Topic 10: ELEVEN

CHAPTER
macro Aggregate
AggregateDemand
DemandIIII
(chapter 11)

macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich

© 2002 Worth Publishers, all rights reserved

 Context
 Chapter 9 introduced the model of aggregate
demand and supply.
 Chapter 10 developed the IS-LM model, the
basis of the aggregate demand curve.
 In Chapter 11, we will use the IS-LM model to
– see how policies and shocks affect income
and the interest rate in the short run when
prices are fixed
– derive the aggregate demand curve
– explore various explanations for the
Great Depression
CHAPTER 11 Aggregate Demand II slide 2
 Equilibrium in the IS-LM Model
The IS curve represents r
equilibrium in the goods LM
market.
Y  C (Y  T )  I (r )  G

The LM curve represents r1

money market equilibrium.
M P  L (r ,Y ) IS
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 11 Aggregate Demand II slide 3
 Policy analysis with the IS-LM Model
Y  C (Y  T )  I (r )  G r
M P  L (r ,Y ) LM

Policymakers can affect

macroeconomic variables r1
with
• fiscal policy: G and/or T
• monetary policy: M IS
Y
We can use the IS-LM Y1
model to analyze the
effects of these policies.

CHAPTER 11 Aggregate Demand II slide 4

An increase in government purchases
1. IS curve shifts right r
1 LM
by G
1  MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the
1. IS2
interest rate to rise… IS1
Y
3. …which reduces investment, Y1 Y2
so the final increase in Y 3.
1
is smaller than G
1  MPC
CHAPTER 11 Aggregate Demand II slide 5
 A tax cut
Because consumers save r
(1MPC) of the tax cut, LM
the initial boost in
spending is smaller for T
than for an equal G… r2
2.
and the IS curve r1
shifts by 1. IS2
MPC
1. T IS1
1  MPC
Y
Y1 Y2
2. …so the effects on r and Y 2.
are smaller for a T than
for an equal G.
CHAPTER 11 Aggregate Demand II slide 6
 Monetary Policy: an increase in M
r
1. M > 0 shifts LM1
the LM curve down
(or to the right) LM2

2. …causing the r1
interest rate to fall r2

3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.

CHAPTER 11 Aggregate Demand II slide 7

 Interaction between
monetary & fiscal policy
 Model:
monetary & fiscal policy variables
(M, G and T ) are exogenous
 Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
 Such interaction may alter the impact of
the original policy change.

CHAPTER 11 Aggregate Demand II slide 8

The Fed’s response to G > 0
 Suppose Congress increases G.
 Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G
are different:

CHAPTER 11 Aggregate Demand II slide 9

Response 1: hold M constant
If Congress raises G, r
the IS curve shifts LM1
right
If Fed holds M r2
constant, then LM r1
curve doesn’t shift. IS2
Results: IS1
Y
Y  Y 2  Y1 Y1 Y2

r  r2  r1

CHAPTER 11 Aggregate Demand II slide 10

Response 2: hold r constant
If Congress raises G, r
the IS curve shifts LM1
right LM2

To keep r constant, r2
Fed increases M to r1
shift LM curve right. IS2
Results: IS1
Y
Y  Y 3  Y1 Y1 Y2 Y3

r  0

CHAPTER 11 Aggregate Demand II slide 11

Response 3: hold Y constant
If Congress raises G, r LM2
the IS curve shifts LM1
right
r3
To keep Y constant, r2
Fed reduces M to r1
shift LM curve left. IS2
Results: IS1
Y  0 Y
Y1 Y2
r  r3  r1

CHAPTER 11 Aggregate Demand II slide 12

Estimates of fiscal policy multipliers
from the DRI macroeconometric model

Estimated Estimated
Assumption about value of value of
monetary policy Y / G Y / T

Fed holds money

0.60 0.26
supply constant
Fed holds nominal
1.93 1.19
interest rate constant

CHAPTER 11 Aggregate Demand II slide 13

 Shocks in the IS-LM Model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
• stock market boom or crash
 change in households’ wealth
 C
• change in business or consumer
confidence or expectations
 I and/or C

CHAPTER 11 Aggregate Demand II slide 14

 Shocks in the IS-LM Model
LM shocks: exogenous changes in the
demand for money.
Examples:
• a wave of credit card fraud increases
demand for money
• more ATMs or the Internet reduce money
demand

CHAPTER 11 Aggregate Demand II slide 15

CASE STUDY
The U.S. economic slowdown of 2001
~What happened~
1. Real GDP growth rate
1994-2000: 3.9% (average annual)
2001: 1.2%
2. Unemployment rate
Dec 2000: 4.0%
Dec 2001: 5.8%

CHAPTER 11 Aggregate Demand II slide 16

CASE STUDY
The U.S. economic slowdown of 2001
~Shocks that contributed to the slowdown~
1. Falling stock prices
From Aug 2000 to Aug 2001: -25%
Week after 9/11: -12%
2. The terrorist attacks on 9/11
• increased uncertainty
• fall in consumer & business confidence

Both shocks reduced spending and

shifted the IS curve left.

CHAPTER 11 Aggregate Demand II slide 17

CASE STUDY
The U.S. economic slowdown of 2001
~The policy response~
1. Fiscal policy
• large long-term tax cut,
immediate $300 rebate checks
• spending increases:
aid to New York City & the airline industry,
war on terrorism
2. Monetary policy
• Fed lowered its Fed Funds rate target
11 times during 2001, from 6.5% to 1.75%
• Money growth increased, interest rates fell

CHAPTER 11 Aggregate Demand II slide 18

CASE STUDY
The U.S. economic slowdown of 2001
~What’s happening now~
 In the first quarter of 2002, Real GDP grew
at an annual rate of 6.1%, suggesting
recession had ended.
 Though since then growth has been slower,
around 2%.
 In its news release in July 2003, the NBER
Business Cycle Dating Committee declared
the ending date for the recessions as
November 2001.
CHAPTER 11 Aggregate Demand II slide 19
What is the Fed’s policy instrument?
What the newspaper says:
“the Fed lowered interest rates by one-half point today”
What actually happened:
The Fed conducted expansionary monetary policy to
shift the LM curve to the right until the interest rate fell
0.5 points.

The
TheFed
Fedtargets
targetsthe
theFederal
FederalFunds
Fundsrate:
rate:
ititannounces
announcesaatarget
targetvalue,
value,
and
anduses
usesmonetary
monetarypolicy
policyto
toshift
shiftthe
theLM
LMcurve
curve
as
asneeded
neededto toattain
attainits
itstarget
targetrate.
rate.
CHAPTER 11 Aggregate Demand II slide 20
What is the Fed’s policy instrument?
Why does the Fed target interest rates
instead of the money supply?
1) They are easier to measure than the
money supply
2) The Fed might believe that LM shocks
are more prevalent than IS shocks. If
so, then targeting the interest rate
stabilizes income better than targeting
the money supply.

CHAPTER 11 Aggregate Demand II slide 21

IS-LM and Aggregate Demand
 So far, we’ve been using the IS-LM model
to analyze the short run, when the price
level is assumed fixed.
 However, a change in P would shift the
LM curve and therefore affect Y.
 The aggregate demand curve
(introduced in chap. 9 ) captures this
relationship between P and Y

CHAPTER 11 Aggregate Demand II slide 22

 Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P ) IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I P1
 Y AD
Y2 Y1 Y

CHAPTER 11 Aggregate Demand II slide 23

Monetary policy and the AD curve
r LM(M1/P1)
The Fed can increase
r1 LM(M2/P1)
aggregate demand:
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
 I P

 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y

CHAPTER 11 Aggregate Demand II slide 24

 Fiscal policy and the AD curve
r LM
Expansionary fiscal policy
(G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
Y1 Y2 Y
 IS shifts right P
 Y at each
value P1
of P AD2
AD1
Y1 Y2 Y

CHAPTER 11 Aggregate Demand II slide 25

Deriving AD curve with algebra
Suppose the expenditure side of the economy is
characterized by:
C  C  b (Y  T ) 0 b 1
I  I  dr d 0
G  G , T T
where: b & d are some numbers,
C is the 'autonomous part of consumption'
and I is 'autonomous investment'

CHAPTER 11 Aggregate Demand II slide 26

Deriving AD curve with algebra
Use the goods market equilibrium condition
Y=C+I+G
Y  C  b (Y  T )  I  dr  G
Solve for Y:
Y  bY  C  bT  I  dr  G
(1  b )Y  C  I  G  bT  I  dr
C  I   1   b   d 
IS:Y       G  T   r
 1b  1  b  1  b  1  b 
A line relating Y to r with slope –d/(1-b)
Can see multipliers here: rise in Y taking r as given.
But r is an endogenous variable and it will change…
CHAPTER 11 Aggregate Demand II slide 27
Deriving AD curve with algebra
Use the money market to find a value for r:
As done for the LM curve previously,
suppose the money market is characterized by:
   eY  fr
d
M / P e  0, f  0
M /P   M /P
s

Equilibrium in money market requires:

M /P   M /P 
s d

So LM: M /P  eY  fr
e   1 M
or write as: r   Y   
f  f  P
Line with slope = e/f

CHAPTER 11 Aggregate Demand II slide 28

 Deriving AD curve with algebra
Now combine the two, substituting in for r:
C  I   1   b   d 
IS: Y   
   G   T    r
 1  b  1  b  1  b  1  b 
e   1 M
LM: r   Y   
f  f  P
C  I   G   bT   d    e   1 M 
Y               Y   f  P 
 1b  1  b  1  b  1  b  f    
Solve for Y. For convenience, define a term:
z  f /[f  de /(1  b )], so 0  z  1
C  I   z   zb   d M
Y  z  
   G   T   
 1b  1  b  1  b   f 1  b   de P

CHAPTER 11 Aggregate Demand II slide 29

Deriving AD curve with algebra
C  I   z   zb   d M
Y  z  
   G   T   
 1b  1  b  1  b   f 1  b   de P
where z  f /[f  de /(1  b )], 0  z 1

This implies a negative P

relationship between output
(Y) and price level (P): an
Aggregate Demand curve. AD
Y
This math can help reveal under what conditions
monetary and fiscal policies will be most effective…
CHAPTER 11 Aggregate Demand II slide 30
 Policy Effectiveness
Fiscal policy is effective (Y will rise much) when:
1) LM flatter (f large or e small, so z near 1)
IS IS LM As the rise in G raises Y,
r 1 2

2 the increase in money demand

1 2’ LM’ does not raise r much:
-small e:Md not responsive to
Y -large f: Md is responsive to r
so investment is not crowed
Y1 Y2 Y2’
out as much.
C  I   z   zb   d M
Y  z      G  T   
 1  b   1  b   1  b   
f 1  b   de P
where z  f /[f  de /(1  b )], 0  z 1
CHAPTER 11 Aggregate Demand II slide 31
 Policy Effectiveness
Fiscal policy is effective (Y will rise much) when:
2) IS steeper (d small: I not responsive to r, z near 1)

r
IS2 LM As the rise in G raises Y:
IS1
2
2’ investment does not respond
1 much to the rising r coming
from the money market,
IS1’ IS2’ so investment is not crowed
Y1 Y2 Y2’ out as much.
C  I   z   zb   d M
Y  z      G  T   
 1  b  1  b  1  b   f 1  b   de P
where z  f /[f  de /(1  b )], 0  z 1
CHAPTER 11 Aggregate Demand II slide 32
 Policy Effectiveness
Monetary policy is effective (Y will rise much) when:
1) IS flatter (d large: Investment is responsive to r)

r As a rise in M lowers the

IS LM1 LM2 interest rate (r),
1
2’ investment rises more in
2 response to the fall in r,
IS’
so output rises more.
Y1 Y2 Y2’

C  I   z   zb   d M
Y  z      G  T   
 1  b  1  b  1  b   f 1  b   de P
where z  f /[f  de /(1  b )], 0  z 1
CHAPTER 11 Aggregate Demand II slide 33
 Policy Effectiveness
Monetary policy is effective (Y will rise much) when:
2) LM steeper (f small: money demand not
responsive to r)
A rise in M requires a large fall in the interest rate ( r)
to make people willing to hold the extra cash.
The large fall in r raises investment expenditure much,
and this raises output much.
(This is hard to show graphically, because f affects
shift as well as slope.)
C  I   z   zb   d M
Y  z      G  T   
 1  b  1  b  1  b   f 1  b   de P
where z  f /[f  de /(1  b )], 0  z 1
CHAPTER 11 Aggregate Demand II slide 34
 IS-LM and AD-AS
in the short run & long run
Recall from Chapter 9: The force that moves
the economy from the short run to the long run
is the gradual adjustment of prices.

In the short-run then over time,

equilibrium, if the price level will
Y Y rise
Y Y fall

Y Y remain constant

CHAPTER 11 Aggregate Demand II slide 35

The SR and LR effects of an IS shock
r LRAS LM(P )
1

IS1
A negative IS shock IS2
shifts IS and AD left, Y
causing Y to fall. Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 36
The SR and LR effects of an IS shock
r LRAS LM(P )
1

In the new short-run

equilibrium, Y  Y
IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 37
 The SR and LR effects of an IS shock
r LRAS LM(P )
1

In the new short-run

equilibrium, Y  Y
IS1
IS2
Over time, Y Y
P gradually falls, P LRAS
which causes
P1 SRAS1
• SRAS to move down
• M/P to increase,
which causes LM AD1
to move down AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 38
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)

IS1
IS2
Over time, Y Y
P gradually falls, P LRAS
which causes
P1 SRAS1
• SRAS to move down
• M/P to increase, P2 SRAS2
which causes LM AD1
to move down AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 39
The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)
This process continues
until economy reaches IS1
a long-run equilibrium IS2
with Y Y Y
Y
P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 40
 EXERCISE:
Analyze SR & LR effects of M
a. Drawing the IS-LM and AD- r LRAS LM(M /P )
1 1
AS diagrams as shown here,
b. show the short run effect of
a Fed increases in M. Label IS
points and show curve shifts
with arrows. Y
Y
c. Show what happens in the
transition from the short run P LRAS
to the long run. Label points.
P1 SRAS1
d. How do the new long-run
equilibrium values compare
to their initial values? AD1

Y Y
CHAPTER 11 Aggregate Demand II slide 41
 EXERCISE: Short run
Short run: r LRAS LM(M /P )
1 1

Rise in M raises real money r 0 LM(M2/P1)

0
supply in money market r1 1

and shifts LM curve right. IS

Also shifts AD curve right. Y

Y Y1
Equilibrium moves from
P LRAS
point 0 to point 1.
Output rises to Y1. P1 SRAS1
0 1
Note that interest rate
AD1AD2
falls from r0 to r1.
Y Y1 Y
CHAPTER 11 Aggregate Demand II slide 42
 EXERCISE: Long run
Price rises in proportion to M, r LRAS LM(M /P )
2 2
from P1 to P2, r0 0,2 LM(M2/P1)
So real money supply r1 1
returns to original level: IS

M2/P2 = M1/P1. Y
Y Y1
So LM curve returns to P LRAS
original position. P2 SRAS2
2
Equilibrium moves from P1 SRAS1
0 1
point 1 to point 2.
AD1AD2
Output and interest rate
Y Y1 Y
return to original levels.
CHAPTER 11 Aggregate Demand II slide 43
 The Great Depression
240 30
240 Unemployment 30
(right scale)
220 25
220 25
dollars

force
1958dollars

laborforce
200 20
200 20

percentofoflabor
billionsofof1958

180 15
180 15

percent
billions

160 10
160 10
Real GNP
140 5
140 (left scale) 5

120 0
120 0
1929 1931 1933 1935 1937 1939
1929 1931 1933 1935 1937 1939

CHAPTER 11 Aggregate Demand II slide 44

CHAPTER 11 Aggregate Demand II slide 45
Great Depression: Observations
 Real side of economy:
– Output: falling
– Consumption: falling
– Investment: falling much
– Gov. purchases: fall (with a delay)

CHAPTER 11 Aggregate Demand II slide 46

CHAPTER 11 Aggregate Demand II slide 47
Great Depression: Observations
 Nominal side:
– Nominal interest rate: falling
– Money supply (nominal): falling
– Price level: falling (deflation)

CHAPTER 11 Aggregate Demand II slide 48

The Spending Hypothesis:
Shocks to the IS Curve
 asserts that the Depression was largely due
to an exogenous fall in the demand for
goods & services -- a leftward shift of the IS
curve
 evidence:
output and interest rates both fell, which is
what a leftward IS shift would cause

CHAPTER 11 Aggregate Demand II slide 49

The Spending Hypothesis:
Reasons for the IS shift
1. Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to
obtain financing for investment
3. Contractionary fiscal policy
 in the face of falling tax revenues and
increasing deficits, politicians raised tax rates
and cut spending
CHAPTER 11 Aggregate Demand II slide 50
The Money Hypothesis:
A Shock to the LM Curve
 asserts that the Depression was largely due
to huge fall in the money supply
 evidence:
M1 fell 25% during 1929-33.
But, two problems with this hypothesis:
1. P fell even more, so M/P actually rose
slightly during 1929-31.
2. nominal interest rates fell, which is the
opposite of what would result from a
leftward LM shift.

CHAPTER 11 Aggregate Demand II slide 51

The Money Hypothesis Again:
The Effects of Falling Prices
 asserts that the severity of the Depression
was due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by
the fall in M, so perhaps money played
an important role after all.
 In what ways does a deflation affect the
economy?

CHAPTER 11 Aggregate Demand II slide 52

The Money Hypothesis Again:
The Effects of Falling Prices
The stabilizing effects of deflation:

 P  (M/P )  LM shifts right  Y

CHAPTER 11 Aggregate Demand II slide 53

The Money Hypothesis Again:
The Effects of Falling Prices
The destabilizing effects of unexpected deflation:
debt-deflation theory
P (if unexpected)
 transfers purchasing power from borrowers
to lenders
 borrowers spend less,
lenders spend more
 if borrowers’ propensity to spend is larger
than lenders, then aggregate spending falls,
the IS curve shifts left, and Y falls

CHAPTER 11 Aggregate Demand II slide 54

The Money Hypothesis Again:
The Effects of Falling Prices
The destabilizing effects of expected deflation:
e
 r  for each value of i
 I  because I = I (r )
 planned expenditure & agg. demand 
 income & output 

CHAPTER 11 Aggregate Demand II slide 55

Why another Depression is unlikely
 Policymakers (or their advisors) now know
much more about macroeconomics:
 The Fed knows better than to let M fall
so much, especially during a contraction.
 Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
 Federal deposit insurance makes widespread
bank failures very unlikely.
 Automatic stabilizers make fiscal policy
expansionary during an economic downturn.

CHAPTER 11 Aggregate Demand II slide 56

 Chapter summary
1. IS-LM model
 a theory of aggregate demand
 exogenous: M, G, T,
P exogenous in short run, Y in long run
 endogenous: r,
Y endogenous in short run, P in long run
 IS curve: goods market equilibrium
 LM curve: money market equilibrium

CHAPTER 11 Aggregate Demand II slide 57

 Chapter summary
2. AD curve
 shows relation between P and the IS-LM
model’s equilibrium Y.
 negative slope because
P  (M/P )  r  I  Y
 expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right
 expansionary monetary policy shifts LM curve
right, raises income, and shifts AD curve right
 IS or LM shocks shift the AD curve

CHAPTER 11 Aggregate Demand II slide 58

CHAPTER 11 Aggregate Demand II slide 59
 CHAPTER THIRTEEN

Aggregate Supply

CHAPTER 11 Aggregate Demand II

 Learning objectives
 three models of aggregate supply in
which output depends positively on the
price level in the short run
 the short-run tradeoff between inflation
and unemployment known as the
Phillips curve

CHAPTER 11 Aggregate Demand II slide 61

Three models of aggregate supply
1. The sticky-wage model
2. The imperfect-information model
3. The sticky-price model
All three models imply:
Y  Y   (P  P ) e

agg. the expected

output price level
a positive
natural rate parameter the actual
of output price level
CHAPTER 11 Aggregate Demand II slide 62
 The sticky-wage model
 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 they set is the product of a
target real wage and the expected price level:

Target
real
W  ω P e wage

W Pe
 ω
P P

CHAPTER 11 Aggregate Demand II slide 63

 The sticky-wage model
W Pe
ω
P P
If it turns out that then
e unemployment and output are
P P at their natural rates
Real wage is less than its target,
P Pe so firms hire more workers and
output rises above its natural rate
e Real wage exceeds its target,
P P so firms hire fewer workers and
output falls below its natural rate

CHAPTER 11 Aggregate Demand II slide 64

 The sticky-wage model
 Implies that the real wage should be counter-
cyclical , it should move in the opposite
direction as output over the course of business
cycles:
– In booms, when P typically rises, the real
wage should fall.
– In recessions, when P typically falls, the real
wage should rise.
 This prediction does not come true in the real
world:

CHAPTER 11 Aggregate Demand II slide 66

The cyclical behavior of the real wage
in real wage
Percentage change

4 1972

3
1998
1965
2
1960 1997
1999
1
1996 2000
1970 1984
0
1982 1993
1991 1992
-1
1990
-2 1975

-3 1979
1974

-4
1980
-5
-3 -2 -1 0 1 2 3 4 5 6 7 8
Percentage change in real GDP
CHAPTER 11 Aggregate Demand II slide 67
The imperfect-information model
Assumptions:
 all wages and prices perfectly flexible,
all markets 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

CHAPTER 11 Aggregate Demand II slide 68

The 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 doesn’t know price level at the time
she makes her production decision, so uses the
e
expected price level, P .
 Suppose P rises but P e does not.
Then 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.
CHAPTER 11 Aggregate Demand II slide 69
 The sticky-price model
 Reasons for sticky prices:
– long-term contracts between firms and
customers
– menu costs
– firms do not wish to annoy customers
with frequent price changes
 Assumption:
– Firms set their own prices
(e.g. as in monopolistic competition)

CHAPTER 11 Aggregate Demand II slide 70

 The sticky-price model
 An individual firm’s desired price is

p  P  a (Y Y )
where a > 0.
Suppose two types of firms:
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
before they know how P and Y will turn out:
p  P e  a (Y e Y e )

CHAPTER 11 Aggregate Demand II slide 71

 The sticky-price model
p  P e  a (Y e Y e )
 Assume sticky price firms expect that output
will equal its natural rate. Then,
p Pe
 To derive the aggregate supply curve, we first
find an expression for the overall price level.
 Let s denote the fraction of firms with sticky
prices. Then, we can write the overall price
level as

CHAPTER 11 Aggregate Demand II slide 72

 The sticky-price model
e
P  sP  (1  s )[P  a(Y Y )]

price set by sticky price set by flexible

price firms price firms

 Subtract (1s )P from both sides:

sP  s P e  (1  s )[a(Y Y )]
 Divide both sides by s :
 (1  s ) a 
P  P e
  (Y  Y )
 s 
CHAPTER 11 Aggregate Demand II slide 73
 The sticky-price model
e  (1  s ) a 
P  P    (Y  Y )
 s 
 High P e  High P
If firms expect high prices, then firms who must set
prices in advance will set them high.
Other firms respond by setting high prices.
 High Y  High P
When income is high, the demand for goods is high.
Firms with flexible prices set high prices.
The greater the fraction of flexible price firms,
the smaller is s and the bigger is the effect
of Y on P.
CHAPTER 11 Aggregate Demand II slide 74
 The sticky-price model
e  (1  s ) a 
P  P    (Y  Y )
 s 

 Finally, derive AS equation by solving for Y :

Y  Y   (P  P e ),
s
where  
(1  s )a

CHAPTER 11 Aggregate Demand II slide 75

 The sticky-price model
In contrast to the sticky-wage model, the sticky-
price model implies a pro-cyclical real wage:
Suppose aggregate output/income falls. Then,
 Firms see a fall in demand for their products.
 Firms with sticky prices reduce production,
and hence reduce their demand for labor.
 The leftward shift in labor demand causes
the real wage to fall.

CHAPTER 11 Aggregate Demand II slide 76

 Summary & implications

P LRAS
Y  Y   (P  P e )

P Pe
SRAS
Each of the
P Pe
three models of
P Pe agg. supply imply
the relationship
Y summarized by
Y the SRAS curve
& equation

CHAPTER 11 Aggregate Demand II slide 77

 Summary & implications
SRAS equation: Y  Y   (P  P e )
Suppose a positive
AD shock moves SRAS2
output above its P LRAS
natural rate SRAS1
and P above the
level people P3  P3e
had expected.
P2
Over time, AD2
P2e  P1  P1e
P e rises,
AD1
SRAS shifts up,
and output returns
Y
to its natural rate. Y2
Y 3  Y1  Y
CHAPTER 11 Aggregate Demand II slide 78
 Inflation, Unemployment,
and the Phillips Curve
The Phillips curve states that  depends on
 expected inflation, e
 cyclical unemployment: the deviation of
the actual rate of unemployment from the
natural rate
 supply shocks, 

where  > 0 is an exogenous constant.

CHAPTER 11 Aggregate Demand II slide 79

Deriving the Phillips Curve from SRAS
(1) Y  Y   (P  P e )

(2) P  P e  (1  ) (Y Y )

(3) P  P e  (1  ) (Y Y )  

(4) (P  P1 )  ( P e  P1 )  (1  ) (Y Y )  

(5)    e  (1  ) (Y Y )  

(6) (1  ) (Y Y )    (u  u n )

(7)    e   (u  u n )  
CHAPTER 11 Aggregate Demand II slide 80
The Phillips Curve and SRAS
SRAS: Y  Y   (P  P e )
Phillips curve:    e   (u  u n )  
 SRAS curve:
output is related to unexpected
movements in the price level
 Phillips curve:
unemployment is related to unexpected
movements in the inflation rate

CHAPTER 11 Aggregate Demand II slide 81

 Adaptive expectations
 Adaptive expectations: an approach that
assumes people form their expectations of
future inflation based on recently observed
inflation.
 A simple example:
Expected inflation = last year’s actual inflation
 e   1
 Then, the P.C. becomes
   1   (u  u n )  

CHAPTER 11 Aggregate Demand II slide 82

 Inflation inertia
   1   (u  u n )  
 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 & prices that people set.

CHAPTER 11 Aggregate Demand II slide 83

Two causes of rising & falling inflation
   1   (u  u n )  
 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.
CHAPTER 11 Aggregate Demand II slide 84
 Graphing the Phillips curve

In the short 
run, policymakers
face a trade-off

between  and u. 1 The short-run
e  Phillips Curve

u
un

CHAPTER 11 Aggregate Demand II slide 85

 Shifting the Phillips curve
People adjust
their 
expectations
over time, so
the tradeoff  2e  
only holds in  1e  
the short run.

E.g., an increase
in e shifts the
u
short-run P.C. un
upward.
CHAPTER 11 Aggregate Demand II slide 86
 The sacrifice ratio
 To reduce inflation, policymakers can
contract agg. demand, causing
unemployment to rise above the natural rate.
 The sacrifice ratio measures
the percentage of a year’s real GDP
that must be foregone to reduce inflation
by 1 percentage point.
 Estimates vary, but a typical one is 5.

CHAPTER 11 Aggregate Demand II slide 87

 The sacrifice ratio
 Suppose policymakers wish to reduce inflation
from 6 to 2 percent.
If the sacrifice ratio is 5, then reducing inflation
by 4 points requires a loss of 45 = 20 percent
of one year’s GDP.
 This could be achieved several ways, e.g.
– reduce GDP by 20% for one year
– reduce GDP by 10% for each of two years
– reduce GDP by 5% for each of four years
 The cost of disinflation is lost GDP. One could
use Okun’s law to translate this cost into
unemployment.
CHAPTER 11 Aggregate Demand II slide 88
 Rational expectations
Ways of modeling the formation of
expectations:
 adaptive expectations:
People base their expectations of future
inflation on recently observed inflation.
 rational expectations:
People base their expectations on all
available information, including information
about current and prospective future
policies.

CHAPTER 11 Aggregate Demand II slide 89

 Painless disinflation?
 Proponents of rational expectations believe
that the sacrifice ratio may be very small:
 Suppose u = u n and  = e = 6%,
and suppose the Fed announces that it will
do whatever is necessary to reduce inflation
from 6 to 2 percent as soon as possible.
 If the announcement is credible,
then e will fall, perhaps by the full 4 points.
 Then,  can fall without an increase in u.

CHAPTER 11 Aggregate Demand II slide 90

 The sacrifice ratio
for the Volcker disinflation
 1981:  = 9.7%
Total disinflation = 6.7%
1985:  = 3.0%

year u un uu n
1982 9.5% 6.0% 3.5%
1983 9.5 6.0 3.5
1984 7.4 6.0 1.4
1985 7.1 6.0 1.1
Total 9.5%

CHAPTER 11 Aggregate Demand II slide 91

 The sacrifice ratio
for the Volcker disinflation
 Previous slide:
– inflation fell by 6.7%
– total of 9.5% of cyclical unemployment
 Okun’s law:
each 1 percentage point of unemployment
implies lost output of 2 percentage points.
So, the 9.5% cyclical unemployment
translates to 19.0% of a year’s real GDP.
 Sacrifice ratio = (lost GDP)/(total disinflation)
= 19/6.7 = 2.8 percentage points of GDP
were lost for each 1 percentage point
reduction in inflation.
CHAPTER 11 Aggregate Demand II slide 92
The natural rate hypothesis
Our analysis of the costs of disinflation, and of
economic fluctuations in the preceding chapters,
is based on the natural rate hypothesis:
Changes
Changesininaggregate
aggregatedemand
demand
affect
affectoutput
outputand andemployment
employment
only
onlyininthe
theshort
shortrun.
run.
In
Inthe
thelong
longrun,
run,
the
theeconomy
economyreturns
returnstoto
the
thelevels
levelsofofoutput,
output,employment,
employment,
and
andunemployment
unemploymentdescribed
describedbyby
the
theclassical
classicalmodel
model(chapters
(chapters3-8).
3-8).
CHAPTER 11 Aggregate Demand II slide 93
An alternative hypothesis: hysteresis
 Hysteresis: the long-lasting influence of history on
variables such as the natural rate of unemployment.
 Negative shocks may increase u n , so economy
may not fully recover:
 The skills of cyclically unemployed workers
deteriorate while unemployed, and they cannot
find a job when the recession ends.
 Cyclically unemployed workers may lose their
influence on wage-setting; insiders (employed
workers) may then bargain for higher wages for
themselves. Then, the cyclically unemployed
“outsiders” may become structurally unemployed
when the recession ends.
CHAPTER 11 Aggregate Demand II slide 94
 Chapter summary
1. Three models of aggregate supply in the short
run:
 sticky-wage model
 imperfect-information model
 sticky-price model
All three models imply that output rises above
its natural rate when the price level falls below
the expected price level.

CHAPTER 11 Aggregate Demand II slide 95

 Chapter summary
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

CHAPTER 11 Aggregate Demand II slide 96

 Chapter summary
3. How people form expectations of inflation
 adaptive expectations
 based on recently observed inflation
 implies “inertia”
 rational expectations
 based on all available information
 implies that disinflation may be
painless

CHAPTER 11 Aggregate Demand II slide 97

 Chapter summary
4. The natural rate hypothesis and hysteresis
 the natural rate hypotheses
 states that changes in aggregate
demand can only affect output and
employment in the short run
 hysteresis
 states that agg. demand can have
permanent effects on output and
employment

CHAPTER 11 Aggregate Demand II slide 98

CHAPTER 11 Aggregate Demand II slide 99