Welcome

Introductory Macroeconomics
© Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra
 Course Flow

• Module 1: National Income Accounts and Data in Macroeconomics

• Module 2: The Economy in the Short Run
• Module 3: IS-LM Model
• Module 4: Aggregate Demand and Supply
• Module 5: Inflation and Unemployment Dynamics

Textbooks:
1. Soumyen Sikdar: Principles of Macroeconomics, Oxford University Press.
2. N. Gregory Mankiw: Macroeconomics.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Module Detail
Module 4: Aggregate Demand and Supply (8 lectures)
Aggregate Demand and Aggregate Supply: Derivation of aggregate demand assuming price flexibility;
Derivation of aggregate supply curves both in the presence and absence of wage rigidity; equilibrium, stability,
and comparative statics-effects of monetary and fiscal policies

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Three Models of Aggregate Supply
1. The sticky-wage model
2. The imperfect-information model
3. The sticky-price model
All three models imply:

Y = Y +  (P − P ) e

agg. the expected

output price level
a positive
natural rate parameter the actual
of output price level © Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Wage Model
• Assumes that firms and workers negotiate contracts and fix the
nominal wage before they know what the price level will turn
out to be.
• The nominal wage they set is the product of a target real wage
and the expected price level:

Target
real
W = ω P e wage

W Pe
 =ω
P P © Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Wage Model
W Pe
=ω
P P
If it turns out that then
e unemployment and output are
P =P at their natural rates
Real wage is less than its target,
P Pe so firms hire more workers and
output rises above its natural rate
e Real wage exceeds its target,
P P so firms hire fewer workers and
output falls below its natural rate © Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Wage Model

• Implies that the real wage should be counter-cyclical , it should move in the
opposite direction as output over the course of business cycles:
• In booms, when P typically rises, the real wage should fall.
• In recessions, when P typically falls, the real wage should rise.

• This prediction does not come true in the real world:

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 The cyclical behavior of the real wage in US

in real wage
Percentage change
4 1972

3
1998
1965
2
1960 1997
1999
1
1996 2000
1970 1984
0
1982 1993
1991 1992
-1
1990
-2 1975

-3 1979
1974

-4
1980
-5
-3 -2 -1 0 1 2 3 4 5 6 7 8
© Dr. Abhishek Naresh
Percentage change in real GDP Assistant Professor
(CQEDS)
BIT Mesra
 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

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 The Imperfect-Information Model

• In this model, the short-run and long-run aggregate supply curves differ because
of temporary misperceptions about prices
• The imperfect-information model assumes that each supplier in the economy
produces a single good and consumes many goods
• Because the number of goods is so large, suppliers cannot observe all prices at all
times.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 The Imperfect-Information Model
• 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.
e
• Suppose P rises but P 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.

Y = Y +  (P − P ) e © Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Price Model

• Reasons for sticky prices:

• long-term contracts between firms and customers
• menu costs
• firms do not wish to annoy customers with frequent price changes
• Assumption:
• Firms set their own prices
(e.g. as in monopolistic competition)

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Price Model
• 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 ) © Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Price Model
p = P e + a (Y e −Y e )
• If sticky price firms expect that output will equal its
natural rate. Then,
p =Pe
▪ 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 © Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Price Model
e
P = s P + (1 − s )[P + a(Y −Y )]

price set by sticky price set by flexible

price firms price firms
• Subtract (1−s )P from both sides:
sP = s P e + (1 − s )[a(Y −Y )]
▪ Divide both sides by s :
e  (1 − s ) a 
P = P +  (Y −Y )
 s  © Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Price Model
e  (1 − s ) a 
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.
© Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Price Model
e  (1 − s ) a 
P = P +  (Y −Y )
 s 

• The greater the fraction of flexible price firms, the smaller is s and the bigger is
the effect
of Y on P.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Price Model
e  (1 − s ) a 
P = P +  (Y −Y )
 s 

• Finally, derive AS equation by solving for Y :

Y = Y +  (P − P e ),

s
where  =
(1 − s )a
© Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra
 The Sticky-Price Model

In contrast to the sticky-wage model, the sticky-price model implies a pro-

cyclical 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 labour
▪ The leftward shift in labour demand causes the real wage to fall

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
India’s Inflation Expectation

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Summary & Implications
P LRAS
Y = Y +  (P − P e )

P Pe
SRAS
e Each of the
P =P
three models of
P Pe agg. supply imply
the relationship
Y summarized by
Y the SRAS curve
& equation
© Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra
 Summary & Implications
SRAS equation: Y = Y +  (P − P e )
Suppose a positive
AD shock moves
P SRAS2
output above its LRAS
natural rate
and P above the SRAS1
level people
had expected. P3 = P3e
P2
Over time, e AD2
P e
= P = P
P e rises,
2 1 1

SRAS shifts up, AD1

and output returns Y
to its natural rate. Y2
Y 3 = Y1 = Y © Dr. Abhishek Naresh
Assistant Professor

Y = Y +  (P − P ) e (CQEDS)
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