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Macroeconomic Models II:

Macroeconomic Models II:. Supply Side. 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

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Macroeconomic Models II:

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  1. Macroeconomic Models II: Supply Side

  2. 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

  3. 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”

  4. 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)

  5. 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

  6. 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

  7. 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

  8. Long-run & Short-run Phillips Curves in terms of Output (Y) p LP p LP or SP t-1pt t-1pt SP Y U UN YN

  9. Changes in Expected Inflation Shift SP Curve Long-run and Short- Run 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 t-1pt SP’ t-1pt’ YN Y

  10. 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

  11. Changes in YN Shift Both LP and SP Curves p LP LP’ With no change in expected inflation, both SP and LP must shift when YN changes. SP SP’ t-1pt Y YN YN’

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