CHAPTER THREE

AGGREGATE DEMAND & AGGREGATE

SUPPLY

3.1 Aggregate Demand

3.1.1 Quantity-Adjustment vs Price-Adjustment
3.1.2 The IS-LM Model
3.1.2.1 The Goods Market and the IS Curve
3.1.2.2 The Money Market and the LM Curve
3.1.2.3 Equilibrium in Goods & Money Markets
3.1.2.4 Explaining Fluctuations with IS-LM Model
3.1.2.5 Interaction b/n Monetary & Fiscal Policies
3.1.3 Deriving the Aggregate Demand Curve
3.2 Aggregate Supply
3.2.1 Introduction to Aggregate Supply
3.2.2 Models of Aggregate Supply
3.2.2.1 The Sticky-wage Model
3.2.2.2 The Worker-Misperception Model
3.2.2.3 The Imperfect-Information Model
3.2.2.4 The Sticky-Price Model
3.2.3 Inflation, Unemp’t & the Phillips Curve
3.2.3.1 Deriving the Phillips Curve
3.2.3.2 Adaptive Expectations and Inflation Inertia
3.2.3.3 Rational Expectations & the Possibility of
Painless Disinflation
3.2.3.4 Hysteresis & the Challenge to the Natural-
Rate Hypothesis
3.1 Aggregate Demand
 3.1.1 Quantity
Quantity--Adjustment vs Price-
Price-Adjustment
 How the discrepancy in equilibrium can be solved
in various markets?

 There are two different view regarding to this

questions:
1. Classical views
2. Keynesian views
 The principal theme of classical(price
theory) argued that if there is an imbalance
between supply & demand in a competitive market,
then prices change to clear the market or establish
equilibrium.
 Cont…
 Real wage flexibility equilibrates the labor market
sector & the real interest rate balances output
allocation between Investment (I) & Consumption
goods.

 Together, the equilibrium labor supply &

capital stock determine the equilibrium
output level.
 However, the Keynesian real sector model
takes a different approach.
 Cont.….
The simplest Keynesian model abstracts
entirely from price changes.

The Keynesian model explains interactions

b/n demand for goods & services, and the
financial sector.

The basic theme of the approach is that, in

the short-run, quantity adjustments occur if
there is imbalance between supply & demand.
Cont…
if there is Rational firm
The imbalance can adjust
Keynesian b/n supply their
model is an & demand, production
application then with the
of the producers extents of
quantity will change demand and
adjustment the quantity supply using
paradigm: of output the inventory
produced. management.
 Cont.…
 Which is applicable in real world?
 Both price & quantity adjustments take place
in reality.

 In the short run, a change in price is often a

costly & unreliable means of balancing sales &
production, esp. with a temporary imbalance
& a desire for rapid response.

 Thus, quantity adjustment is the primary

adjustment mechanism used to maintain
sales-production equilibrium in the short run.
 Cont.…
 Price changes are often made rarely &
therefore the principal adjustments to supply
& demand imbalances in the short run are
quantity changes.
 The above conclusion relies upon two
characteristics of the product market:
1. It is presumed that goods can be held in
inventory (true for manufactured goods).

2. Some degree of product differentiation.

 3.1.2 The IS-
IS-LM Model
In the short run when P is fixed, shifts in AD
lead to changes in national income.

The IS–LM model, a model of AD, aims at

showing what determines National income for
any given price level or what causes shifts in
AD.

The 2 parts of the model are IS & LM.

IS stands for “Investment” & “Saving”, that the

IS curve represents what’s going on in the
market for goods & services.
 Cont…
 LM stands for “Liquidity” (demand for money) &
“Money” (supply of money), & the LM curve
represents what’s happening to the supply of &
demand for money.

 The basic question is how to link the real and

monetary sector?

 The interest rate links the two halves of the IS–

LM model since it influences both investment &
money demand.

 The IS–LM model shows how interactions b/n these

markets determine the position & slope of the AD
curve.
 3.1.2.1 The Goods Market and the IS Curve
 The IS curve plots the relationship b/n interest rate
& income level that arises in the market for goods
& services.
 In The General Theory, Keynes proposed that an
economy’s total income was, in the short run,
determined largely by the desire to spend by
households, firms, and the government.
 The more people want to spend, the more goods
and services firms can sell. The more firms can sell,
the more output they will choose to produce and
the more workers they will choose to hire.
 Thus, the problem during recessions and
depressions, according to Keynes, was inadequate
spending.
 Cont….
 The Keynesian cross is an attempt to model
this insight.
 The Keynesian Cross & Income Determination
Determination::
 To develop the IS curve we start with a basic
model called the Keynesian cross.
 We begin our derivation of the Keynesian cross by drawing
a distinction between actual and planned expenditure.

 Actual expenditure (AE) is the amount households, firms,

and the government spend on goods and services, and as
we first saw in Chapter 2, it equals the economy’s gross
domestic product (GDP).

 Planned expenditure (E) is the amount households, firms,

and the government would like to spend on goods and
 Cont.…..
This model is the simplest interpretation of
Keynes’s theory of National income(NI) & is a
building block for the more realistic IS–LM
model.
The Keynesian cross begins by distinguishing
b/n actual & planned expenditure.
AE is the amount that households, firms & the
gov’t spend on goods & services, & equals GDP.
An AE of say 10 billion Birr is translated to a 10
billion Birr value for GDP, giving rise to a 450
line relating AE & GDP.
AE

90

10

0
45
10 90 Y (= output, GDP)
 Cont. …
 PE is the amount that the households, firms & the
gov’t would like to spend on goods & services.
 For a closed economy (NX = 0), PE is the sum of
consumption(C) planned investment (I) & gov’t
purchases (G). Then:
PE = C + I + G.
 To this equation, we add the following:
 The consumption function: C = C(Y − T);

 Assumption of fixed G & T (fiscal policy); &

 A simplifying assumption of exogenously fixed planned

investment.
 Cont…

Cont, …
 Cont, …
 Why would actual expenditure ever differ from planned
expenditure?

 The answer is that firms might engage in unplanned

inventory investment because their sales do not
meet their expectations.

 When firms sell less of their product than they

planned, their stock of inventories automatically rises;
conversely, when firms sell more than planned, their
stock of inventories falls.

 Because these unplanned changes in inventory are

counted as investment spending by firms, actual
expenditure can be either above or below planned
expenditure.
 Cont,..
 The Economy in Equilibrium
 The next piece of the Keynesian cross is the
assumption that the economy is in equilibrium when
actual expenditure equals planned expenditure.

 This assumption is based on the idea that when

people’s plans have been realized, they have no
reason to change what they are doing.
 With the addition of the planned-expenditure function to 45-
degree line, this diagram becomes the Keynesian cross.

 The equilibrium of this economy is at point A, where the

planned-expenditure function crosses the 45-degree
line(Actual Expenditure).
Cont…
 Cont.,…
1. Why would AE ever differ from PE?
2. How does the economy get to the equilibrium?
 Answer:
Answer firms might engage in unplanned inventory
investment when their sales do not meet their
expectations.
 When firms sell less of their product than they
planned, their stock of inventories automatically
rises, and vice versa.
 Since unplanned changes in inventory are counted
as investment spending by firms, AE can be > or <
PE.
 Cont…
 How does the economy get to the equilibrium?
 In this model, inventories play an important role in
the adjustment process.

 Whenever the economy is not in equilibrium, firms

experience unplanned changes in inventories, and
this induces them to change production levels.

 Changes in production in turn influence total

income and expenditure, moving the economy
toward equilibrium.
Cont, …
 Cont….

 In summary, the Keynesian cross shows how

income Y is determined for given levels of
planned investment I and fiscal policy G and T.
 We can use this model to show how income
changes when one of these exogenous
variables changes.
 3.1.2.1 The Goods Market and the IS Curve
Some NI Identities of the Closed Economy
1. Consumption and Saving Functions
C  C  cY d
S Y C
d

Thus, the consumption function C  C  cY d

corresponds to the saving function S Yd C
which simplifies to S  C (1  c)Y d

2. Planned versus Actual Investment

PE = C(Y–T)+I+G & AE = C(Y–T)+I+∆inv+G;
where I is planned investment (IPLANNED) & I +
∆inv is actual investment (IACTUAL).
PE = AE is thus equivalent to planned investment
= actual investment.
 Cont, ….
Thus, it always holds that IACTUAL = IPLANNED +
undesired changes in inventories (∆inv).
At equilibrium, IACTUAL = IPLANNED. This requires
that there is no undesired or unplanned change
in inventories (∆inv = 0).
Thus, the equilibrium condition PE = AE could be
stated as IACTUAL = IPLANNED or as ∆inv = 0.
3. Saving–Investment Identities
The condition PE = AE = Y is the same as saying
that Y = C + I + G, which could be rewritten in a
number of ways.
Subtracting taxes from both sides:
Y – T = C + I + G – T.
 Cont, ….
 Y–T is disposable income, which is either
consumed or saved. So,Yd = C + I + (G –T).
 For a hypothetical economy with no gov’t (G = T =
0), it follows that:Yd = C + I.
 Subtracting C from both sides yields:
Yd – C = C + I – C.
 The LHS of this identity is saving & the RHS is
planned investment. Thus, we have:
S=I
 For the case with gov’t, subtracting C from both
sides of Yd = C + I + (G – T):
Yd – C = I + (G – T).
 Moving (G – T) to the left we will have:
Yd – C + (T – G) = I.
 Cont, ….
 Yd – C on the left is saving by the private sector of
the economy, SP.
 T – G is the difference between what gov’t collects
as taxes (net) & gov’t purchases. It is saving by the
public sector, SG.
 Thus, Yd–C+(T–G) = I reduces to SP+SG = I.
S (= SG + SP) = I.
 In sum, S = I is merely another way of stating the
basic equilibrium condition.
4.The Injection – Leakage Identity
 This is the another way of stating the equilibrium
condition.
 The NI identity Y = C + I + G gives the sources of
national income.
 Cont, ….
Viewed from the income allocation side, the
income earned is shared among tax payments,
consumption & saving:
Y = T + C + S.
Bringing the two sides together:
C + I + G = Y = T + C + S.
In relation to the circular flow diagram, C, I & G
are injections/additions into the flow while C, S
& T are leakages/withdrawals from the circle.
Thus, injections = withdrawals at equilibrium.
C + I + G = T + C + S (or I + G = S + T) is
another way of representing the equilibrium
condition.
 Goods Market equilibrium, IS Curve and multiplier
The Multiplier
The Keynesian cross shows how income Y is
determined for given levels of planned
investment I & fiscal policy variables G & T.
Now, we use it to show how Y changes when
an exogenous variable changes.
More specifically, we will consider how output
(or GDP) responds to changes in:
government purchases,
autonomous taxes,
autonomous spending (on C or I),
G & T by the same amount (the balanced
budget multiplier), and
the tax rate.
 Cont….
The Government Purchases Multiplier (Y/G)
It tells us how much income rises in response to a 1
Birr change in G.
Raising G by G (from G1 to G2) causes PE to shift
upward from PE1 to PE2 (by G).
 Cont….
Consequently, equilibrium moves from A to B.
An increase in G leads to an even greater increase in
Y, i.e., Y > G.
For the movement from A to B caused by G, the
Y is shown by arrows from Y1 to Y2 both on the
horizontal & vertical axes.
The vertical distance b/n Y1 to Y2 is the same as the
distance from Point B to C.
The resulting Y > G (the distance b/n the two PE
expenditure curves).
The ratio ∆Y/ ∆G is called the government purchases
multiplier; it tells us how much income rises in
response to a $1 increase in government purchases.
 Cont,…
An implication of the Keynesian cross is that
the government-purchases multiplier is larger
than 1.
Thus, the government-purchases multiplier is
> 1.This is called the Multiplier effect.
Why does fiscal policy have a multiplied
effect on income?

Cont, ……
The reason is that, according to the
consumption function C = C(Y − T), higher Y
causes higher C.
When an increase in G raises Y, it also raises C,
which further raises Y, which further raises C,
and so on.
Therefore, in this model, an increase in G
causes a greater increase in Y.
How big is the multiplier?
To answer this question, we trace through each
step of the change in income.

Cont, …..

Round The Effect of G

on Consumption on Income
1 G
2 MPC x G MPC x G
3 MPC2 x G MPC2 x G
4 MPC3 x G MPC3 x G
… …
C = (MPC + MPC2 + Y = (1 + MPC + MPC2 +
SUM
MPC3 +…) x G MPC3 +…) x G

Y/G = 1 + MPC + MPC2 + MPC3 +…

Y/G = 1/(1 – MPC)
The larger MPC, the larger the multiplier.

Cont,…….

C  Ca  c(Y  T )
1
Y  Ca  cY  cT  I  G  Y  [Ca  cT  I  G ]
1 c

1
dY  [dC a  cdT  dI  dG ]
1 c

Cont,…….
From the final equation dY  1 [dCa  cdT  dI  dG ] :
1 c
dY 1 dY 1 dY 1
  
dG 1  c dCa 1  c dI 1  c
dY c dY
 ?
dT 1  c dG
dG dT

1
dY dG  dT  [dCa  cdG  dI  dG ]
1 c
1
dY dG  dT  [dC a  (1  c)dG  dI ]
1 c
dY 1 c
dG  dT  1
dG 1 c

Cont,…..
If tax is a (linear) function of income (T = tY):
Y  Ca  c(Y  tY )  I  G
dY  dCa  c[dY  d (tY )]  dI  dG
 dY  dCa  c[dY  (tdY  Ydt)]  dI  dG
 dY  dCa  cdY  ctdY  cYdt  dI  dG
 dY  cdY  ctdY  dCa  cYdt  dI  dG
 (1  c  ct )dY  dCa  cYdt  dI  dG
1
 dY  [dCa  cYdt  dI  dG]
(1  c  ct )

Cont, …..
If tax is a (linear) function of income (T = tY):
1
dY  [dCa  cYdt  dI  dG]
(1  c  ct )
dY dY dY 1
  
dCa dI dG 1  c  ct
The tax rate multiplier:
dY  cY

dt 1  c  ct
 Example:
1. In the Keynesian cross, assume that the
consumption function is given by C = 200 + 0.75
(Y − T ). Planned investment is 100; government
purchases and lump sum taxes are both 100.
A. Graph planned expenditure as a function of income?
B. What is the equilibrium level of income?
C. If government purchases increase to 125, what is the new
equilibrium income?
D. If the government tax decrease by 125, what is the new
equilibrium level of income?
E. What level of government purchases is needed to
achieve an income of 1,600?
F. What level of LUMP SUM tax is need to achieve an
income of 1600?

IS Curve
Interest Rate, Investment and the IS Curve
The Keynesian cross makes a simplifying
assumption that planned investment is fixed.
But, planned investment depends on the
interest rate, r – i.e., I = I(r).
Since r is the cost of borrowing to finance
investment projects, a rise in r reduces I: the
investment function slopes downward.
To determine how income changes when
interest rate changes, we combine the
investment function with Keynesian-cross.
IS curve is a curve that shows the various
combination of income (Y) and interest rate (r)
where the goods market is in equilibrium.


Deriving the IS Curve Panel (a) shows

the investment function: an increase in
the interest rate from r1 to r2 reduces
planned investment from I(r1) to I(r2).
Panel (b) shows the Keynesian cross: a
decrease in planned investment from
I(r1) to I(r2) shifts the planned
expenditure function downward and
thereby reduces income from Y1 to Y2.
Panel (c) shows the IS curve
summarizing this relationship between
the interest rate and income: the higher
the interest rate, the lower the level of
income.
 Cont…
 In summary, the IS curve shows the combinations of
the interest rate and the level of income that are
consistent with equilibrium in the market for goods
and services.

 The IS curve is drawn for a given fiscal policy.

 Changes in fiscal policy that raise the demand for

goods and services shift the IS curve to the right.

 Changes in fiscal policy that reduce the demand for

goods and services shift the IS curve to the left.

Cont…
Using C = Ca+c(Y–T) & a linear investment
function (I = Ia–br) together with the
equilibrium condition Y = C + I + G,
Y  Ca  c(Y  T )  I a  br  G
1
r [(1  c)Y  Ca  cT  I a  G ]
b
A higher r is associated with a lower level of
equilibrium Y, given the other variables.
The slope of the IS curve: dr  (1  c)

dY b
The slope of the IS curve depends on the
sensitivity of investment to changes in r (b) & on
MPC (c) or the multiplier.
 Cont….
 If I is very sensitive to r, so that b is large, a given  in r
produces a large  in PE & thus shifts PE curve up by a
large amount.
 A large shift in PE schedule produces a correspondingly
large  in equilibrium income (Y).
 If a given  in r produces a large  in Y, the IS curve is very
flat.
 With b small & I not very sensitive to r, the IS curve is
relatively steep.
 The larger MPC & the larger the multiplier, the flatter the IS
curve.
 Larger multiplier: larger Y produced by a given r, or
smaller r needed for a given Y.
 Points above & to the right of the IS curve signify excess supply
of goods, & vice versa.
 Cont, ….
 In summary,
 IS shows combinations of r & Y consistent with equilibrium
in market for goods & services.
 The IS curve is negatively sloped as a rise in r reduces I &
PE, thereby reducing equilibrium Y.
 To the right of the IS curve, there is excess supply in the
goods market, & vice versa.
 The smaller the multiplier (MPC) & the less sensitive I is to
 in r, the steeper the IS curve.
 The IS curve is drawn for a given fiscal policy.
 s in fiscal policy that raise (reduce) demand for goods
shift IS curve to right (left).
 IS curve is also shifted by s in autonomous spending of
private economic agents (Ca & Ia) .
A Loanable-
Loanable-Funds Interpretation of the IS Curve
 Recall that the national income accounts identity
can be written as:
Y − C − G = I S = I.
 The left-hand side of this equation is national
saving S, and the right-hand side is investment I.
 National saving represents the supply of loanable
funds, and investment represents the demand for
these funds.
 To see how the market for loanable funds
produces the IS curve, substitute the consumption
function for C and the investment function for I:
Y − C(Y − T) − G = I(r).
 Cont,….
 The left-hand side of this equation shows that the
supply of loanable funds depends on income and
fiscal policy.
 The right-hand side shows that the demand for
loanable funds depends on the interest rate.
 The interest rate adjusts to equilibrate the supply
and demand for loans.
 In next figure, we can interpret the IS curve as
showing the interest rate that equilibrates the
market for loanable funds for any given level of
income.
 Cont,….
 When income rises from Y1 to Y2, national saving,
which equals Y − C − G, increases.
 Consumption rises by less than income, because
the marginal propensity to consume is less than 1.
 As panel (a) shows, the increased supply of loanable
funds drives down the interest rate from r1 to r2.
 The IS curve in panel (b) summarizes this
relationship: higher income implies higher saving,
which in turn implies a lower equilibrium interest
rate.
 For this reason, the IS curve slopes downward.
 Cont, ….
 This alternative interpretation of the IS curve also explains
why a change in fiscal policy shifts the IS curve.
 An increase in government purchases or a decrease in taxes
reduces national saving for any given level of income.
 The reduced supply of loanable funds raises the interest rate
that equilibrates the market. Because the interest rate is now
higher for any given level of income, the IS curve shifts
upward in response to the expansionary change in fiscal
policy. Finally, note that the IS curve does not determine
either income Y or the interest rate r.
 Instead, the IS curve is a relationship between Y and r arising
in the market for goods and services or, equivalently, the
market for loanable funds.
 To determine the equilibrium of the economy, we need
another relationship between these two variables, to which
we now turn

3.1.2.2 The Money Market and the LM Curve
The money market is just one component of the
broader concept of asset markets.
Asset markets are markets where money, bonds,
stocks, houses & other forms of wealth are traded.
We simplify matters by grouping assets into two:
money & interest-bearing assets.
At a given time, an individual has to decide how to
allocate his/her financial wealth b/n two
alternatives – money & bond.
The more bonds held, the more interest received;
the more money held, the more likely the
individual is to have money available for making a
purchase.
Such decisions on the form in which to hold assets
are portfolio decisions.

Cont,…..
The portfolio decisions on how much money &
on how many bonds to hold are really the same
decision.
The LM curve plots the relationship b/n r & Y that
arises in the money market.
The theory of liquidity preference is the building
block for this relationship.
The Theory of Liquidity Preference
The theory explains how r is determined in the
short run; it posits that r adjusts to balance supply
of & demand for the economy’s most liquid asset
– money.
A. The supply of real money balances
If M stands for money stock & P for the price
level, M/P = supply of real money balances.
 Cont…
 The money supply M is an exogenous policy variable
chosen by a central bank, such as the Federal
Reserve/ENB.

 The price level P is also an exogenous variable in this

model. (We take the price level as given because the IS–
LM model—our ultimate goal in this chapter—explains
the short run when the price level is fixed.)

 These assumptions imply that the supply of real money

balances is fixed and, in particular, does not depend on
the interest rate.

 Thus, when we plot the supply of real money balances

against the interest rate in following figure, we obtain a
vertical supply curve.

Cont, …
The theory of liquidity preference assumes a
fixed supply of real money balances: M S M
( ) 
P P
M is an exogenous policy variable chosen by a
central bank (NBE in our case).
P is an exogenous variable in this model: we
take P as given (IS–LM explains the SR).
These imply that supply of real money
balances is fixed & does not depend on r.
B.The demand for real money balances
Demand for money is demand for real
balances: we hold money for what it can buy.
The higher P, the more nominal balances a
person has to hold to be able to purchase a
given quantity of goods.
 Cont, …
 If P doubles, one has to hold twice as many nominal
balances to be able to buy the same amount of goods.

 Next, consider the demand for real money balances.

 The theory of liquidity preference posits that the interest

rate is one determinant of how much money people
choose to hold.

 The reason is that the interest rate is the opportunity cost

of holding money: it is what you forgo by holding some of
your assets as money, which does not bear interest, instead
of as interest-bearing bank deposits or bonds.

 When the interest rate rises, people want to hold less of

their wealth in the form of money.

 We can write the demand for real money balances as:

(M/P) d = L(r),

cont., ….
The Theory of Liquidity Preference
On these grounds, the demand for real
• The supply and demand for real
money balances determine the
balances rises with Y & decreases with r:
interest rate. The supply curve for
M d real money balances is vertical
( )  kY  hr because the supply does not
P depend on the interest rate.
• The demand curve is downward
For a given level of Y, the quantity demanded
sloping because a higher interest
of M/P is a decreasing function of r.
rate raises the cost of holding
money and thus lowers the
Higher Y means larger demand for M/P, &
quantity demanded.
• d
At the equilibrium interest rate, the
therefore shifts the (M/P) curve to the right.
quantity of real money balances
(M/P)S & (M/P)d determine what r prevails in
demanded equals the quantity
supplied.
the economy (what r equilibrates the money
market).
How money supply affect r?
 Income, Money Demand, and the LM Curve
 Suppose, when income increases from Y1 to Y2. As panel (a)
illustrates, this increase in income shifts the money demand
curve to the right.
 With the supply of real money balances unchanged, the
interest rate must rise from r1 to r2 to equilibrate the
money market.
 Therefore, according to the theory of liquidity preference,
higher income leads to a higher interest rate.
 The LM curve plots this relationship between the level of
income and the interest rate.
 The higher the level of income, the higher the demand for
real money balances, and the higher the equilibrium interest
rate.
 For this reason, the LM curve slopes upward, as in panel (b).

Cont, ….
Income, Money Demand, and the LM Curve
When Y is high, expenditure is high, so people
engage in more transactions that require the
use of money.
The higher Y, the higher (M/P)d will be, and
the higher the equilibrium r.
Therefore, a higher Y leads to a higher r.
The LM curve plots this positive relationship
b/n Y & r.
 Cont, ….
 In summary, the LM curve shows the
combinations of the interest rate and the level
of income that are consistent with equilibrium
in the market for real money balances.

 The LM curve is drawn for a given supply of real

money balances.

 Decreases in the supply of real money balances

shift the LM curve upward. Increases in the
supply of real money balances shift the LM
curve downward.

LM equation

Cont, …..
In summary,
The LM curve shows combinations of r & Y consistent
with equilibrium in the money market.
The LM curve is positively sloped: given MS, a rise in Y
raises the quantity of M demanded, & has to be
accompanied by an increase in r.
The greater the responsiveness of (M/P)d to Y & the
lower the responsiveness of (M/P)d to r, the steeper
the LM curve will be.
To the right of the LM curve, there is an excess
(M/P)d & to its left, there is an excess (M/P)S.
The LM curve is drawn for a given (M/P)S: decreases
in (M/P)S shift the LM curve upward; increases in
(M/P)S shift it downward.

3.1.2.3 Equilibrium in Goods & Money Markets
IS & LM together determine economy’s eqlm.
The model takes G,T, M & P as exogenous.
Given these variables, IS gives combinations
of r & Y that satisfy Y=C(Y–T)+I(r)+G,
Equilibrium in the &IS–LM LM
Model: The intersection of
combinations of r & Y that satisfy M/P=L(r, Y).
the IS and LM curves
The eqlm of the economy is the simultaneous
represents point at
equilibrium in the market for
which the IS curve & the LM curve cross.
goods and services and in
At this point, AE = PE & (M/P) d = (M/P)
the market for realS .money
balances for given values of
government spending, taxes,
the money supply, and the
price level.

Cont, ….
To find eqlm r & eqlm Y algebraically, solve
the IS & the LM equations simultaneously.
1
IS : r  [(1  c)Y  Ca  cT  I a  G ].........(1)
b
1 M
LM : r  (kY  ) or Y  1 (hr  M ).........(2)
h P k P

 1 (1  c) M
r [ (hr  )  Ca  cT  I a  G ]
b k P

k (1  c) M
r [Ca  I a  G   cT ]
bk  (1  c)h k P

Cont, …
1 M
Y  {hr  }
k P

1 hk (1  c) M M
Y { [Ca  I a  G   cT ]  }
k [bk  (1  c)h] k P P

1 hk bk M
Y { [Ca  I a  G  cT ]  ( )}
k [bk  (1  c)h] [bk  (1  c)h] P

h b M
Y [Ca  I a  G  cT  ( )]
bk  (1  c)h h P

The effect of policy changes
 The intersection of the IS & the LM curves determines level of
national income (Y).
 When one of these curves shifts, the short-run equilibrium
changes & Y fluctuates.

Changes in Fiscal Policy

s in G or T influence PE & thereby shift the
IS curve.
Consider an increase in G.

Goods Market Money Market

G  PE 
Md  r 
Production & Y 
I  PE  Y
Cont, …

Cont…….
The effect of fiscal policy (say, G) on Y in
the IS-LM model is weaker than the effect of
the same policy in the Keynesian Cross.
This is because of the crowding out effect.
Changes in Monetary Policy
 in MS influences (M/P)S & thereby shifts
the LM curve.
Consider an increase in MS.

Money Market Goods Market

I  PE 
MS  r 
Production & Y 
MD  r
Cont, …

Mathematically …..

k (1  c) M
From r  [Ca  I a  G   cT ] ,
bk  (1  c)h k P
k (1  c) dM MdP
dr  [dCa  dI a  dG  cdT  [  2 ]
bk  (1  c)h k P P
dr dr dr k
   0
dCa dI a dG bk  (1  c)h
dr  ck
 0
dT bk  (1  c)h

dr  (1  c) P 1
 0
dM bk  (1  c)h

3.1.2.4 Explaining Fluctuations with IS-
IS-LM Model
h b M
From Y  [Ca  I a  G  cT  ( )] ,
bk  (1  c)h h P

h b dM MdP
dY  [dCa  dI a  dG  cdT  (  2 )]
(1  c)h  bk h P P

dY dY dY h
   0
dCa dI a dG (1  c)h  bk

dY  ch
 0
dT (1  c)h  bk

dY bP1
 0
dM (1  c)h  bk

Effectiveness of both policies…..
Fiscal policy is more effective at influencing Y:
the flatter the LM curve – (M/P)d less sensitive to
Y &/or more sensitive to r, &
the larger the MPC (larger right- or left-ward
shift in IS curve) & the less sensitive I to r
(smaller crowding out effect).
Monetary policy is more effective at influencing Y:
the flatter the IS curve – the larger the MPC &
the more sensitive I to r, &
the less sensitive (M/P)d to r (larger down- or
up-ward shift in LM curve) &/or the less sensitive
(M/P)d to Y.

3.1.2.5 Interaction b/n Monetary & Fiscal Policies
A change in monetary/fiscal policy may
influence the other, & the interdependence
may alter the impact of a policy change.
For example, suppose gov’t raises taxes.
The effect of this policy depends on how the
central bank responds to the tax raise.
The figure below shows three of the many
possible outcomes.
 Example:
1. Suppose that the money demand function is (M/P) d =
1,000 − 100r, where r is the interest rate in percent. The
money supply M is 1,000 and the price level P is 2.

A. Graph the supply and demand for real money balances.

B. What is the equilibrium interest rate?

C. Assume that the price level is fixed. What happens to the

equilibrium interest rate if the supply of money is raised
from 1,000 to 1,200?

D. If the Fed wishes to raise the interest rate to 7 percent,

what money supply should it set?
 From the IS–
IS–LM Model to the Aggregate Demand Curve
 To understand the determinants of aggregate
demand more fully, we now use the IS–LM
model, rather than the quantity theory, to
derive the aggregate demand curve.
 First, we use the IS–LM model to show why
national income falls as the price level rises—
that is, why the aggregate demand curve is
downward sloping.
 Second, we examine what causes the
aggregate demand curve to shift.
 Cont…
 To explain why the aggregate demand curve slopes
downward, we examine what happens in the IS–LM model
when the price level changes.
 This is done in next figure. For any given money supply M, a
higher price level P reduces the supply of real money balances
M/P.
 A lower supply of real money balances shifts the LM curve
upward, which raises the equilibrium interest rate and lowers
the equilibrium level of income, as shown in panel (a).
 Here the price level rises from P1 to P2, and income falls from
Y1 to Y2.
 The aggregate demand curve in panel (b) plots this negative
relationship between national income and the price level.
 In other words, the aggregate demand curve shows the set of
equilibrium points that arise in the IS–LM model as we vary
the price level and see what happens to income.
 Cont, …
 What causes the aggregate demand curve to shift?
 Because the aggregate demand curve is merely a summary of
results from the IS–LM model, events that shift the IS curve or
the LM curve (for a given price level) cause the aggregate
demand curve to shift.
 For instance, an increase in the money supply raises income in
the IS–LM model for any given price level; it thus shifts the
aggregate demand curve to the right, as shown in panel (a) of
next figure.
 Similarly, an increase in government purchases or a decrease in
taxes raises income in the IS-LM model for a given price level; it
also shifts the aggregate demand curve to the right, as shown in
panel (b) of next figure.
 Conversely, a decrease in the money supply, a decrease in
government purchases, or an increase in taxes lowers income in
the IS–LM model and shifts the aggregate demand curve to the
left.
 Cont, …
 We can summarize these results as follows: A change
in income in the IS–LM model resulting from a change
in the price level represents a movement along the
aggregate demand curve.

 A change in income in the IS–LM model for a fixed

price level represents a shift in the aggregate demand
curve.
 Cont, …
 AD curve is drawn for given values of G, T, M & P
(exogenous variables in IS-LM model).
 Events that shift the IS or LM curves (for a given P) cause
AD curve to shift.
 A change in G, T, or MS will affect the equilibrium Y for
every P & hence the position of AD curve.
Solving IS & LM equations simultaneously:

b -1 h
Y {MP  [Ca  cT  I a  G]}
bk  h(1  c) b
Y b M
The slope of AD is:  [ 2]
P bk  h(1  c) P
P bk  h(1  c) P 2
 [ ]  0
Y b M
Thank you!
3.2 Aggregate Supply

3.2.1 Introduction to Aggregate Supply
The levels of eqlm output & price that prevail
in an economy depend on AD & AS.
AS describes the amount of output that
producers are willing & able to supply.
The AS curve implicit in IS-LM is based on
the notion of no supply constraints & pre-
determined prices in the short-run.
Whatever output level demanded will be
produced & the AS curve is horizontal.
There is sufficient excess capacity so that 
AD  production without  costs & prices.
At the opposite extreme to the horizontal AS
curve lies the vertical AS curve of classicals.
In this view, each market reaches an eqlm
which determines relative prices & quantity.

3.2.2 Models of Aggregate Supply
The two AS curves are theoretical extremes,
do not depict the real world behavior.
An upward sloping SRAS is more realistic.
4 prominent models of SRAS.
The models differ in some details, but share a
common theme about what makes SRAS &
LRAS curves differ & a common end that
SRAS curve is upward sloping.
In all of them, some market imperfection
causes Y to deviate from the classical
benchmark (the natural rate, Y ).
 Nominal wages have not been
corrected for inflation, and real 3.2.2.1 The Sticky-
Sticky-wage Model
wages are corrected for inflation.
Why SRAS curve is upward sloping?
Due to sluggish adjustment of nominal wages.
Nominal wages are set by long-term
contracts & cannot adjust quickly.
Even without formal contracts, implicit agree-
ments b/n workers & firms or social norms &
notions of fairness may limit s in W.
So, nominal wages are sticky in the short run.
1) Workers & firms bargain & agree on nominal
wage (W) before they know what P will be.
They set W based on target real wage (ω) &
on expected price level (Pe): W    P e
2) After W has been set & before L has been
hired, firms learn P; real wage will be W/P.

3.2.2.1 The Sticky-
Sticky-wage Model
e
W P

P P
Real wage (W/P) deviates from its target (ω)
if P differs from Pe:
If P > Pe, W/P < ω;
if P < Pe, W/P > ω.
3) Finally emp’t is determined by QL firms dd &
output by production function.
 Workers agree to provide as much L as firms
want at the preset wage.
 The firms’ hiring decisions is described by
the labor demand function: L = Ld(W/P).
 Output is determined by the production
function:Y = F(L).

3.2.2.1 The Sticky-
Sticky-wage Model
As W is sticky, an unexpected P moves W/P
away from ω & this influences the amounts of
L hired & Y produced.

The AS curve can be written as:

Y  Y   (P  P ) e

Output deviates from its natural level when P

deviates from Pe.

3.2.2.2 The Worker-
Worker-Misperception Model
W can adjust freely & quickly to set Ls = Ld.
Unexpected P affects Ls as workers tempo
rarily confuse real & nominal wages.
The 2 components of the model: Ls & Ld.
Ld = Ld(W/P).
Ls = Ls(W/Pe).
Workers know W, but not P: when deciding
how much to work, they consider W/Pe:
W W P
e
  e
P P P
P/Pe = workers’ misperception of price level.
If P/Pe > 1, P is greater than what workers
expected & W/P < W/Pe.
 Ls = Ls[(W/P) X (P/Pe)].

3.2.2.2 The Worker-
Worker-Misperception Model
Position of Ls curve & eqlm depend on P/Pe.
When P rises, economy’s reaction depends on
whether workers anticipate the change.
If they do, then Pe rises proportionately with
P: neither Ls nor Ld s; W rises proportionally
with Ps; W/P & emp’t remain the same.
If the P catches workers by surprise, Pe
remains the same when P rises.
The rise in P/Pe shifts Ls to right, lowering
W/P & raising the level of emp’t.
Hence, workers believe that P is lower & thus
W/P is higher than actually is the case.
This induces them to supply more labor.

3.2.2.2 The Worker-
Worker-Misperception Model
Firms are assumed to be better informed
than workers & to recognize the fall in W/P:
they hire more L & produce more Y.
Deviations of P from Pe induce workers to 
their Ls & this s quantity of Y firms produce:
Y  Y   (P  P ) e

In the 2 models above (with an unchanging Ld

curve) an unexpected rise in P lowers W/P &
thus raises quantities of L hired & Y produced:
W/P is countercyclical.
Yet real world data show a weak & opposite
correlation b/n W/P & Y; if W/P is cyclical, it is
slightly procyclical.
Most economists conclude that the 2 models
cannot fully explain AS: they advocate models
in which Ld shifts over the business cycle.

3.2.2.3 The Imperfect-
Imperfect-Information Model
Markets clear, i.e., all wages & prices are free
to adjust.
The SRAS & LRAS curves differ because of
temporary misperceptions about prices.
Each supplier in the economy produces a
single good & consumes many goods.
As the number of goods is large, suppliers
cannot observe all prices at all times.
Due to imperfect information, they some-
times confuse s in overall P & in relative Ps.
This influences decisions about how much to
ss & leads to a positive r/p b/n P & Y in the SR.
Consider the decision facing a supplier – a
wheat farmer, for instance.
The amount of wheat she produces depends
on relative P of wheat: if RPW is high, she is
motivated to work hard & produce more.

3.2.2.3 The Imperfect-
Imperfect-Information Model
Consider how the farmer responds if all
prices, including PW, increase.
One possibility: she expected this  in Ps; her
estimate of RPW is unchanged & she does not
work any harder.
The other possibility: the farmer did not
expect P to rise: observing a rise in PW, she is
not sure whether other Ps have risen or only
PW has risen.
The rational inference: some of each has
happened: the farmer infers RPW has risen
somewhat, works harder & produces more.
When P rises unexpectedly, all suppliers
observe rises in prices of goods they produce.
They all infer that their RPs have risen: they
work harder & produce more.
Y  Y   (P  P ) e

3.2.2.4 The Sticky-
Sticky-Price Model
Firms do not instantly adjust their prices in
response to changes in demand.
Sometimes prices are set by long-term
contracts b/n firms & customers.
Even without formal agreements, firms may
hold prices steady in order not to annoy their
customers with frequent price changes.
Some prices are sticky because once a firm
has printed & distributed its catalog or price
list, it is costly to alter prices.
We first consider pricing decisions of
individual firms & then add up these decisions
Perfectly competitive firms are P-takers; to
consider how a firm sets P, we take firms with
some power over Ps.
Consider the decision facing a typical firm.

3.2.2.4 The Sticky-
Sticky-Price Model
The firm’s desired price p depends on two
macroeconomic variables:
Overall level of prices P – higher P implies
higher costs for the firm; the higher P, the
more the firm would like to charge.
Level of aggregate income Y – higher Y
raises demand for the firm’s product; as MC
rises at higher levels of production, the
greater the demand, the higher the p.
We write the firm’s desired price as:
p  P  a(Y  Y )
p depends on P & the level of output relative
to the natural rate.
a measures how much the desired price
responds to the level of Y.

3.2.2.4 The Sticky-
Sticky-Price Model
Assume that there are two types of firms.
 Some have flexible prices: they always set their
prices according to this equation.
 Others have sticky prices: they announce their
prices in advance based on what they expect
economic conditions to be.
Firms with sticky prices set ePs according to:
p  P  a (Y  Y )
e e

Assume these firms expect output to be at its

natural rate (last term is zero); then: p  P e
Firms with sticky prices set prices based on
what they expect other firms to charge.
We can use the pricing rules of the two
groups of firms to derive the AS equation.
The overall price level in the economy is the
weighted average of Ps set by the 2 groups.

3.2.2.4 The Sticky-
Sticky-Price Model
If s is fraction of firms with sticky prices & 1−s
the fraction with flexible prices, then:
P  sP  (1  s)[P  a(Y  Y )]
e

Now subtract (1−s)P from both sides:

sP  sP  (1  s)a(Y  Y )
e

Divide both sides by s to solve for P:

P  P  (1  s)(a )(Y  Y )
e
s
 When firms expect a high price level, they expect
high costs. Those firms that fix prices in advance
set their prices high. This causes the other firms to
set high prices. Hence, a high Pe leads to a high P.
 When Y is high, demand for goods is high. Firms
with flexible prices set prices high, leading to a high
P.The effect of Y on P depends on s.
 Hence, P depends on Pe & the level of output.

3.2.2.4 The Sticky-
Sticky-Price Model
Algebraic rearrangement puts this pricing
equation into a more familiar form:
Y  Y   (P  P ) e

Deviation of output from the natural rate is

positively related to deviation of P from Pe.
Consider what is happening in labor market.
If a firm’s price is stuck in SR, then a fall in AD
reduces what the firm can sell.
The firm responds to drop in sales by
reducing its production & demand for labor.
Here, the firm does not move along a fixed Ld
curve; instead, s in Y imply shifts in Ld curve.
Due to shifts in Ld, emp’t, production & real
wage can all move in the same direction –
real wage can be procyclical.

Models of Aggregate Supply
Though the 4 models of AS differ in their
assumptions & emphases, they have similar
implications for AS.
Deviations of output from the natural rate are
related to deviations of the price level from the
expected price level. If P > Pe, Y exceeds natural
rate; if P < Pe, Y falls short of natural rate.
Notice that the SRAS curve is drawn for a
given expectation Pe & that a change in Pe
would shift the curve.
A rise in Pe shifts the SRAS curve upward &
vice versa.

3.2.3 Inflation, Unemp’t & the Phillips Curve
The upward sloping SRAS curve implies a
tradeoff b/n inflation & unemp’t.
Phillips curve states that  depends on:
 Expected inflation;
 Deviation of unemp’t from the natural rate; &
 Supply shocks v.
     (u  u )  v
e n

Where does this equation come from?

From our equation for SRAS.
To see how, first write SRAS equation as:
P  P e  ( 1 )(Y  Y )


3.2.3.1 Deriving the Phillips Curve
Add to the RHS of the equation a supply
shock v to represent exogenous events (such
as a change in world oil prices) that alter the
price level & shift SRAS curve.
P  P e  ( 1 )(Y  Y )  v

Subtract last year’s price level P−1 from both
sides: P  P  ( P e  P )  ( 1 )(Y  Y )  v
1 1 
   e  ( 1 )(Y  Y )  v
Using okun’s law ( ( 1 )(Y  Y )    (u  u n ) ),

     (u  u )  v
e n

The Phillips curve & the SRAS represent

essentially the same ideas.
Both show a link b/n real & nominal variables
that causes the classical dichotomy to break
down in the short run.

3.2.3.2 Adaptive Expectations and Inflation Inertia
To make Phillips curve useful for analyzing
the choices facing policymakers, we need to
say what determines expected inflation.
A simple & often plausible assumption is that
people form their expectations of inflation
based on recently observed inflation.
This is called adaptive expectations.
Suppose people expect prices to rise this year
at the same rate as they did last year.
Then e equals last year’s inflation: e = -1.
In this case, we can write the Phillips curve as:
,
Inflation depends on past inflation, cyclical
unemp’t & supply shock.
The first term, -1, implies that inflation has
inertia.

3.2.3.2 Adaptive Expectations and Inflation Inertia
i.e., like an object moving through space, 
keeps going unless something acts to stop it.
In particular, if unemp’t is at the natural rate
& if there are no supply shocks, the continued
rise in P neither speeds up nor slows down.
This inertia arises because past  influences
expectations of future  & because these
expectations influence the wages & prices
that workers & firms set.
“We have inflation because we expect inflation, and we
expect inflation because we’ve had it.”
The 2nd & 3rd terms in Phillips curve equation
show 2 forces that can change inflation rate.
The 2nd term shows that cyclical unemp’t
exerts an up/down-ward pressure on inflation.
Low unemp’t pulls  up – demand-pull .
High unemp’t pulls  down.

3.2.3.2 Adaptive Expectations and Inflation Inertia
 measures how responsive  is to cyclical
unemp’t.
The 3rd term (v) shows that  also rises/falls
because of supply shocks.
An adverse supply shock, such as the rise in
world oil prices in 1970s, implies a positive
value of v & causes  to rise – cost-push .
A beneficial supply shock, such as the oil glut
that led to a fall in oil prices in the 1980s,
makes v negative and causes inflation to fall.
What options does the Phillips curve give to a
policymaker who can influence AD?
At any moment, e & supply shocks are
beyond the policymaker’s immediate control.
Yet, by changing AD, the policymaker can
alter output, unemp’t & .

3.2.3.2 Adaptive Expectations and Inflation Inertia
The policymaker can expand AD to lower
unemp’t & raise , or depress AD to raise
unemp’t & lower .
When unemp’t is at its natural rate (u = un), 
depends on e & the supply shock (v).
β is the slope of the tradeoff b/n  & unemp’t.
For a given level of e, policymakers can
manipulate AD to choose a combination of 
& unemp’t on the short-run Phillips curve.
The position of the short-run Phillips curve
depends on e.
If e rises, the curve shifts up, & the tradeoff
becomes less favorable –  is higher for any
level of unemp’t.
As e changes, the economy moves from one
short-run Phillips curve to another.

3.2.3.2 Adaptive Expectations and Inflation Inertia
The combination of the level of unemp’t & 
that occurs depends on the e.
When economic agents begin to expect  to
rise, the short-run Phillips curve begins to
shift, thereby generating higher  at each
unemp’t level.
The short run Phillips curve shifts with e.
 corresponding to any given level of unemp’t
(output) therefore s over time as e s.
The higher the e, the higher the 
corresponding to any level of unemp’t/output.
This is one reason why it is possible for  &
unemp’t rate to rise together, or for  to rise
while the level of output falls.
The other important reason is that a supply
shock may hit the economy.

3.2.3.2 Adaptive Expectations and Inflation Inertia
On each short-run Phillips curve, e is
constant & except at points where Y = Yn , e
will turn out to be different from actual .
If  remains constant for any long period,
firms & workers will expect that rate to
continue, & e will become equal to actual .
The assumption that  = e distinguishes the
long-run from the short-run Phillips curve.
The long-run Phillips curve describes the r/p
b/n  & unemp’t/output when  = e.
With  = e, Phillips curve shows that Y = Yn.
Hence, the long-run Phillips curve is a vertical
line joining points on short-run Phillips curves
at which  = e.
In the long run, the level of unemp’t is
independent of .

3.2.3.2 Adaptive Expectations and Inflation Inertia
In the short run, with a given e, higher  is
accompanied by higher output; in the long
run, with =e, unemp’t is independent of .
Because people adjust their expectations of 
over time, the tradeoff b/n  & unemp’t holds
only in the short run.
The policymaker cannot keep  above e (&
thus unemp’t below its natural rate) forever.
Eventually, expectations adapt to whatever 
the policymaker has chosen.
In the long run, the classical dichotomy holds,
unemp’t returns to its natural rate, & there is
no tradeoff b/n  & unemp’t.
The Phillips curve shows that in the absence
of a positive supply shock, lowering  requires
a period of high unemp’t & reduced output.

3.2.3.2 Adaptive Expectations and Inflation Inertia
But by how much & for how long would
unemp’t need to rise above the natural rate?
Before deciding whether to reduce , policy-
makers must know how much output would
be lost during the transition to lower .
This cost can then be compared with the
benefits of lower inflation.
Much research has used the available data to
examine the Phillips curve quantitatively.
Results of such studies are often summarized
in a number called the sacrifice ratio, the
percentage of a year’s real GDP that must be
forgone to reduce  by 1 percentage point.
If the sacrifice ratio is estimated to be 5, for
every percentage point that  is to fall, 5% of
one year’s GDP must be sacrificed.

3.2.3.2 Adaptive Expectations and Inflation Inertia
The sacrifice ratio can also be expressed in
terms of unemp’t.
Okun’s law: a  of 1 percentage point in
unemp’t rate translates into a  of 2% in GDP.
So, reducing  by 1 percentage point requires
2.5 percentage points of cyclical unemp’t.
We can use the sacrifice ratio to estimate by
how much & for how long unemp’t must rise
to reduce .
If reducing  by 1 percentage point requires a
sacrifice of 5% of a year’s GDP, reducing  by
4 percentage points requires a sacrifice of
20% of a year’s GDP, or equivalently, a sacrifice
of 10 percentage points of cyclical unemp’t.
This disinflation may take various forms, each
totaling the sacrifice of 20% of a year’s GDP.

3.2.3.2 Adaptive Expectations and Inflation Inertia
For example, a rapid disinflation would lower
output by 10% for 2 years; a moderate
disinflation would lower output by 5% for 4
years; an even more gradual disinflation
would depress output by 2% for a decade.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation
 Because expectations of  influences the short-run
tradeoff b/n  & unemployment, it is vital to understand
how people form expectations.

 So far, we have assumed that e depends on recently

observed .

 Though this assumption is plausible, it may be too simple to

apply in all circumstances.

 An alternative is to assume that people have rational

expectations, i.e., people optimally use all the available information,
including information about current gov’t policies, to forecast the future.

 Because monetary & fiscal policies influence , e should

also depend on the monetary & fiscal policies in effect.

 Under rational expectations, people do not make

systematic mistakes in forming their expectations.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation

Systematic mistakes – for instance, always

under-predicting  – are easily spotted.
According to the rational expectations
hypothesis, people correct such mistakes &
change the way they form expectations.
On average, rational expectations are correct
because people understand the environment
in which they operate.
Of course people make mistakes from time
to time, but they do not make systematic
mistakes.
With expectations formed according to the
hypothesis of rationality, there is no trade-off
between unemp’t &  at all.
Unemp’t is equal to the natural rate plus a
deviation that is purely random.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation

By the very definition of rationality, there is

no opportunity for the systematic emergence
of unanticipated .
Only surprises that are due to random events
or an unanticipated policy change can lead to
 that differs from e.
Thus unemp’t rate differs from the natural
rate only when there is a shock or surprise.
Furthermore, such deviations must be short-
lived since a surprise cannot last beyond the
current period.
In the next period it becomes part of the
available information set used by economic
agents to determine  rationally.
A shock may appear to persist because its
magnitude & extent were also a surprise.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation
The natural rate Phillips curve model implies
that unemp’t rate differs from the natural
rate when  is unanticipated.
With rational expectations, unanticipated  is
always a random/unpredictable phenomenon.
Therefore, all deviations, including short-run
deviations, of the unemp’t rate from the
natural rate are random events.
The policy implication of rational
expectations can be seen by considering again
an eqlm disturbed by an expansionary policy.
If the policy is known to economic agents,
they will use their knowledge of how such a
policy affects the economy.
In a model with a natural rate, expansionary
policy leads to  & does not  the natural
rate eqlm.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation
If expectations are formed rationally, e will
adjust immediately & the new eqlm will be
established immediately.
The immediate adjustment of e to all the
implications of the policy expansion has
eliminated the distinction b/n the long-run &
short-run response.
Hence the policy ineffectiveness proposition
(PIP) of the rational expectations school:
In an eqlm model, where expectations are
formed rationally, a fully anticipated policy will
have no effect on the level of real economic
activity.
Put concisely, we have the startling & trouble-
some implication: “policy doesn’t matter.”
If the policy is not fully anticipated, real-
sector effects do occur.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation

A policy which surprises the public can lead to

an error in  prediction & a deviation of the
unemp’t rate from the natural rate.
But, such effects must be short-lived since
agents will respond & adjust their expect-
ations once the policy becomes apparent.
It is important to note that PIP is a result of 2
elements of the model structure.
First, the natural rate Phillips curve indicates
a unique & stable natural rate of unemp’t.
Second, expectations are formed rationally,
with complete knowledge of the underlying
eqlm structure & all relevant information.
If the public is well informed about the
economic structure, economic conditions, &
policy goals, it will be able to forecast .

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation

That makes it impossible to set a policy that

makes unemp’t rate differ systematically
from the natural rate.
As long as expectations are an informed
forecast which utilize the actual structure of
the economy, unemp’t rate will differ from
natural rate only if there is a policy surprise:
an effective policy must be unanticipated.
Only by systematically fooling the public can
policymakers force unemp’t rate to deviate
from the natural eqlm.
There may be some reasons, though, why the
public may be fooled into making errors in
forecasting :
 economic agents may have an imperfect
understanding of the workings of the economy;
 their information may be limited.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation

Policy-makers may have better & more up-to-

date information about the structure of the
economy.
Besides, policy-makers may be able to fool the
public by pursuing expansionary policy
without saying so.
Finally, institutional constraints like long-term
labor contracts may imply expectational
errors.
Deviations of unemp’t rate persist for much
longer periods of time than the rational
expectations hypothesis suggests.
Nevertheless, the implications of the rational
expectations Phillips curve are important.
PIP has had a profound effect on our underst-
anding of what macroeconomic policy can do.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation

An additional lesson to be learned from the

new classical approach (the policy evaluation
or uncertainty proposition):
In a model where expectations are rational, the
responses of the economy to economic policy
initiatives are variable & uncertain.
This proposition is not as unrealistically
strong as PIP.
Nevertheless, it implies that it may be
impossible to use discretionary policy to
guide the economy since the implementation
of policy alters the responses.
According to theory of rational expectations,
a  in monetary/fiscal policy will  expec-
tations, & an evaluation of any policy  must
incorporate this effect on expectations.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation

Advocates of rational expectations argue that

the short-run Phillips curve does not
accurately represent the options that
policymakers have available.
They believe that if policymakers are credibly
committed to reducing , rational people will
understand the commitment & will quickly
lower their expectations of .
Inflation can then come down without a rise
in unemp’t & fall in output.
If people form their expectations rationally,
then  may have less inertia than it first
appears.
Accordingly, traditional estimates of the
sacrifice ratio are not useful for evaluating
the impact of alternative policies.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation

Under a credible policy, the costs of reducing

 may be much lower than estimates of the
sacrifice ratio suggest.
In the most extreme case, one can imagine
reducing  without causing any recession.
A painless disinflation has two conditions:
1) the plan to reduce  must be announced before
the workers & firms who set wages & prices have
formed their expectations; &
2) workers & firms must believe the announcement;
otherwise, they will not reduce their
expectations of .
If both conditions are met, the announce-
ment will immediately shift the short-run
tradeoff b/n  & unemp’t downward,
permitting a lower  without higher unemp’t.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation

Although the rational-expectations approach

remains controversial, almost all economists
agree that expectations of  influence the
short-run tradeoff b/n  & unemp’t.
The credibility of a policy to reduce  is
therefore one determinant of how costly the
policy will be.
Unfortunately, it is often difficult to predict
whether the public will view the
announcement of a new policy as credible.
The central role of expectations makes
forecasting the results of alternative policies
far more difficult.
To sum up,
 If expectations are backward-looking, wages &
prices will adjust slowly over time, so that the
Phillips curve has a negative slope.

3.2.3.3 Rational Expectations & the Possibility of Painless Disinflation
 Under rational expectations, any anticipated  in
AD is incorporated in expectations of prices &
wages, so that, with respect to anticipated s in
AD, Phillips curve is vertical even in the short run.

3.2.3.4 Hysteresis & the Challenge to the Natural-
Natural-Rate Hypothesis

Our discussion of fluctuations is based on the

assumption of the natural-rate hypothesis:
Fluctuations in AD affect output & emp’t only in the
SR; in the LR, the economy returns to levels of output,
emp’t & unemp’t described by the classical model.
The natural-rate hypothesis allows macro-
economists to study separately SR & LR
developments in the economy; It is one
expression of the classical dichotomy.
Recently, some economists have challenged
the natural-rate hypothesis by suggesting that
AD may affect output & emp’t even in the LR.
They have pointed out a number of
mechanisms through which recessions might
leave permanent scars on the economy by
altering the natural rate of unemp’t.

3.2.3.4 Hysteresis & the Challenge to the Natural-
Natural-Rate Hypothesis

Hysteresis: term used to describe the long-

lasting influence of history on natural rate.
A recession can have permanent effects if it
s the people who become unemployed.
For instance, workers might lose valuable job
skills when unemployed, lowering their ability
to find a job even after the recession ends.
Alternatively, a long period of unemp’t may
change an individual’s attitude toward work &
reduce his desire to find emp’t.
In either case, the recession permanently
inhibits the process of job search & raises the
amount of frictional unemp’t.
Another way in which a recession can
permanently affect the economy is by
changing the process that determines wages.

3.2.3.4 Hysteresis & the Challenge to the Natural-
Natural-Rate Hypothesis

Those who become unemployed may lose

their influence on the wage-setting process.
Unemployed workers may lose their status as
union members, for example.
More generally, some of the insiders in the
wage-setting process become outsiders.
If the smaller group of insiders cares more
about high real wages & less about high
emp’t, then the recession may permanently
push real wages further above the eqlm level
& raise the amount of structural unemp’t.
Hysteresis remains a controversial theory.
Some believe the theory helps explain
persistently high unemp’t coinciding with
disinflation & even after  is stabilized.

3.2.3.4 Hysteresis & the Challenge to the Natural-
Natural-Rate Hypothesis

Moreover, the increase in unemp’t tended to

be larger for countries that experienced the
greatest reductions in , such as Ireland, Italy,
and Spain.
Yet there is still no consensus whether the
hysteresis phenomenon is significant, or why
it might be more pronounced in some
countries than in others.
If it is true, however, the theory is important,
because hysteresis greatly increases the cost
of recessions.
Put another way, hysteresis raises the
sacrifice ratio, because output is lost even
after the period of disinflation is over.