Chapter 6
Aggregate Supply: Wages,
Prices and Unemployment
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-1
Objectives
• Explore the economics that underlie the
aggregate supply curve
• Link inflation and economics through the
Phillips curve
• Use the Phillips curve to derive the aggregate
supply curve
• Consider the policy adjustment process
• Explain why wages and prices may be ‘sticky’
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-2
Chapter Organisation
6.1
The AS Curve and the Price Adjustment Mechanism
6.2
Inflation and Unemployment
6.3
The Wage–Unemployment Relationship
6.4
From Phillips Curve to the AS Curve
6.5
The Effects of a Monetary Expansion
6.6
So Why are Wages and Prices Sticky?
6.7
Stagflation, Expected Inflation and the Inflation–
Expectations–Augmented Phillips Curve
6.8
The Rational Expectations Revolution
6.9
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-3
6.1 AS and the Price Adjustment
Mechanism
• Equation (6.1) gives the AS curve and explains
the relationship between prices and output.
• Pt + 1 = Pt[1 + λ(Y – Y*)]
(6.1)
• Where Pt +1 is the price level next period, Pt is
the price level today, Y* is potential output and
 is the speed of price adjustment.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-4
AS and the Price Adjustment Mechanism
• The equation states that if output is above
potential output then prices will rise next
period and vice versa.
• If  is large, the AS curve will be steeper and
the AS mechanism will return the economy to
potential output relatively quickly.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-5
Chapter Organisation
6.1
The AS Curve and the Price Adjustment Mechanism
6.2
Inflation and Unemployment
6.3
The Wage–Unemployment Relationship
6.4
From Phillips Curve to the AS Curve
6.5
The Effects of a Monetary Expansion
6.6
So Why are Wages and Prices Sticky?
6.7
Stagflation, Expected Inflation and the Inflation–
Expectations–Augmented Phillips Curve
6.8
The Rational Expectations Revolution
6.9
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-6
6.2 Inflation and Unemployment
• Empirical studies suggest that there may be
a systematic relationship between inflation
and unemployment.
• One such model that explains this relationship
is the Phillips curve.
• The Phillips curve shows an inverse relationship
between the rate of unemployment and the rate
of increase in money wages.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-7
The Phillips Curve (PC)
• The higher the rate of unemployment,
the lower the rate of wage inflation.
• Equation (6.2) illustrates this relationship:
• Where gw is the rate of wage inflation
and u* is the NRU.
• When u > u*, wage inflation is falling.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-8
The Phillips Curve (PC)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-9
The Phillips Curve (PC)
• The PC implies that wages and prices adjust
slowly to changes in AD.
• Hence, in the short run, we are faced with
a policy trade-off between:
– High unemployment and low inflation, or
– High inflation and low unemployment.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-10
Chapter Organisation
6.1
The AS Curve and the Price Adjustment Mechanism
6.2
Inflation and Unemployment
6.3
The Wage–Unemployment Relationship
6.4
From Phillips Curve to the AS Curve
6.5
The Effects of a Monetary Expansion
6.6
So Why are Wages and Prices Sticky?
6.7
Stagflation, Expected Inflation and the Inflation–
Expectations–Augmented Phillips Curve
6.8
The Rational Expectations Revolution
6.9
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-11
6.3 Wage–Unemployment Relationship
• The Phillips curve suggests that wages adjust
gradually in response to unemployment.
• Wages are ‘sticky’ when they move slowly
over time.
• Because ‘sticky’ wages are not fully flexible,
full employment is not ensured.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-12
The Wage–Unemployment Relationship
(6.5)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-13
The Wage–Unemployment Relationship
• If employment is above the full-employment
level, the wage next period increases above
this period’s wage.
•
N > N* implies Wt +1 > Wt
• If employment is held above N* next period,
then the increase in wages is shown by an
upward shift of the WN curve next period.
• If N > N* is maintained then Wt + 2 > Wt +1
• This spiral process works in reverse as well.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-14
Chapter Organisation
6.1
The AS Curve and the Price Adjustment Mechanism
6.2
Inflation and Unemployment
6.3
The Wage–Unemployment Relationship
6.4
From Phillips Curve to the AS Curve
6.5
The Effects of a Monetary Expansion
6.6
So Why are Wages and Prices Sticky?
6.7
Stagflation, Expected Inflation and the Inflation–
Expectations–Augmented Phillips Curve
6.8
The Rational Expectations Revolution
6.9
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-15
6.4 From PC to the AS Curve
• To derive the AS curve we need to:
– Translate unemployment to output
– Link the prices firms charge to their costs
– Use the PC relationship between wages and
unemployment
– Put the three components together to derive an
upward-sloping AS curve.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-16
From PC to the AS Curve
• Okun’s Law can be used to translate
unemployment to output.
(6.6)
• Okun’s law shows the relationship
between unemployment and output
(Equation (6.5)).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-17
From PC to the AS Curve
• Costs and prices:
– Firms will supply output at a price that at least
covers their costs.
– Firms set price as a mark-up (z) on labour costs of
production (W/a).
– The mark-up costs cover the costs of the other
factors
of production and the firm’s normal profits.
(6.7)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-18
From PC to the AS Curve
• Employment and wages and the AS curve:
– The three components of the AS curve are Okun’s
law (Equation (6.6)), the price–cost relationship (6.7) and
the Phillips curve (6.3a).
– Substituting Equation (6.7) into (6.3a) gives (note
incorrect ratios in (6.8)):
1  z 
1  z 
Pt 1 
  Pt 
1   u  u 
 a 
 a 
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-19
From PC to the AS Curve

Setting  = Y*
gives the earlier Equation (6.1):
 Pt + 1 = Pt [1 +  (Y – Y*)]
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-20
From PC to the AS Curve
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-21
From PC to the AS Curve
• If output is above full-employment level, Y*,
then next period the AS curve will shift up to AS‘.
• If Y < Y* then next period the AS will shift down
to AS''.
• The AS curve implies that wages are less than
fully flexible.
• Prices increase with the level of output because
increased output implies increased employment
(reduced unemployment) and therefore increased
labour costs.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-22
Chapter Organisation
6.1
The AS Curve and the Price Adjustment Mechanism
6.2
Inflation and Unemployment
6.3
The Wage–Unemployment Relationship
6.4
From Phillips Curve to the AS Curve
6.5
The Effects of a Monetary Expansion
6.6
So Why are Wages and Prices Sticky?
6.7
Stagflation, Expected Inflation and the Inflation–
Expectations–Augmented Phillips Curve
6.8
The Rational Expectations Revolution
6.9
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-23
6.5 The Effects of a Monetary Expansion
• The aggregate supply model can be used
to analyse the effects of changes in the
money supply.
• Consider an increase in the nominal money
stock (Figure 6.8).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-24
The Effects of a Monetary Expansion
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-25
The Effects of a Monetary Expansion
• Short-run effects
– At each price level, real balances are higher, interest
rates are lower and hence the demand for output
increases.
– AD shifts to AD'.
– Firms run down inventories and, accordingly, hire
more labour and increase output to E'.
– At E' both prices and output have increased.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-26
The Effects of a Monetary Expansion
• Medium-term adjustment
– At E' prices continue to rise.
– Workers demand a higher wage to compensate
and this shifts the AS curve up to AS'.
– New equilibrium is at E'' where output is lower than
that of the first period and prices have risen further.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-27
The Effects of a Monetary Expansion
• Long-term adjustment
– As long as output is above the full-employment level,
wages are rising.
– The increase in wages means firms experience cost
increases and pass them on, which continues to shift
the AS curve up.
– Output declines back to Y* and prices continue to rise
– At E' '' prices increase by the same proportion as the
nominal money stock
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-28
The Effects of a Monetary Expansion
– Hence, the real money stock (M/P) returns back to
its original level, and so do interest rates, AD, output
and employment.
– The increase in the money stock has no real effects
(money is neutral as it only raises prices).
– The neutrality of money holds in the long run but
not in the short run.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-29
Chapter Organisation
6.1
The AS Curve and the Price Adjustment Mechanism
6.2
Inflation and Unemployment
6.3
The Wage–Unemployment Relationship
6.4
From Phillips Curve to the AS Curve
6.5
The Effects of a Monetary Expansion
6.6
So Why are Wages and Prices Sticky?
6.7
Stagflation, Expected Inflation and the Inflation–
Expectations–Augmented Phillips Curve
6.8
The Rational Expectations Revolution
6.9
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-30
6.6 Wage Stickiness
• The Phillips curve trade-off can be explained
in terms of the manner in which wages and
prices adjust.
• Explanations of wage stickiness include:
–
–
–
–
–
Imperfect information
Coordination problems
Efficiency wages
Contracts and long-term relationships
Insider–outsider models.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-31
Wage Stickiness
• Imperfect information: market clearing
– Wages are fully flexible but adjust slowly because
information is imperfect.
– When wages go up because prices increase, workers
mistakenly believe real wages have increased and are
willing to increase labour supply.
– This increases output and reduces unemployment until
workers realise that real wages have not gone up.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-32
Wage Stickiness
• Coordination problems
– As all firms cannot coordinate their prices, any firm
that increases its price due to a change in money
supply will lose market share.
– Hence, firms raise prices slowly, as the effects of a
change in money stock is felt through an increased
demand for goods at existing prices.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-33
Wage Stickiness
• Efficiency wages and costs of price change
– Efficiency wage theory focuses on wages as a means
of motivating labour.
– Firms may want to pay workers above the marketclearing wage to ensure that employees work harder.
– This may reduce disguised ‘shirking’ by workers.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-34
Wage Stickiness
• Contracts and long-term relationships
– Working conditions and wages are renegotiated.
periodically, but not frequently, because it is costly
to do so.
– Not all contracts are renegotiated at the same time.
– This leads to a staggered price adjustment process
with the supply curve rising form period to period as
wages ‘leapfrog’.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-35
Wage Stickiness
• Insider–outsider models
– It is costly for firms to turn over labour due to firing
costs, hiring costs and training costs.
– As a result, insiders have an advantage over outsiders.
– It may be beneficial for the firm to reach a deal with
insiders and pay higher wages, even if there are
unemployed people who would be willing to work
for less.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-36
Chapter Organisation
6.1
The AS Curve and the Price Adjustment Mechanism
6.2
Inflation and Unemployment
6.3
The Wage–Unemployment Relationship
6.4
From Phillips Curve to the AS Curve
6.5
The Effects of a Monetary Expansion
6.6
So Why are Wages and Prices Sticky?
6.7
Stagflation, Expected Inflation and the Inflation–
Expectations–Augmented Phillips Curve
6.8
The Rational Expectations Revolution
6.9
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-37
6.7 Stagflation, Expected Inflation and the
Inflation–Expectations–Augmented PC
• The simple Phillips curve neglects anticipated
inflation.
• Decisions are made with regard to real wages,
so nominal wages are usually adjusted for any
expected inflation.
• Unemployment depends not on the level of
unemployment but on the excess of inflation
over what was expected.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-38
Inflation–Expectations–Augmented PC
• Incorporating anticipated inflation into our
PC Equation (6.3) gives Equation (6.10):
 = e – ε(u – u*)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-39
Inflation–Expectations–Augmented PC
• There are two critical properties of the inflation–
expectations–augmented PC:
– That expected inflation is passed on one for one into
actual inflation
– Unemployment is at the natural rate when actual inflation
equals expected inflation.
• The PC intersects the NRU at the level of
expected inflation.
• For persistent inflation, the short-run PC shifts up.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-40
Chapter Organisation
6.1
The AS Curve and the Price Adjustment Mechanism
6.2
Inflation and Unemployment
6.3
The Wage–Unemployment Relationship
6.4
From Phillips Curve to the AS Curve
6.5
The Effects of a Monetary Expansion
6.6
So Why are Wages and Prices Sticky?
6.7
Stagflation, Expected Inflation and the Inflation–
Expectations–Augmented Phillips Curve
6.8
The Rational Expectations Revolution
6.9
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-41
6.8 The Rational Expectations Revolution
• The expectations augmented PC relationship
depends on people being wrong about inflation
in a predictable way.
• This approach does not allow for unexpected
changes in inflation which have not been foreseen.
• The theory of rational expectations differentiates
between anticipated and unanticipated changes
in policy which influence prices.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-42
The Rational Expectations Revolution
• For example, if changes in the money supply were
anticipated, expectations would be fulfilled:
– If agents knew that the RBA increased the money
supply by 8%
– Then agents would expect 8% inflation
– Unemployment would remain unchanged
– Inflation would rise to 8%.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-43
Rational Expectations
– However, if agents did not know the money supply
had grown by 8%, then they would have to guess,
using all the available information.
– If actual inflation turned out to be greater than
anticipated inflation, AD would increase and
unemployment would decrease.
– As soon as agents are aware of their mistake, they
adjust very rapidly, as inflationary expectations are
set to the correct value, shifting up the AS curve to
its long-run position.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-44
Rational Expectations
– Anticipated policy changes have no real effects.
– Unanticipated policy changes do affect real variables,
but only for a short period, as the adjustment process
is rapid.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-45
Chapter Organisation
6.1
The AS Curve and the Price Adjustment Mechanism
6.2
Inflation and Unemployment
6.3
The Wage–Unemployment Relationship
6.4
From Phillips Curve to the AS Curve
6.5
The Effects of a Monetary Expansion
6.6
So Why are Wages and Prices Sticky?
6.7
Stagflation, Expected Inflation and the Inflation–
Expectations–Augmented Phillips Curve
6.8
The Rational Expectations Revolution
6.9
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-46
6.9 Supply Shocks
• A supply shock is a disturbance to the economy
that initially shifts the aggregate supply curve.
• To analyse the impact of a supply shock prices
of raw materials have to be incorporated in the
aggregate supply function.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-47
Supply Shocks
•
Incorporating materials prices into the analysis
–
Previously, labour costs and the mark-up were the
only determinants of output prices.
–
Materials prices also impact upon the prices of
final goods.
–
Equations (6.15) to (6.17) incorporate the impact
of materials prices.
–
Equation (6.17) shows that, for given wages, profit
margins and labour productivity, an increase in the
real price of materials increases prices and shifts
the AS up.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-48
Supply Shocks
W 1  z 
(6.15)
P
 vPm
a
where vPm denotes materials input costs.
Pm
Setting Pm 
and 1  vpm gives :
P
1 z W 
P
 
(6.17)
1  vpm  a 
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-49
Supply Shocks
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-50
An Adverse Supply Shock
• Assume that there is an increase in the price
of oil.
– The AS curve shifts up and the economy moves to
point E' (Figure 6.12).
– Initially, prices have increased and output decreased.
– The unemployment at point E' forces wages, and thus
the price level, down.
– The economy moves back to point E.
– Employment is back to full employment.
– However, real wages have decreased since nominal
prices have returned to their original levels while
nominal wages have decreased.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-51
Accommodation of Supply Shocks
• Monetary or fiscal policy could be used to
offset the impact of the supply shock
– The government may accommodate the supply
shock by increasing AD.
– The economy moves to E*.
– Price would increase again while nominal wages
remain unchanged, implying lower real wages.
– Accommodating policies face the trade-off
between the inflationary impact of a shock and its
recessionary effects.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
6-52