Worth: Mankiw Economics 5e 352 PART IV Business Cycle Theory: The Economy in the Short Run figure 13-2 Percentage hange in real 4 1972留 1998■ ■1965 996■ a1970 1984m 1982 1993■ 1990■ 1975■ 1979■ 1974■ Percentage change in real GDP The Cyclical Behavior of the Real Wage This scatterplot shows the percentage change in ith the sticky-wage mode, age is somewhat procyclical. This observation is inconsistent direction That is. the real wa Source: U.S. Department of Commerce and U.S. Department of Labor. The Imperfect-Information Model 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 closely the prices of what they produce but less closely the prices of all the goods they consume. Because of imperfect information, they sometimes confuse changes in he overall level of prices with changes in relative prices. This confusion influ- ences decisions about how much to supply, and it leads to a positive relationship between the price level and output in the short run Consider the decision facing a single supplier- a wheat farmer, for instance. Because the farmer earns income from selling wheat and uses this income to buy pods and services, the amount of wheat she chooses to produce depends on the User JoENA: Job EFFo1429: 6264_ch13: Pg 352: 27759#/eps at 100sl Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 352:27759#/eps at 100% *27759* Mon, Feb 18, 2002 12:56 AM The Imperfect-Information Model The second 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 closely the prices of what they produce but less closely the prices of all the goods they consume. Because of imperfect information, they sometimes confuse changes in the overall level of prices 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. Consider the decision facing a single supplier—a wheat farmer, for instance. Because the farmer earns income from selling wheat and uses this income to buy goods and services, the amount of wheat she chooses to produce depends on the 352 | PART IV Business Cycle Theory: The Economy in the Short Run figure 13-2 Percentage change in real wage Percentage change in real GDP 1982 1975 1993 1992 1960 1996 1999 1997 1998 1979 1970 1980 1991 1974 1990 1984 2000 1972 1965 3 2 10 1 2 3 7 8 4 5 6 4 3 2 1 0 1 2 3 4 5 The Cyclical Behavior of the Real Wage This scatterplot shows the percentage change in real GDP and the percentage change in the real wage (measured here as real private hourly earnings). As output fluctuates, the real wage typically moves in the same direction. That is, the real wage is somewhat procyclical. This observation is inconsistent with the sticky-wage model. Source: U.S. Department of Commerce and U.S. Department of Labor
Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 353 price of wheat relative to the prices of other goods and services in the economy. If the relative price of wheat is high, the farmer is motivated to work hard and produce more wheat, because the reward is great. If the relative price of wheat is low, she prefers to enjoy more leisure and produce less wheat. Unfortunately, when the farmer makes her production decision, she does not know the relative price of wheat. As a wheat producer, she monitors the wheat market closely and always knows the nominal price of wheat. But she does not know the prices of all the other goods in the economy. She must, therefore, esti- mate the relative price of wheat using the nominal price of wheat and her ex- pectation of the overall price level Consider how the farmer responds if all prices in the economy, including the price of wheat, increase. One possibility is that she expected this change in prices.When she observes an increase in the price of wheat, her estimate of its relative price is unchanged. She does not work any harder The other possibility is that the farmer did not expect the price level o Increase (or to increase by this much). When she observes the increase in the price of wheat, she is not sure whether other prices have risen(in which case wheat's relative price is unchanged) or whether only the price of wheat has risen(in which case its rela tive price is higher). The rational inference is that some of each has happened. In other words, the farmer infers from the increase in the nominal price of wheat that its relative price has risen somewhat. She works harder and produces more Our wheat farmer is not unique. When the price level rises unexpectedly, all uppliers in the economy observe increases in the prices of the goods they pro- duce. They all infer, rationally but mistakenly, that the relative prices of the goods hey produce have risen. They work harder and produce more To sum up, the imperfect-information model says that when actual prices ex ceed expected prices, suppliers raise their output. The model implies an aggre- gate supply curve that is now familiar Y=Y Output deviates from the natural rate when the price level deviates from the ex- level The Sticky-Price Model Our third explanation for the upward-sloping short-run aggregate supply curve is called the sticky-price model. This model emphasizes that firms do not in- stantly adjust the prices they charge in response to changes in demand. Some times prices are set by long-term contracts between firms and customers. Even 3 Two economists who have emphasized the role of imperfect information for understanding the short-run effects of monetary policy are the Nobel Prize winners Milton Friedman and Lucas. See Milton Friedman, The Role of Monetary Policy, American Economic Revie 58 1968: 1-17; and Robert E. Lucas, ]r, " Understanding Business Cycles "Stabilization of the and International Economy, vol 5 of Carnegie-Rochester Conference on Public Policy (Amsterdam: North-Holland, 1977) User JoENA: Job EFFo1429: 6264_ch13: Pg 353: 27760#/eps at 100s Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 353:27760#/eps at 100% *27760* Mon, Feb 18, 2002 12:56 AM price of wheat relative to the prices of other goods and services in the economy. If the relative price of wheat is high, the farmer is motivated to work hard and produce more wheat, because the reward is great. If the relative price of wheat is low, she prefers to enjoy more leisure and produce less wheat. Unfortunately, when the farmer makes her production decision, she does not know the relative price of wheat. As a wheat producer, she monitors the wheat market closely and always knows the nominal price of wheat. But she does not know the prices of all the other goods in the economy. She must, therefore, estimate the relative price of wheat using the nominal price of wheat and her expectation of the overall price level. Consider how the farmer responds if all prices in the economy, including the price of wheat, increase. One possibility is that she expected this change in prices.When she observes an increase in the price of wheat, her estimate of its relative price is unchanged. She does not work any harder. The other possibility is that the farmer did not expect the price level to increase (or to increase by this much).When she observes the increase in the price of wheat, she is not sure whether other prices have risen (in which case wheat’s relative price is unchanged) or whether only the price of wheat has risen (in which case its relative price is higher).The rational inference is that some of each has happened. In other words, the farmer infers from the increase in the nominal price of wheat that its relative price has risen somewhat. She works harder and produces more. Our wheat farmer is not unique.When the price level rises unexpectedly, all suppliers in the economy observe increases in the prices of the goods they produce.They all infer, rationally but mistakenly, that the relative prices of the goods they produce have risen.They work harder and produce more. To sum up, the imperfect-information model says that when actual prices exceed expected prices, suppliers raise their output.The model implies an aggregate supply curve that is now familiar: Y =Y − + a(P − Pe ). Output deviates from the natural rate when the price level deviates from the expected price level.3 The Sticky-Price Model Our third 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 customers. Even CHAPTER 13 Aggregate Supply | 353 3 Two economists who have emphasized the role of imperfect information for understanding the short-run effects of monetary policy are the Nobel Prize winners Milton Friedman and Robert Lucas. See Milton Friedman,“The Role of Monetary Policy,’’American Economic Review 58 (March 1968): 1–17; and Robert E. Lucas, Jr.,“Understanding Business Cycles,’’ Stabilization of the Domestic and International Economy, vol. 5 of Carnegie-Rochester Conference on Public Policy (Amsterdam: North-Holland, 1977)
Worth: Mankiw Economics 5e 354 PART IV Business Cycle Theory: The Economy in the Short Run without formal agreements, firms may hold prices steady in order not to annoy heir regular customers with frequent price changes. Some prices are sticky be cause of the way markets are structured: once a firm has printed and distributed its catalog or price list, it is costly to alter prices. To see how sticky prices can help explain an upward-sloping aggregate supply urve, we first consider the pricing decisions of individual firms and then add to- gether the decisions of many firms to explain the behavior of the economy as a whole. Notice that this model encourages us to depart from the assumption of perfect competition, which we have used since Chapter 3. Perfectly competitive firms are price takers rather than price setters. If we want to consider how firms set prices, it is natural to assume that these firms have at least some monopoly control over the prices they charge. Consider the pricing decision facing a typical firm. The firms desired price p depends on two macroeconomic variables The overall level of prices P. A higher price level implies that the firms costs are higher. Hence, the higher the overall price level, the more the firm would like to charge for its product. The level of aggregate income Y. A higher level of income raises the de- mand for the firms product. Because marginal cost increases at higher levels f production, the greater the demand, the higher the firms desired price We write the firm's desired price as p=P+a(r-r This equation says that the desired price p depends on the overall level of prices P and on the level of aggregate output relative to the natural rate Y-Y. The pa- rameter a(which is greater than zero) measures how much the firms desired price responds to the level of aggregate output low 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 condi- tions to be. Firms with sticky prices set prices according to pe +a(y-y where, as before, a superscript"e"represents the expected value of a variable. For simplicity, assume that these firms expect output to be at its natural rate, so that he last term, a(r-y), is zero. Then these firms set the price That is, firms with sticky prices set their prices based on what they expect othe firms to chars 4 Mathematical note: The firm cares most about its relative price, which is the ratio of its nominal price level, then this equation states that the desired relative price depends on the deviation of out- User JoENA: Job EFFo1429: 6264_ch13: Pg 354: 27761#/eps at 100s Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 354:27761#/eps at 100% *27761* Mon, Feb 18, 2002 12:56 AM without formal agreements, firms may hold prices steady in order not to annoy their regular customers with frequent price changes. Some prices are sticky because of the way markets are structured: once a firm has printed and distributed its catalog or price list, it is costly to alter prices. To see how sticky prices can help explain an upward-sloping aggregate supply curve, we first consider the pricing decisions of individual firms and then add together the decisions of many firms to explain the behavior of the economy as a whole. Notice that this model encourages us to depart from the assumption of perfect competition, which we have used since Chapter 3. Perfectly competitive firms are price takers rather than price setters. If we want to consider how firms set prices, it is natural to assume that these firms have at least some monopoly control over the prices they charge. Consider the pricing decision facing a typical firm.The firm’s desired price p depends on two macroeconomic variables: ➤ 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 would like to charge for its product. ➤ 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. We write the firm’s desired price as p = P + a(Y −Y −). This equation says that the desired price p depends on the overall level of prices P and on the level of aggregate output relative to the natural rate Y −Y −.The parameter a (which is greater than zero) measures how much the firm’s desired price responds to the level of aggregate output.4 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 = Pe + a(Ye −Y −e ), where, as before, a superscript “e’’ represents the expected value of a variable. For simplicity, assume that these firms expect output to be at its natural rate, so that the last term, a(Ye −Y −e ), is zero.Then these firms set the price p = Pe . That is, firms with sticky prices set their prices based on what they expect other firms to charge. 354 | PART IV Business Cycle Theory: The Economy in the Short Run 4 Mathematical note: The firm cares most about its relative price, which is the ratio of its nominal price to the overall price level. If we interpret p and P as the logarithms of the firm’s price and the price level, then this equation states that the desired relative price depends on the deviation of output from the natural rate
Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 355 We can use the pricing rules of the two groups of firms to derive the aggre gate supply equation. To do this, we find the overall price level in the economy which is the weighted average of the prices set by the two groups. If s is the frac tion of firms with sticky prices and 1-s the fraction with fexible prices, then the overall price level is P (1-s[P+a(Y-Y) The first term is the price of the sticky-price firms weighted by their fraction in the economy, and the second term is the price of the fexible-price firms weighted by their fraction. Now subtract(1-s)P from both sides of this equation to obtain :p=sp +(1 -sla(y-Y)I Divide both sides by s to solve for the overall price level: P=PC+[(1-s)a/(Y-Y) The two terms in this equation are explained as follows: 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 P leads to a high actual price level P. When output is high, the demand for goods is high. Those firms with fexible 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 fexible 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 fa lilian form: Y=Y+a( 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 de- viation of the price level from the expected price level Although the sticky-price model emphasizes the goods market, consider briefly what is happening in the labor market. If a firms price is stuck in the short run, then a reduction in aggregate demand reduces the amount that the firm is able to sell. The firm responds to the drop in sales by reducing its produc- tion and its demand for labor. Note the contrast to the sticky-wage model: the firm here does not move along a fixed labor demand curve. Instead, fluctuations in output are associated with shifts in the labor demand curve.Because ofthese in the same directon. Thus, the real wage can be procyclical wage can all move shifts in labor demand, employment, production, and the real For a more advanced development of the sticky-price model, see Julio Rotemberg, "Monopolis- tic Price Adjustment and Aggregate Output, "Review of Economic Studies 49(1982): 517-53 User JoENA: Job EFFo1429: 6264_ch13: Pg 355: 27762#/eps at 100s Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 355:27762#/eps at 100% *27762* Mon, Feb 18, 2002 12:56 AM 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, which is the weighted average of the prices set by the two groups. If s is the fraction of firms with sticky prices and 1 − s the fraction with flexible prices, then the overall price level is P = sPe + (1 − s)[P + a(Y −Y −)]. The first term is the price of the sticky-price firms weighted by their fraction in the economy, and the second term is the price of the flexible-price firms weighted by their fraction. Now subtract (1 − s)P from both sides of this equation to obtain sP = sPe + (1 − s)[a(Y −Y −)]. Divide both sides by s to solve for the overall price level: P = Pe + [(1 − s)a/s](Y −Y −)]. The two terms in this equation are explained as follows: ➤ 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 Pe leads to a high actual price level P. ➤ 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: Y =Y − + a(P − Pe ), 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. Although the sticky-price model emphasizes the goods market, consider briefly what is happening in the labor market. If a firm’s price is stuck in the short run, then a reduction in aggregate demand reduces the amount that the firm is able to sell.The firm responds to the drop in sales by reducing its production and its demand for labor. Note the contrast to the sticky-wage model: the firm here does not move along a fixed labor demand curve. Instead, fluctuations in output are associated with shifts in the labor demand curve. Because of these shifts in labor demand, employment, production, and the real wage can all move in the same direction.Thus, the real wage can be procyclical.5 CHAPTER 13 Aggregate Supply | 355 5 For a more advanced development of the sticky-price model, see Julio Rotemberg,“Monopolistic Price Adjustment and Aggregate Output,’’Review of Economic Studies 49 (1982): 517–531
Worth: Mankiw Economics 5e 356 PART IV Business Cycle Theory: The Economy in the Short Run International Differences in the Aggregate Supply Curve Although all countries experience economic fluctuations, these fluctuations are not exactly the same everywhere. International differences are intriguing puzzles in themselves, and they often provide a way to test alternative economic theories Examining international differences has been especially fruitful in research on aggregate supply When economist Robert Lucas proposed the imperfect-information model, he derived a surprising interaction between aggregate demand and aggregate supply: according to his model, the slope of the aggregate supply curve should depend on the volatility of aggregate demand. In countries where aggregate demand fluctuates widely, the aggregate price level fluctuates widely as well. Because most movements in prices in these countries do not represent movements in relative prices, suppliers should have learned not to respond much to unexpected changes in the price level Therefore, the aggregate supply curve should be relatively steep(that is, a will be small). Conversely, in countries where aggregate demand is relatively stable, suppliers should have learned that most price changes are relative price changes. Accordingly in these countries, suppliers should be more responsive to unexpected price changes, making the aggregate supply curve relatively fat(that is, a will be large Lucas tested this prediction by examining international data on output and prices. He found that changes in aggregate demand have the biggest effect on output in those countries where aggregate demand and prices are most stable Lucas concluded that the e evidence supports the imperfect-information model The sticky-price model also makes predictions about the slope of the short- run aggregate supply curve. In particular, it predicts that the average rate of infla tion should influence the slope of the short-run aggregate supply curve. When the average rate of inflation is high, it is very costly for firms to keep prices fixed for long intervals. Thus, firms adjust prices more frequently. More frequent price adjustment in turn allows the overall price level to respond more quickly to shocks to aggregate demand. Hence, a high rate of infation should make the short-run aggregate supply curve steeper. International data support this prediction of the sticky-price model. In coun- tries with low average inflation, the short-run aggregate supply curve is relatively fat: fluctuations in aggregate demand have large effects on output and are slowly reflected in prices. High-inflation countries have steep short-run aggregate sup- ply curves. In other words, high inflation appears to erode the frictions that cause to be stick Note that the sticky-price model can also explain Lucas's finding that coun- tries with variable aggregate demand have steep aggregate supply curves. If the price level is highly variable, few firms will commit to prices in advance (s will be small). Hence, the aggregate supply curve will be steep(a will be small bRobert E. Lucas, Jr, "Some International Evidence on Output-Inflation Tradeoffs, "American Eco- 7Laurence Ball, N. Gregory Mankiw, and David Romer, "The New Key Economics and the Output-Inflation Tradeoff, " Brookings Papers on Economic Activity(1988: 1 ) 1-6 User JoENA: Job EFFo1429: 6264_ch13: Pg 356: 27763#/eps at 100sl l Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 356:27763#/eps at 100% *27763* Mon, Feb 18, 2002 12:56 AM 356 | PART IV Business Cycle Theory: The Economy in the Short Run CASE STUDY International Differences in the Aggregate Supply Curve Although all countries experience economic fluctuations, these fluctuations are not exactly the same everywhere. International differences are intriguing puzzles in themselves, and they often provide a way to test alternative economic theories. Examining international differences has been especially fruitful in research on aggregate supply. When economist Robert Lucas proposed the imperfect-information model, he derived a surprising interaction between aggregate demand and aggregate supply: according to his model, the slope of the aggregate supply curve should depend on the volatility of aggregate demand. In countries where aggregate demand fluctuates widely, the aggregate price level fluctuates widely as well. Because most movements in prices in these countries do not represent movements in relative prices, suppliers should have learned not to respond much to unexpected changes in the price level. Therefore, the aggregate supply curve should be relatively steep (that is, a will be small).Conversely,in countries where aggregate demand is relatively stable,suppliers should have learned that most price changes are relative price changes.Accordingly, in these countries, suppliers should be more responsive to unexpected price changes, making the aggregate supply curve relatively flat (that is,a will be large). Lucas tested this prediction by examining international data on output and prices. He found that changes in aggregate demand have the biggest effect on output in those countries where aggregate demand and prices are most stable. Lucas concluded that the evidence supports the imperfect-information model.6 The sticky-price model also makes predictions about the slope of the shortrun aggregate supply curve. In particular, it predicts that the average rate of inflation should influence the slope of the short-run aggregate supply curve.When the average rate of inflation is high, it is very costly for firms to keep prices fixed for long intervals.Thus, firms adjust prices more frequently. More frequent price adjustment in turn allows the overall price level to respond more quickly to shocks to aggregate demand. Hence, a high rate of inflation should make the short-run aggregate supply curve steeper. International data support this prediction of the sticky-price model. In countries with low average inflation, the short-run aggregate supply curve is relatively flat: fluctuations in aggregate demand have large effects on output and are slowly reflected in prices. High-inflation countries have steep short-run aggregate supply curves. In other words, high inflation appears to erode the frictions that cause prices to be sticky.7 Note that the sticky-price model can also explain Lucas’s finding that countries with variable aggregate demand have steep aggregate supply curves. If the price level is highly variable, few firms will commit to prices in advance (s will be small). Hence, the aggregate supply curve will be steep (a will be small). 6 Robert E. Lucas, Jr.,“Some International Evidence on Output-Inflation Tradeoffs,’’American Economic Review 63 ( June 1973): 326–334. 7 Laurence Ball, N. Gregory Mankiw, and David Romer,“The New Keynesian Economics and the Output-Inflation Tradeoff,’’ Brookings Papers on Economic Activity (1988:1): 1–65