Lesson 33
THREE MODELS OF AGGREGATE SUPPLY (CONTINUED)
2- THE IMPERFECT-INFORMATION MODEL
Assumptions:
x All wages and prices perfectly flexible.
x All markets are clear.
x Each supplier produces one good, consumes many goods.
x 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.
3- THE STICKY-PRICE MODEL
Reasons for sticky prices are as follows:
x Long-term contracts between firms and customers.
x Menu costs.
x Firms do not wish to annoy customers with frequent price changes.
Assumptions:
Firms set their own prices (e.g. as in monopolistic competition).
An individual firm’s desired price is
Where a > 0.
Suppose two types of firms:
x Firms with flexible prices, set prices as above
x Firms with sticky prices, must set their price before they know how P and Y will turn
out:
Assume firms with sticky prices expect that output will equal its natural rate. Then,
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
Subtract (1s) P from both sides:
Divide both sides by 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.
()
p
PYY
a
()
eee
pP Y Y
a
e
pP
(1 ) [ ( ) ]
e
PsP sP YY
a
Price set by sticky
price firm
Price set by flexible
price firm
(1 ) [ ( ) ]
e
sP s P s Y Y
a
(1 ) ()
e
s
PP YY
s
ªº
«»
¬¼
a
docsity.com
