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1 Overview
In Macro I (Chapter 7 of the textbook), you studied how the long run level of unemployment rate (or the natural
rate of unemployment) is determined. We now explore the short run deviation of unemployment from the natural
rate. This requires reviewing the derivation of the SRAS curve.
Before looking at the models, let us state an important empirical relationship between unemployment and GDP.
Since unemployed workers do not engage in production of goods and services, increases in unemployment should be
associated with decreases in real GDP. Such negative relationship between unemployment and real GDP is called
Okun's law. Textbook p286, Figure 10-4 depicts this relationship in the U.S. data; it is a scatterplot of the change
in the unemployment rate on the horizontal axis, and the percentage change in real GDP on the vertical axis. The
magnitude of this relationship is expressed as
Percentage Change in Real GDP = 3% 2 Change in the Unemployment Rate.
Thus, if there is no changes to the unemployment rate, real GDP grows by about 3 percent per year due to
growth in the labor force, capital accumulation, and technological progress. For every percentage point rise in the
unemployment rate, real GDP growth typically falls by 2 percent.
(1)
Here, Y is output, Y is the natural level of output, P is the price level, and EP is the expected price level (To be
precise, it is better to consider these as the natural log of the original variables; we will come back to this issue in
Section 3).
p = EP + a(EY E Y ),
(3)
where EP , EY , and E Y are expected values of P , Y , and Y . For simplicity, let us assume EY = E Y . Then, the
p = EP.
(4)
Thus, rms with sticky prices set prices based on the expectation of the prices set by other rms.
The overall price level in the economy is the weighted average of the prices set by two groups. Let s be the
fraction of rms with sticky prices, and 1 s be the fraction of rms with exible prices. Then, the overall price
level is
P = sEP + (1 s){P + a(Y Y )}.
(5)
Solving this for P , we obtain
(1 s)a
(Y Y ).
(6)
P = EP +
s
This equation can be explained as follows. When rms expect a high price level, sticky prices rms set high prices
since they expect high costs. This causes the other rms to set high prices, which leads to high P . When output is
high, exible prices rms set high prices since the demand for goods is high, which again increases P . This eect
is stronger with a higher fraction of exible prices rms.
Rearranging (6), we obtain the familiar expression
Y = Y + (P EP ),
where =
s
(1s)a
> 0.
That is, output exceeds the natural level if the actual price level exceeds the expected price level, and output falls
below the natural level when the actual price level turns out to be lower than its expected value. Thus, the SRAS
curve is upward sloping, as shown in Figure 1.
Let us examine the eects of an unexpected rise in the aggregate demand. Suppose that in Figure 2, the economy
is initially at point A, which corresponds to the long run equilibrium. Suppose now the AD curve shifts from AD1
to AD2 . Then, the price level exceeds its expected value EP2 , so the economy moves along SRAS1 to point B,
and output temporarily exceeds the natural level. However, in the long run, the expected price level catches up
with the actual price level, and shifts the SRAS curve to SRAS2 . Thus, the expected price level rises to EP3 , and
the equilibrium moves to point C. The actual price level rises from P2 to P3 , and output falls from Y2 to Y3 (= Y ).
Thus, while money is not neutral in the short run, it is so in the long run.
2
LRAS
SRAS
Y = Y + ( P EP)
EP
1
(Y Y ) + .
(7)
Subtracting the price level of the previous year, P1 , from both sides,
(P P1 ) = (EP P1 ) +
1
(Y Y ) + .
(8)
As mentioned in Section 2.1, it is more appropriate to interpret the price levels and output as denoting the
natural log of the original variable, so let us interpret as such. Then, (8) can be rewritten, using the ination rate
and the rate of expected ination E , as
= E +
1
(Y Y ) + .
Finally, let us recall Okun's law discussed in Section 1. One formulation of Okun's law is that the (percentage)
deviation of output from its natural level, Y Y , is negatively related to the deviation of the unemployment rate
from its natural level, that is,
1
(Y Y ) = (u un ).
(9)
The Phillips curve equation implies that the deviation of the ination rate from its natural level, E , is negatively
related to the deviation of unemployment from its natural rate, u un . In other words, it expresses the tradeo
between unemployment and ination.
The Phillips curve, as originally proposed by A. W. Phillips, indicated the negative relation between the unemployment rate and the rate of wage ination. The modern Phillips curve diers from its original formulation in
three regards. It considers price ination instead of wage ination, it includes expected ination, and it includes
supply shocks.
3
LRAS
SRAS 2
C
P3 = EP3
SRAS 1
B
P2
P1 = EP1 = EP2
A
AD2
AD1
Y1 = Y3 = Y
Y2
(11)
This equation implies that ination depends on past ination, cyclical unemployment, and supply shocks. When
the Phillips curve is written in this form, the natural rate of unemployment is sometimes called the non-accelerating
ination rate of unemployment (NAIRU).
The rst term in (11), 1 , implies that ination has inertia. That is, if unemployment is at the NAIRU, and if
there are no supply shocks, the ination rate equals the past ination rate. Such inertia arises since past ination
aects expectation of future ination, which in turn inuences wages and prices.
In the AD-AS model, ination inertia is interpreted as persistent upward shifts of the AD and AS curves.
Increases in prices raise the expected price level, and shift the SRAS curve upwards. This continues until some
event changes ination, and thereby changes expected ination. On the other hand, the continued rise in the
aggregate demand is most often due to persistent growth in the money supply. If the central bank stops money
growth, the aggregate demand stabilizes, and the upward shift of the aggregate supply causes a recession. The
recession leads to high unemployment, which lowers ination and expected ination, dampening ination inertia.
of cost-push ination, the unemployment rate and the ination rate may rise simultaneously. Such case is called
stagation, since stagnation and ination occurs at the same time.
E +
un
could take various forms, for example, 10 percent lower output for 2 years, 2 percent lower output for 10 years, and
so on.