Economics 827_87

Macroeconomic Models II:
Supply Side
Copyright 1998, R. H. Rasche
Macroeconomy - Supply
Side

Supply side of Macroeconomy consists of:
– Aggregate Production function relating output
produced to inputs of labor and capital (machines
and equipment)
– Supply and demand curves in Labor Market
– Labor Market equilibrium condition

Short-cut to summarize all these pieces:
– Expectations Augmented Phillips Curve
Copyright 1998, R. H. Rasche
Expectations Augmented
Phillips Curve

Phillips thought there was a single, fixed relationship
between the unemployment rate and inflation… but...

The relationship between Inflation and Unemployment
is not stable! It shifts up and down as expected rate of
inflation changes

pt = t-1pt + g(Ut - UNt)
» pt = Actual Inflation
» t-1pt = Current Expected Inflation Rate
» UNt = “natural unemployment rate”
Copyright 1998, R. H. Rasche
Expectations Augmented
Phillips Curve: Slope

In expectational equilibrium pt = t-1pt.
Hence U- UN = 0, regardless of the value of the
inflation rate.
– in expectational equilibrium Phillips curve is
vertical. (Long-run Phillips Curve (LP))

Holding t-1pt fixed, changes in unemployment rate
produce changes in inflation in opposite direction
(g < 0)
– Short-run Phillips curve (SP) is negatively sloped)
Copyright 1998, R. H. Rasche
Long-run -- Short-run
Phillips Curves
Long-run and
Short-Run
Phillips Curves
intersect when
actual inflation
is equal to
expected rate of
inflation.
p
LP
t-1pt
SP
UN
U
Copyright 1998, R. H. Rasche
Actual and Forecast (AR[1])
Annual Inflation: 1877-1994
Actual and Expected Annual Inflation AR(1),patterns
25
20
15
10
5
0
-5
-10
-15
1877
1890
1903
1916
1929
1942
1955
1968
1981
1994
Copyright 1998, R. H. Rasche
Unexpected Inflation vs
Unemployment: 1877-1994
Annual Unexpected Inflation vs Unemployment
20
15
10
5
0
-5
-10
-15
-20
-25
0
5
10
15
20
25
30
Copyright 1998, R. H. Rasche
Long-run & Short-run Phillips
Curves in terms of Output (Y)
p
p
LP
LP
or
t-1pt
SP
t-1pt
SP
UN
U
YN
Y
Copyright 1998, R. H. Rasche
Changes in Expected
Inflation Shift SP Curve
Long-run and ShortRun Phillips Curves
intersect when actual
inflation is equal to
expected rate of
inflation.
When expected
rate of inflation
changes, the height of
the SP curve at YN
is increased or
decreased
p
LP
SP
SP’
t-1pt
t-1pt’
YN
Y
Copyright 1998, R. H. Rasche
Supply Shocks

Think of changes in YN as “Supply Shocks”
– These can result from anything that changes
productivity
– Also result from shifts in labor supply function

Shocks to Yn affect both LP and SP curves
Copyright 1998, R. H. Rasche
Changes in YN Shift Both LP
and SP Curves
With no change in
expected
inflation, both SP
and LP must shift
when YN changes.
p
LP’
LP
SP
SP’
t-1pt
YN
YN’
Y
Copyright 1998, R. H. Rasche

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