2. BRIEFLY ABOUT ME
¡ Olga Denislamova
¡ Born and raised in Moscow, Russia
¡ MA in Economics and Political Science from University of Edinburgh (2014)
¡ Ph.D. in Economics from UCSD (2021)
¡ Assistant Teaching Professor at UofT as of 2020: mostly macro & international econ
¡ Research on Macro-Labor and Firm Dynamics:
¡ How important is Intangible Capital (Knowledge Based Capital) for firm growth
¡ The role of skilled workers in firm’s performance
¡ How firms allocate tasks across workers
3. ADMINISTRATIVE STUFF: MATERIAL DELIVERY
¡ Today, on July 6th and July 11th:“normal lectures”
¡ Starting on Wednesday July 13th switch to pre-recorded videos and in-person workshops:
¡ Videos for next week posted on Thursday (2 videos 50-70 mins long each) (except for this week)
¡ You MUST watch them – treatment will differ a little from the textbook, these are your replacement
¡ On Monday and Wednesday, we will have workshops where we will discuss data, news, do group exercises and past exam
questions – 50-70 minutes each
¡ After that I will stay behind to answer your questions about the material
¡ Might move the tutorial on Wednesday to an earlier time slot
¡ Why?
4. ADMINISTRATIVE STUFF:ASSESSMENTS
¡ Graded homeworks:
¡ CM short and long answer type questions, for most HWs you will have 50 minutes to complete, scan and upload your
answers once you start the HW; 5% grade reduction per 1 minute late.
¡ Available to you Friday noon – due Saturday 11:59am EVERY WEEK
¡ Open book – open notes, NO collaboration allowed
¡ Somewhat of a time crunch
¡ Lowest score dropped automatically
¡ Writing assignment:
¡ Will be up to 1500 words, maybe less
¡ Prompt posted at least two weeks before the deadline
¡ MT3 & Final
¡ 2 hours each, in person, only calculators allowed, no MC
¡ Somewhat cumulative – material builds on the last term
5. ADMINISTRATIVE STUFF: COMMUNICATION
¡ Office Hours: online via zoomThursday 11.10 am-12pm.
¡ Can ask your questions after the workshops
¡ Course email: eco202.denislamova@utoronto.ca
¡ Please use it mostly for administrative stuff, for content questions use Discussion Board, my OH,TA OH,WS
¡ Use o.denislamova@utoronto.ca sparingly
6. BRIEF RECAP:WHERE DO WE STAND IN THE COURSE?
¡ So far – building up to the big model of economic fluctuations and policy response:
¡ IS-LM model to represent equilibria in goods and money markets
¡ Generates AD curve – all the combinations of P andY such that the goods market and the money market in the economy
are in equilibrium
¡ The main connection is through the interest rate in the closed economy model (CH. 12)
¡ The main connection is through the exchange rate in the open economy model (CH.13)
¡ Now:
¡ Build the theory of the supply side of the economy – most important short-run tradeoff
¡ Put it all together
¡ Next lecture:
¡ Culmination in the dynamic model
7. CHAPTER 14: AS & INFLATION AND
UNEMPLOYMENT IN THE SHORT RUN
8. INTRODUCTION
• In previous chapters, we assumed that the price level P was “stuck” in
the short run.
¡ This implies a horizontal SRAS curve.
• Now, we consider two prominent models of aggregate supply in the
short run:
¡ Sticky-price model
¡ Imperfect-information model
9. ¡ Other things equal, Y and P are positively related, so the SRAS curve is upward
sloping.
¡ Both models imply:
INTRODUCTION, PART 2
10. THE STICKY-PRICE MODEL, PART 1
• 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 (or have some degree of market power).
11. THE STICKY-PRICE MODEL, PART 2
• An individual firm’s desired price is:
¡ where a > 0.
¡ Suppose there are two types of firms:
¡ firms with flexible prices—set prices as above
¡ firms with sticky prices—must set their prices before they know how P and Y will turn out:
-
p P a Y Y
( )
!"! #
-
= +
p EP a EY EY
( )
12. THE STICKY-PRICE MODEL, PART 3
¡ Assume that sticky-price firms expect that output will equal its natural rate. Then,
§ To derive the aggregate supply curve, first find an expression for the
overall price level.
§ s = fraction of firms with sticky prices.
Then, we can write the overall price level as . . .
-
= +
p EP a EY EY
( )
=
p EP
13. • Subtract (1 − s)P from both sides:
• Divide both sides by s:
• Open up the brackets:
14. THE STICKY-PRICE MODEL, PART 5
• High EP g high P
• If firms expect high prices, then firms that must set prices in advance will set them high.
Other firms respond by setting prices high.
• High Y g high P
• When income is high, the demand for goods is high. Firms with flexible prices set prices high.
• The greater the fraction of flexible-price firms, the smaller is s and the bigger the
effect of ΔY on P.
-
-
1
= +
s a
P EP Y Y
s
( )
( )
15. THE STICKY-PRICE MODEL, PART 6
• Finally, derive the AS equation by solving for Y :
-
-
1
= +
s a
P EP Y Y
s
( )
( )
16. AS CURVE
-
= + ( ),
Y Y α P EP
-
where = >0
(1 )
s
α
s a
17. THE IMPERFECT-INFORMATION MODEL, PART 1
¡ Assumptions:
• All wages and prices are perfectly flexible, and all markets are clear.
• Each supplier produces one good and consumes many goods.
• Each supplier knows the nominal price of the good they produce but does
not know the overall price level.
18. THE IMPERFECT-INFORMATION MODEL, PART 2
• The supply of each good depends on its relative price: the nominal price of
the good divided by the overall price level.
• The supplier doesn’t know price level at the time the make their production
decision so they use EP.
• Suppose P rises but EP does not.
• Supplier thinks their relative price has risen, so they produce more.
• With many producers thinking this way, Y will rise whenever P rises above EP.
25. TYPES OF UNEMPLOYMENT
¡ Divide unemployment into three categories
¡ Frictional
¡ Structural
¡ Cyclical
26. NATURAL LEVEL OF UNEMPLOYMENT
u U-rate = frictional + structural + cyclical
uThe Natural Rate of Unemployment is the unemployment rate that would prevail if the economy
was neither in a boom nor a recession:
27. INFLATION, UNEMPLOYMENT,AND THE PHILLIPS CURVE
¡ The Phillips curve states that π depends on:
• expected inflation, Eπ
• cyclical unemployment: the deviation of the actual rate of unemployment (u) from the natural rate (un)
• supply shocks, ν (Greek letter nu).
¡ where β > 0 is an exogenous constant.
- -
= ( ) +
E u u ν
n
π π β
28. DERIVING THE PHILLIPS CURVE FROM SRAS
-
(1) = + ( )
Y α P EP
Y
-
(2) = +(1 )( )
P EP α Y Y
-
(3) = +(1 )( )+
P EP α Y Y ν
- -
- - -
1 1
(4)( )=( )+(1 )( )+
P P EP P α Y Y ν
-
(5) = +(1 )( )+
E α Y Y ν
π π - - -
(6)(1 )( ) = ( )
n
α Y Y β u u
- -
(7) = ( ) +
n
E β u u ν
π π
29. COMPARING SRAS AND THE PHILLIPS CURVES
• SRAS curve:
Output is related to unexpected movements in the price level.
• Phillips curve:
Unemployment is related to unexpected movements in the inflation rate.
-
SRAS : = + ( )
Y Y α P EP
- -
Phillips curve : = ( ) +
n
E β u u ν
π π
30. ADAPTIVE EXPECTATIONS
• Adaptive expectations: an approach that assumes people form their
expectations of future inflation based on recently observed inflation.
• A simple version:
expected inflation = last year’s actual inflation
• Then, Phillips curve equation becomes
-1
=
Eπ π
- - -
1
= ( ) +
n
π π β u u ν
31. INFLATION INERTIA
¡ In this form, the Phillips curve implies that inflation has inertia:
• In the absence of supply shocks or cyclical unemployment, inflation will continue
indefinitely at its current rate.
• Past inflation influences expectations of current inflation, which in turn influences the
wages and prices that people set.
- - -
1
= ( ) +
n
π π β u u ν
32. TWO CAUSES OF RISING AND FALLING INFLATION
• cost-push inflation:
inflation resulting from supply shocks
Adverse supply shocks typically raise production costs and induce firms to raise prices, pushing inflation up.
• demand-pull inflation:
inflation resulting from demand shocks
¡ Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which pulls the
inflation rate up.
- - -
1
= ( ) +
n
π π β u u ν
36. THE SACRIFICE RATIO, PART 1
• To reduce inflation, policymakers can contract aggregate demand, causing unemployment to
rise above the natural rate.
• How?
• The sacrifice ratio measures the percentage of a year’s real GDP that must be forgone to
reduce inflation by 1 percentage point.
• The sacrifice ratio can be estimated using the disinflation episode of the early 1980s in
Canada.
37. CALCULATING THE SACRIFICE RATIO FOR 1980S DISINFLATION
IN CANADA
• Data:
• Inflation fell by 8.3 percentage points over four years,
• Total cyclical unemployment was 10.5%.
• Okun’s law:
• 1% of unemployment = 3% of lost output
• Thus, 10.5% of cyclical unemployment = 31.5 percentage points of annual GDP.
• Sacrifice ratio = (lost GDP) / (total disinflation)
• = 31.5/8.3 = 3.8 percentage points of GDP were lost for each 1 percentage point reduction in inflation.
38. THE SACRIFICE RATIO, PART 2
How much GDP must we sacrifice if we want to reduce inflation from 6% to 2%?
This loss could be incurred in one year or spread over several (example: 3.8% loss for each of four years).
The cost of disinflation is lost GDP.
One could use Okun’s law to translate this cost into unemployment.
39. RATIONAL EXPECTATIONS
¡ Ways of modelling the formation of expectations:
¡ adaptive expectations:
¡ People base their expectations of future inflation on recently observed inflation.
¡ Because inflation has inertia, have to give up output in order to decrease inflation
¡ rational expectations:
¡ People base their expectations on all available information, including information about current and prospective future policies.
¡ May have painless disinflation
40. PAINLESS DISINFLATION?
• Proponents of rational expectations believe that the sacrifice ratio may be very small as long as agents
incorporate all available information and the policymakers are credible
• Suppose u = un and π = Eπ = 6%, and suppose the Federal Reserve announces that it will do whatever
is necessary to reduce inflation from 6% to 2% as soon as possible.
• If the announcement is credible, then Eπ will fall, perhaps by the full 4 points.
• Then, π can fall without an increase in u.
- -
= ( ) +
E u u ν
n
π π β
41. C H A P T E R S U M M A R Y, P A R T 1
Two models of aggregate supply in the short run:
¡ sticky-price model
¡ imperfect-information model
¡ Both models imply that output rises above its natural rate when the price level rises above the expected price
level.
42. C H A P T E R S U M M A R Y, P A R T 2
Phillips curve
¡ derived from the SRAS curve
¡ states that inflation depends on:
¡ expected inflation
¡ cyclical unemployment
¡ supply shocks
¡ presents policymakers with a short-run tradeoff between inflation and unemployment
43. C H A P T E R S U M M A R Y, P A R T 3
How people form expectations of inflation matters:
¡ adaptive expectations
¡ based on recently observed inflation
¡ implies “inertia”
¡ rational expectations
¡ based on all available information
¡ implies that disinflation may be painless
