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AGGREGATE SUPPLY:The sticky-price model

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Macroeconomics ECO 403
VU
LESSON 33
AGGREGATE SUPPLY
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
·
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 expected price level, P e.
·
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.
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)
·
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 )
·
Assume firms with sticky prices expect that output will equal its natural rate. Then,
e
p =P
·
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
P = s P  e + (1 - s )[P + a(Y -Y )]
Price set by
Price set by
sticky price firm
flexible price firm
156
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Macroeconomics ECO 403
VU
·
Subtract (1-s) P from both sides:
sP = s P  e + (1 - s )[a(Y -Y )]
Divide both sides by s :
·
⎡ (1 - s ) a ⎤
e
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.
·
Finally, derive AS equation by solving for Y:
Y = Y + α (P - P  e ),
s
where α =
(1 - s )a
In contrast to the sticky-wage model, the sticky-price model implies a procyclical 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.
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand