Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 357 Summary and Implications We have seen three models of aggregate supply and the market imperfection that each uses to explain why the short-run aggregate supply curve is upward slop- ng. One model assumes nominal wages are sticky; the second assumes informa tion about prices is imperfect; the third assumes prices are sticky. Keep in mind that these models are not incompatible with one another. We need not accept one model and reject the others. The world may contain all three of these market imperfections, and all may contribute to the behavior of short-run aggregate Although the three models of aggregate supply differ in their assumptions and emphases, their implications for aggregate output are similar. All can be summa- rized by the equation Th al rate are related to deviations of the price level from the expected price level. If the price level is higher than the expected price level, output exceeds its natural rate. If the price level is lower than the expected price level, output falls short of its natural rate. Figure 13-3 graphs this equation. Notice that the short-run aggregate supply curve is drawn for a given expectation P and that a change in Pe would shift the curve Now that we have a better understanding of aggregate supply, let's put ag- gregate supply and aggregate demand back together. Figure 13-4 uses our ag gregate supply equation to show how the economy responds to an unexpected increase in aggregate demand attributable, say, to an unexpected monetary ex pansion In the short run, the equilibrium moves from point a to point B. The increase in aggregate demand raises the actual price level from P, to P2. Because people did not expect this increase in the price level, the expected price level remains at Pi, and output rises from Yi to Y2, which is above the natural rate Y. Thus, the unexpected expansion in aggregate demand causes the economy figure 13-3 Price level, P The Short-Run Aggregate r=p+a(P-pe) Supply Curve Output aggregate deviates from the natural rate supp Y if the price level P deviates from the expected price level Short-run aggregate supply pe User JoENA: Job EFFo1429: 6264_ch13: Pg 357: 27764#/eps at 100s Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 357:27764#/eps at 100% *27764* Mon, Feb 18, 2002 12:56 AM Summary and Implications We have seen three models of aggregate supply and the market imperfection that each uses to explain why the short-run aggregate supply curve is upward sloping. One model assumes nominal wages are sticky; the second assumes information about prices is imperfect; the third assumes prices are sticky. Keep in mind that these models are not incompatible with one another. We need not accept one model and reject the others.The world may contain all three of these market imperfections, and all may contribute to the behavior of short-run aggregate supply. Although the three models of aggregate supply differ in their assumptions and emphases, their implications for aggregate output are similar.All can be summarized by the equation Y =Y − + a(P − Pe ). This equation states that deviations of output from the natural rate are related to deviations of the price level from the expected price level.If the price level is higher than the expected price level, output exceeds its natural rate. If the price level is lower than the expected price level, output falls short of its natural rate. Figure 13-3 graphs this equation. Notice that the short-run aggregate supply curve is drawn for a given expectation Pe and that a change in Pe would shift the curve. Now that we have a better understanding of aggregate supply, let’s put aggregate supply and aggregate demand back together. Figure 13-4 uses our aggregate supply equation to show how the economy responds to an unexpected increase in aggregate demand attributable, say, to an unexpected monetary expansion. In the short run, the equilibrium moves from point A to point B. The increase in aggregate demand raises the actual price level from P1 to P2. Because people did not expect this increase in the price level, the expected price level remains at P2 e , and output rises from Y1 to Y2, which is above the natural rate Y −. Thus, the unexpected expansion in aggregate demand causes the economy to boom. CHAPTER 13 Aggregate Supply | 357 figure 13-3 Price level, P Income, output, Y P = Pe P > Pe P < Pe Y Y a(P Pe ) Y Short-run aggregate supply Long-run aggregate supply The Short-Run Aggregate Supply Curve Output deviates from the natural rate Y − if the price level P deviates from the expected price level Pe .
Worth: Mankiw Economics 5e 358 PART IV Business Cycle Theory: The Economy in the Short Run figure 13-4 Price level. p How Shifts in Aggregate Demand Lead to short-Run Fluctuations Here equilibrium, point A. When aggregate demand increases unexpectedly, the price P3=P5 level rises from P, to P2. Because the price level P2 is above the expected price level P2, output rises temporarily above the natural rate, as the economy moves along the short-run aggregate supply curve from point A to point B In the long run, the expected price level rises to Ps, causing the short-run aggregate supply Short-run curve to shift upward. The economy increase price level returns to a new long-run equilbrium, oint C, where output is back at its Short-run fuctuation Yet the boom does not last forever. In the long run, the expected price level rises to catch up with reality, causing the short-run aggregate supply curve to shift upward. As the expected price level rises from Ps to Ps, the equilibrium of the economy moves from point b to point C. The actual price level rises from P2 to P3, and output falls from Y2 to Y3. In other words, the economy returns to the natural level of output in the long run, but at a much higher price level. This analysis shows an important principle, which holds for each of the three models of aggregate supply: long-run monetary neutrality and short-run mone tary nonneutrality are perfectly compatible. Short-run nonneutrality is repre- sented here by the movement from point a to point B, and long-run monetary neutrality is represented by the movement from point a to point C. We reconcile the short-run and long-run effects of money by emphasizing the adjustment of expectations about the price level 73-2 Inflation, Unemployment and the Philips curve Two goals of economic policymakers are low inflation and low unemployment but often these goals confict. Suppose, for instance, that policymakers were to use monetary or fiscal policy to expand aggregate demand. This policy would move the economy along the short-run aggregate supply curve to a point of higher output and a higher price level.(Figure 13-4 shows this as the change from point A to point B. Higher output means lower unemployment, because firms need more workers when they produce more. A higher price level, given User JoENA: Job EFFo1429: 6264_ch13: Pg 358: 27765 #/eps at 100sl Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 358:27765#/eps at 100% *27765* Mon, Feb 18, 2002 12:56 AM Yet the boom does not last forever. In the long run, the expected price level rises to catch up with reality, causing the short-run aggregate supply curve to shift upward.As the expected price level rises from P2 e to P3 e , the equilibrium of the economy moves from point B to point C.The actual price level rises from P2 to P3, and output falls from Y2 to Y3. In other words, the economy returns to the natural level of output in the long run, but at a much higher price level. This analysis shows an important principle, which holds for each of the three models of aggregate supply: long-run monetary neutrality and short-run monetary nonneutrality are perfectly compatible. Short-run nonneutrality is represented here by the movement from point A to point B, and long-run monetary neutrality is represented by the movement from point A to point C.We reconcile the short-run and long-run effects of money by emphasizing the adjustment of expectations about the price level. 13-2 Inflation, Unemployment, and the Phillips Curve Two goals of economic policymakers are low inflation and low unemployment, but often these goals conflict. Suppose, for instance, that policymakers were to use monetary or fiscal policy to expand aggregate demand. This policy would move the economy along the short-run aggregate supply curve to a point of higher output and a higher price level. (Figure 13-4 shows this as the change from point A to point B.) Higher output means lower unemployment, because firms need more workers when they produce more. A higher price level, given 358 | PART IV Business Cycle Theory: The Economy in the Short Run figure 13-4 Price level, P Income, output, Y C P3 P3 e P1 P1 e P2 e P2 A B AD2 AD1 AS1 AS2 Long-run increase in price level Short-run increase in price level Short-run fluctuation in output Y1 Y3 Y Y2 How Shifts in Aggregate Demand Lead to Short-Run Fluctuations Here the economy begins in a long-run equilibrium, point A. When aggregate demand increases unexpectedly, the price level rises from P1 to P2. Because the price level P2 is above the expected price level P2 e , output rises temporarily above the natural rate, as the economy moves along the short-run aggregate supply curve from point A to point B. In the long run, the expected price level rises to P3 e , causing the short-run aggregate supply curve to shift upward. The economy returns to a new long-run equilbrium, point C, where output is back at its natural rate