# Macro economics

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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
­  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
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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