copyright 1998, r. h. rasche macroeconomic models ii: supply side

Copyright 1998, R. H. Rasche

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

– Labor Market equilibrium condition

Short-cut to summarize all these pieces:

– Expectations Augmented Phillips Curve


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”


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)


Long-run -- Short-run Phillips Curves

p

UUN

LP

SPt-1pt

Long-run and Short-Run Phillips Curves intersect when actual inflation is equal to expected rate of inflation.


Actual and Forecast (AR[1]) Annual Inflation: 1877-1994

Actual and Expected Annual Inflation AR(1),patterns

1877 1890 1903 1916 1929 1942 1955 1968 1981 1994-15

-10

-5

0

5

10

15

20

25


Unexpected Inflation vs Unemployment: 1877-1994

Annual Unexpected Inflation vs Unemployment

0 5 10 15 20 25 30

-25

-20

-15

-10

-5

0

5

10

15

20


Long-run & Short-run Phillips Curves in terms of Output (Y)

p

YYN

LP

SP

t-1pt

p

UUN

LP

SP

t-1pt

or


Changes in Expected Inflation Shift SP Curve

p

YYN

LPSP

t-1pt’

Long-run and Short-Run Phillips Curves intersect when actualinflation is equal to expected rate of inflation.

When expectedrate of inflation changes, the height of the SP curve at YN

is increased or decreased

SP’t-1pt


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


Changes in YN Shift Both LP and SP Curves

p

Y

t-1pt

With no change in expected inflation, both SP and LP must shift when YN changes.

SPLP

YN YN’

LP’

SP’

copyright 1998, r. h. rasche macroeconomic models ii: supply side

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