below its natural rate un at u'.
Let’s start at point A, a point of price stability ( = 0%) and full employment (u = un).
When the economic agents realize the new level of inflation, they
will end up on a new short-run Phillips curve where expected
inflation equals the new rate of inflation (5%) at point C, where
actual inflation (5%) equals expected inflation (5%).
Remember, each short-run Phillips curve is defined by the presence of fixed expectations.
If the monetary authorities opt to obtain a lower u again,
then they will increase the money supply such that  is 10
percent, for example. The economy moves to point D,
where actual inflation is 10%, but, E is 5%p.
When expectations adjust, the
economy will land on a new SRPC, at
point E, where both  and E equal
10 percent.
u'
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17. Chapter Thirteen 17
17
» Sticky-price model
» Imperfect-information model
» Phillips curve
» Adaptive expectations
» Demand-pull inflation
» Cost-push inflation
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