ECON10003 Lecture Notes - Lecture 7: Real Wages, Aggregate Demand, Output Gap
Introductory Macroeconomics Week 7
LECRTURE 13: AGGREGATE SUPPLY
AS Curve map out set of points (Y, π) where firms production decisions consistent with price
changes
What determines price changes at firms?
1. Firms care about cost of production
2. Firms may sell output more or less quickly than expected – prices respond
correspondingly
a. If level of output higher than their goal (higher level of demand for their
goods/services)– increase price
b. If level of output lower than their goal (lower level of demand for their
goods/services)– decrease price / decrease rate at which prices are
increasing
AS Curve: Firm and Worker Bargaining
Cost of production; wages/labour Is major cost
Workers and firms bargain over future wages
• These wage increases determine large part of production costs and hence product
price changes
• But how do workers and firms bargain over wage increases?
Assume that firms and worker bargaining in the following manner:
• Workers want fair share of revenue
• Firms also want fair share of revenue
• Workers and firms care about real wage (w/p) but they determine the nominal
wage
• Under these conditions, wage changes will depend upon expected changes in price
• ∴ care about real wage because it determines future consumption possibilities but
will bargain over nominal wage
If prices are increasing by 10% /year, → nominal wage should increase by at least 10% to
keep real wage unchanged
If prices are increasing by 2% /year, → nominal wage should increase by at least 2% to keep
real wage unchanged
∴ level of nominal wage depends on how prices are increasing
Inflation Inertia
What determines expected price changes? Inflation inertia suggests today’s inflation
predicts future inflation
Inflation inertia: inflation is slow to adjust over time
• If inflation is high, expect high costs increases in the future (because firms and
workers will be bargaining over very high increases in the nominal wages today →
leads to high costs of production → increases in price in the future) leading to – this
creates high inflation in the future
• If inflation intertia was the main factor determining inflation, we could represent
behavior as:
πte = πt-1 → how inflation expectations are formed: formed under concept of inflation inertia
πt = πte + ϵt → cost of production have impact on inflation rate. (ϵt = shock/random error)
πt = πt-1 + ϵt → inflation is dependent upon previous inflation
Determinants of Inflation
Shocks to inflation: think of exogenous events that influence prices
• Standard example is oil price shocks – fluctuation in price of a key intermediate input
• Natural disasters – cyclones destroying crops
• Unexpected wage bargaining outcomes
What else affects inflation?
• Condition in product market
• Firms have a desired or target level of production (potential output, Y*, think of it as
a long run profit-maximizing output)
Output Gaps and Inflation
Y – Y* = 0: inflation then determined by expectations
Y – Y* > 0
• sales exceed normal level of output (firms selling more than they’d like in the long
run)
• start to increase prices to reduce demand
• inflation begins to accelerate above beyond expected inflation (π ↑)
Y < Y* < 0
• sales are less than normal level of output (firms not selling as much as they’d like)
• will reduce prices/increase prices less than they’d normally do to increase demand
• inflation begins to decelerate below expected inflation (π ↓)
• Aggregate Supply Curve in algebraic firm
• Inflation on LHS depends on:
o Inflation at time, t-1 (πt-1); measure of expectations of future inflation
o γ: parameter/constant indicating how responsive inflation to deviations in
output from potential level of output
▪ if γ is large, (Y – Y*)/Y* (deviation from potential output occurs), then
there’s large ↑ in π (inflation
o (Yt – Y*)/Y*: captures product market conditions
o ϵt: captures random shocks outside expectations
