Most economists analyze short-run fluctuations in aggregate income and the price level using the AD/AS model. Chapter 13 – Aggregate Supply and the Short-run Tradeoff Between Inflation and Unemployment – covers the three theories of aggregate supply that examine the frictions of macroeconomics. This chapter also covers why the Phillips-curve equation is a convenient way to analyze tradeoff between inflation and unemployment. I will explain these theories and also how the Phillips-curve equation works.
The three aggregate supply models are: sticky-price, sticky-wage, and imperfect-information. Although each of the three theories adheres to the same functional form, each one of them takes us through a different route, but each route ends up in the same place; the short-run aggregate supply equation form. The functional form is Y= Ȳ + α (P – Pᵉ), α>0, where Y is output, Ȳ is the natural level of output, P is the price level, and Pᵉ is the expected price level. α indicates how much output responds to unexpected changes in P and 1/α is the slope of the AS curve.
The first model – The Sticky-Price Model – explains an upward sloping AS curve by assuming that some prices are sticky because firms do not instantly adjust the prices they charge in response to changes in the economy. Two of the reasons why firms hold prices steady are: firms have long-term contracts with customers, and in order not to annoy regular customer with frequent price changes. A way to conceptualize the relationship between price level and output in the sticky-price model is when the level of output is high, the demand for goods and services is also high. Thus, when the firms set their sticky-prices, they set them high to account for the high demand. When firms set their prices high, the overall price level increases. Thus, a high level of output leads to a high level of demand, which leads to a high price... [continues]
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