4.3 Exchange Rates: Exchange Rate Is The Rate at Which A Person Can Trade The Currency of One Country For The Currency

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[LECTURE NOTE FOR MACROECONOMICS]
4.3 Exchange Rates

International transactions are influenced by international prices. The two most important
international prices are the nominal exchange rate and the real exchange rate. The nominal
exchange rate is the rate at which a person can trade the currency of one country for the currency
of another. The nominal exchange rate is expressed in two ways:
• In units of foreign currency per one domestic currency.
• And in units of domestic currency per one unit of the foreign currency.
Assume the exchange rate between the Japanese yen and Ethiopia birr is 20 yen to one dollar.
• One birr trades for 20 yen.
• One yen trades for 1/20 (= 0.05) of a birr
Appreciation refers to an increase in the value of a currency as measured by the amount of
foreign currency it can buy. Depreciation refers to a decrease in the value of a currency as
measured by the amount of foreign currency it can buy. If a dollar buys more foreign currency,
there is an appreciation of the dollar. If it buys less there is a depreciation of the dollar.
The real exchange rate is the rate at which a person can trade the goods and services of one
country for the goods and services of another.
The real exchange rate compares the prices of domestic goods and foreign goods in the domestic
economy.
• If a case of German beer is twice as expensive as American beer, the real
exchange rate is 1/2 case of German beer per case of American beer.
The real exchange rate depends on the nominal exchange rate and the prices of goods in the two
countries measured in local currencies.
The real exchange rate is a key determinant of how much a country exports and imports.
Nominal exchange rate  Domestic price

Real exchange rate =
Foreign price
4.4 The Mundell-Fleming model

Mundell–Fleming model is an open-economy version of the IS–LM model. Both models stress
the interaction between the goods market and the money market. Both models assume that the
price level is fixed and then show what causes short-run fluctuations in aggregate income (or,
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equivalently, shifts in the aggregate demand curve).The key difference is that the IS–LM model
assumes a closed economy, whereas the Mundell–Fleming model assumes an open economy.
The Mundell–Fleming model makes one important and extreme assumption: it assumes that the
economy being studied is a small open economy with perfect capital mobility .That is, the economy
can borrow or lend as much as it wants in world financial markets and, as a result, the economy’s
interest rate is determined by the world interest rate.
𝒓 = 𝒓∗
The r = r* equation represents the assumption that the international flow of capital is rapid enough
to keep the domestic interest rate equal to the world interest rate. In a small open economy, the
domestic interest rate might rise by a little bit for a short time, but as soon as it did, foreigners
would see the higher interest rate and start lending to this country (by, for instance, buying this
country’s bonds).The capital inflow would drive the domestic interest rate back toward r*.
Similarly, if any event were ever to start driving the domestic interest rate downward, capital would
flow out of the country to earn a higher return abroad, and this capital outflow would drive the
domestic interest rate back upward toward r*.
a. The Goods Market and the IS* Curve
The Mundell–Fleming model describes the market for goods and services:
𝑌 = 𝐶(𝑌 − 𝑇) + 𝐼(𝑟 ∗) + 𝐺 + 𝑁𝑋(𝑒)
This equation states that aggregate income Y is the sum of consumption C, investment I,
government purchases G, and net exports NX. Consumption depends positively on disposable
income 𝑌 − 𝑇. Investment depends negatively on the interest rate, which equals the world interest
rate r*. Net exports depend negatively on the exchange rate e. As before, we define the exchange
rate e as the amount of foreign currency per unit of domestic currency—for example, e might be
20 yen per birr.
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a. The net Export Schedule b. The Keynesian cross c. The IS* Curve
Exchange rate e Expenditure Exchange rate
e2
∆𝑁𝑋
e1 IS*
∆𝑁𝑋
NX(e2) NX(e1) NX y2 y1 Y y2 y1 Y
The IS* Curve: The IS* curve is derived from the net-exports schedule and the Keynesian cross.
Panel (a) shows the net-exports schedule: an increase in the exchange rate from e1 to e2 lowers
net exports from 𝑁𝑋(𝑒1) to𝑁𝑋(𝑒2). Panel (b) shows the Keynesian cross: a decrease in net
exports from 𝑁𝑋(𝑒1) to 𝑁𝑋(𝑒2) shifts the planned expenditure schedule downward and reduces
income from Y1 to Y2. Panel (c) shows the IS* curve summarizing this relationship between the
exchange rate and income: the higher the exchange rate, the lower the level of income.
Note the net export depends on the real exchange rate (the relative price of goods at home and
abroad) rather than the nominal exchange rate (the relative price of domestic and foreign
currencies). If e is the nominal exchange rate, then the real exchange rate e equals 𝑒𝑃/𝑃 ∗, where
P is the domestic price level and P* is the foreign price level. The Mundell–Fleming model,
however, assumes that the price levels at home and abroad are fixed, so the real exchange rate is
proportional to the nominal exchange rate.
b. The Money Market and the LM* Curve
The Mundell–Fleming model represents the money market with an equation that should be familiar
from the IS–LM model, with the additional assumption that the domestic interest rate equals the
world interest rate:
𝑀/𝑃 = 𝐿(𝑟 ∗, 𝑌).
This equation states that the supply of real money balances, M/P, equals the demand, L(r, Y ).The
demand for real balances depends negatively on the interest rate, which is now set equal to the
world interest rate r*, and positively on income Y. The money supply M is an exogenous variable
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controlled by the central bank, and because the Mundell–Fleming model is designed to analyze
short-run fluctuations, the price level P is also assumed to be exogenously fixed.
a. The LM curve b. The LM* Curve
Interest rate LM Exchange rate
LM*
r=r*
Y* Y Y* Y
The LM* Curve Panel (a) shows the standard LM curve [which graphs the equation 𝑀/𝑃 =
𝐿(𝑟, 𝑌)] together with a horizontal line representing the world interest rate r*. The intersection of
these two curves determines the level of income, regardless of the exchange rate. Therefore, as
panel (b) shows, the LM* curve is vertical.
Generally, according to the Mundell–Fleming model, a small open economy with perfect capital
mobility can be described by two equations:
𝑌 = 𝐶(𝑌 − 𝑇 ) + 𝐼(𝑟 ∗) + 𝐺 + 𝑁𝑋(𝑒) 𝐼𝑆 ∗
𝑀/𝑃 = 𝐿(𝑟 ∗, 𝑌 ) 𝐿𝑀 ∗.
The first equation describes equilibrium in the goods market, and the second equation describes
equilibrium in the money market. The exogenous variables are fiscal policy G and T, monetary
policy M, the price level P and the world interest rate r*.The endogenous variables are income Y
and the exchange rate e.
The Mundell–Fleming Model
Exchange rate
IS* LM*
Equilibrium level
Equilibrium of Income
Exchange rate
y , income, output
The Mundell–Fleming Model This graph of the Mundell–Fleming model plots the goods market
equilibrium condition IS* and the money market equilibrium condition LM*. Both curves are
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drawn holding the interest rate constant at the world interest rate. The intersection of these two
curves shows the level of income and the exchange rate that satisfy equilibrium both in the goods
market and in the money market.
4.5 Fiscal and monetary policies in an open economy with perfect capital
mobility
a. Under Floating exchange rate
Under floating exchange rates, the exchange rate is allowed to fluctuate in response to changing
economic conditions.
Fiscal Policy: an expansionary fiscal policy (an increase in government purchases or cut in taxes)
increases planned expenditure, it shifts the IS* curve to the right. As a result, the exchange rate
appreciates, whereas the level of income remains the same.
In the closed-economy IS–LM model, a fiscal expansion raises income, whereas in a small open
economy with a floating exchange rate, a fiscal expansion leaves income at the same level.
Why the difference?
When income rises in a closed economy, the interest rate rises, because higher income increases
the demand for money. That is not possible in a small open economy: as soon as the interest rate
tries to rise above the world interest rate r*, capital flows in from abroad. This capital inflow
increases the demand for the domestic currency in the market for foreign-currency exchange and,
thus, bids up the value of the domestic currency. The appreciation of the exchange rate makes
domestic goods expensive relative to foreign goods, and this reduces net exports. The fall in net
exports offsets the effects of the expansionary fiscal policy on income.
Why is the fall in net exports so great that it renders fiscal policy powerless to influence income?
In both closed and open economies, the quantity of real money balances supplied M/P is fixed,
and the quantity demanded (determined by r and Y) must equal this fixed supply. In a closed
economy, a fiscal expansion causes the equilibrium interest rate to rise. This increase in the interest
rate (which reduces the quantity of money demanded) allows equilibrium income to rise (which
increases the quantity of money demanded). By contrast, in a small open economy, r is fixed at r*,
so there is only one level of income that can satisfy this equation, and this level of income does
not change when fiscal policy changes. Thus, when the government increases spending or cuts
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taxes, the appreciation of the exchange rate and the fall in net exports must be large enough to
offset fully the normal expansionary effect of the policy on income.
A Fiscal Expansion under Floating Exchange Rates
Exchange rate, e
LM*
e2
e1 𝐼𝑆2∗
𝐼𝑆1∗
Income, output Y
An increase in government purchases or a decrease in taxes shifts the IS* curve to the right. This
raises the exchange rate but has no effect on income.
Monetary Policy: Suppose now that the central bank increases the money supply. Because the
price level is assumed to be fixed, the increase in the money supply means an increase in real
balances. The increase in real balances shifts the LM* curve to the right. Hence, an increase in the
money supply raises income and lowers the exchange rate.
Although monetary policy influences income in an open economy, as it does in a closed economy,
the monetary transmission mechanism is different. In a closed economy an increase in the money
supply increases spending because it lowers the interest rate and stimulates investment. In a small
open economy, the interest rate is fixed by the world interest rate. As soon as an increase in the
money supply puts downward pressure on the domestic interest rate, capital flows out of the
economy as investors seek a higher return elsewhere. This capital outflow prevents the domestic
interest rate from falling. In addition, because the capital outflow increases the supply of the
domestic currency in the market for foreign-currency exchange, the exchange rate depreciates. The
fall in the exchange rate makes domestic goods inexpensive relative to foreign goods and, thereby,
stimulates net exports. Hence, in a small open economy, monetary policy influences income by
altering the exchange rate rather than the interest rate.
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A Monetary Expansion under Floating Exchange Rates

Exchange rate
LM*
e1
e2 IS*
Income, output, Y
An increase in the money supply shifts the LM* curve to the right, lowering the exchange rate and
raising income.
Exercise:
What is the impact of a restricted trade policy (tariff or an import quota) on national income and
exchange rate under floating exchange rate?
It will decrease import and hence increases the 𝑛𝑒𝑡 𝑒𝑥𝑝𝑜𝑟𝑡 = 𝑒𝑥𝑝𝑜𝑟𝑡 – 𝑖𝑚𝑝𝑜𝑟𝑡. This shifts the
IS* curve outward. This will appreciate the exchange rate but has no effect on output.
b. Under Fixed exchange rate

Under a system of fixed exchange rates, a central bank stands ready to buy or sell the domestic
currency for foreign currencies at a predetermined price. A fixed exchange rate dedicates a
country’s monetary policy to the single goal of keeping the exchange rate at the announced level.
How a Fixed-Exchange-Rate System Works:
a. The Equilibrium Exchange Rate Is

Greater Than the Fixed Exchange Rate
b. The Equilibrium Exchange Rate Is
Less Than the Fixed Exchange Rate
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Exchange rate Exchange rate

LM1* LM2* LM2* LM1*
Fixed Exchange rate Fixed exchange rate
Y Y
In panel (a), the equilibrium exchange rate initially exceeds the fixed level. Arbitrageurs will buy
foreign currency in foreign-exchange markets and sell it to the Fed for a profit. This process
automatically increases the money supply, shifting the LM* curve to the right and lowering the
exchange rate. In panel (b), the equilibrium exchange rate is initially below the fixed level.
Arbitrageurs will buy dollars in foreign-exchange markets and use them to buy foreign currency
from the Fed. This process automatically reduces the money supply, shifting the LM* curve to the
left and raising the exchange rate.
Fiscal Policy:
e
LM*1 LM*2
Fixed exchange rate
IS*
Y1 Y2 Y
A Fiscal Expansion under Fixed Exchange Rates: A fiscal expansion shifts the IS* curve to
the right. To maintain the fixed exchange rate, the government must increase the money supply,
thereby shifting the LM* curve to the right. Hence, in contrast to the case of floating exchange
rates, under fixed exchange rates a fiscal expansion raises income.
Monetary Policy:
A Monetary Expansion under Fixed Exchange Rates: If the government tries to increase the
money supply—for example, by buying bonds from the public—it will put downward pressure on
the exchange rate. To maintain the fixed exchange rate, the money supply and the LM* curve must
return to their initial positions. Hence, under fixed exchange rates, normal monetary policy is
ineffectual.
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LM*1 LM*2
Fixed exchange rate

IS*
A Monetary Expansion under Fixed Exchange Rates If the Fed tries to increase the money
supply—for example, by buying bonds from the public—it will put downward pressure on the
exchange rate. To maintain the fixed exchange rate, the money supply and the LM* curve must
return to their initial positions. Hence, under fixed exchange rates, normal monetary policy is
ineffectual.
A country with a fixed exchange rate can, however, conduct a type of monetary policy: it can
decide to change the level at which the exchange rate is fixed. A reduction in the value of the
currency is called devaluation, and an increase in its value is called a revaluation. In the Mundell–
Fleming model, a devaluation shifts the LM* curve to the right; it acts like an increase in the money
supply under a floating exchange rate. Devaluation thus expands net exports and raises aggregate
income. Conversely, a revaluation shifts the LM* curve to the left, reduces net exports, and lowers
aggregate income.
Exercise: What is the impact of a restricted trade policy (tariff or an import quota) on national
income under fixed exchange rate regime?
The result of a trade restriction under a fixed exchange rate is very different from that under a
floating exchange rate. In both cases, a trade restriction shifts the net-exports schedule to the right,
but only under a fixed exchange rate does a trade restriction increase net exports NX. The reason
is that a trade restriction under a fixed exchange rate induces monetary expansion rather than an
appreciation of the exchange rate. The monetary expansion, in turn, raises aggregate income.
Ashenafi H(MSc)
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The Mundell–Fleming Model: Summary of Policy Effects

EXCHANGE-RATE REGIME
Policy Floating, impact on fixed

Income Ex.ge rate Net export Income Ex.ge rate Net export
Fiscal expansion 0 0
Monetary expansion 0 0 0
Import restriction 0 0 0 0
4.6 Limitations of the Mundell-Fleming model

Interest-Rate Differentials: because of Country Risk and Exchange-Rate Expectations there is an
interest rate differential across countries. The assumption of perfect capital mobility doesn’t works
always.
𝑟 = 𝑟 ∗ + 𝑣.
Rather than 𝑟 = 𝑟 ∗ where v stands for risk premium in reality.
An Increase in the Risk Premium: An increase in the risk premium associated with a country
drives up its interest rate. Because the higher interest rate reduces investment, the IS* curve shifts
to the left. Because it also reduces money demand, the LM* curve shifts to the right. Income rises,
and the exchange rate depreciates.
The Mundell–Fleming Model with a Changing Price Level
a. The Mundell–Fleming Model b. The aggregate demand curve
LM*(P1)
E1 LM*(P2) P1
E2 P2
IS* AD
Y1 Y2 Y Y1 Y2
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Mundell–Fleming as a Theory of Aggregate Demand Panel (a) shows that when the price level
falls, the LM* curve shifts to the right. The equilibrium level of income rises. Panel (b) shows that
this negative relationship between P and Y is summarized by the aggregate demand curve.
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CHAPTER FIVE
5 AGGREGATE SUPPLY
5.1 Introduction
Most economists analyze short-run fluctuations in aggregate income and the price level using the
model of aggregate demand and aggregate supply. The aggregate demand and aggregate supply
curves together pin down the economy’s price level and quantity of output.
Aggregate supply (AS) is the relationship between the quantity of goods and services supplied
and the price level. Because the firms that supply goods and services have flexible prices in the
long run but sticky prices in the short run, the aggregate supply relationship depends on the time
horizon. We need to discuss two different aggregate supply curves: the long-run aggregate supply
curve LRAS and the short-run aggregate supply curve SRAS. We also need to discuss how the
economy makes the transition from the short run to the long run.
5.2The classical Approach to Aggregate Supply

According to the classicals` view the amount of output produced depends on the fixed amounts of
capital and labor and on the available technology.
̅ 𝐿̅) = 𝑌̅
𝑌 = 𝐹(𝐾,
This happens in the long run. According to the classical model, output does not depend on the
price level. To show that output is the same for all price levels, we draw a vertical aggregate supply
curve. If the aggregate supply curve is vertical, then changes in aggregate demand affect prices but
not output.
P
LRAS
𝑌̅ Y
If the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not
output. For example, if the money supply falls, the aggregate demand curve shifts downward.
Kurabachew M.(PhD)
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The vertical aggregate supply curve satisfies the classical dichotomy, because it implies that the
level of output is independent of the money supply. This long run level of output, Y–, is called the
full-employment or natural level of output. It is the level of output at which the economy’s
resources are fully employed or, more realistically, at which unemployment is at its natural rate.
P
LRAS
P1 A
AD1
P2 B AD2
Y
𝑌̅
A reduction in the money supply shifts the aggregate demand curve downward from AD1 to AD2.
The equilibrium for the economy moves from point A to point B. Since the aggregate supply curve
is vertical in the long run, the reduction in aggregate demand affects the price level but not the
level of output.
The classical model and the vertical aggregate supply curve apply only in the long run. In the short
run, some prices are sticky and, therefore, do not adjust to changes in demand. Because of this
price stickiness, the short-run aggregate supply curve is not vertical.
All prices are fixed in the short run. Therefore, the short-run aggregate supply curve, SRAS, is
horizontal.
P SRAS
Y
A fall in aggregate demand reduces output in the short run because prices do not adjust instantly.
After the sudden fall in aggregate demand, firms are stuck with prices that are too high. With
demand low and prices high, firms sell less of their product, so they reduce production and lay off
workers. The economy experiences a recession.
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P SRAS
AD2 AD1
Y2 Y1
NOTE: Over long periods of time, prices are flexible, the aggregate supply curve is vertical, and
changes in aggregate demand affect the price level but not output. Over short periods of time,
prices are sticky, the aggregate supply curve is flat, and changes in aggregate demand do affect
the economy’s output of goods and services.
The long-run equilibrium is the point at which aggregate demand crosses the long-run aggregate
supply curve. Prices have adjusted to reach this equilibrium. Therefore, when the economy is in
its long-run equilibrium, the short-run aggregate supply curve must cross this point as well.
P LRAS
SRAS
AD
Y
Adjustment in the long run: the following graph shows how equilibrium is reached when demand
is reduced through price adjustment.
P
LRAS
B A SRAS
C AD1
AD2
Y
The economy begins in long-run equilibrium at point A. A reduction in aggregate demand, perhaps
caused by a decrease in the money supply, moves the economy from point A to point B, where
output is below its natural level. As prices fall, the economy gradually recovers from the recession,
moving from point B to point C.
Exercise: discuss about the effects of supply & demand shock and their stabilization mechanisms.
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5.3 The Keynesian Approach to Aggregate Supply

According to the Keynesians, some market imperfection (that is, some type of friction) causes the
output of the economy to deviate from the classical benchmark. As a result, the short-run aggregate
supply curve is upward sloping, rather than horizontal, and shifts in the aggregate demand curve
cause the level of output to deviate temporarily from the natural rate. These temporary deviations
represent the booms and busts of the business cycle. The Short run aggregate supply expressed in
equation form as:
𝑌 = 𝑌̅ + 𝑎(𝑃 − 𝑃𝑒 ), 𝑎 > 0
Where Y is output, 𝑌̅is the natural rate of output, P is the price level, and 𝑃𝑒 is the expected price level.
This equation states that output deviates from its natural rate when the price level deviates from the expected
price level. The parameter 𝑎 indicates how much output responds to unexpected changes in the price level;
1/ 𝑎 is the slope of the aggregate supply curve. There are four models to this respect.
5.3.1 The sticky wage model
When the wage is fixed/stuck, a rise in the price level LOWERS the real wage (w/p) making labor CHEAPER.
The Lower real wage induces firms to hire MORE labor. The additional labor hired produces MORE output.
To explain why the short-run aggregate supply curve is upward sloping, many economists stress
the sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term
contracts, so wages cannot adjust quickly when economic conditions change. Even in industries
not covered by formal contracts, implicit agreements between workers and firms may limit wage
changes. Wages may also depend on social norms and notions of fairness that evolve slowly. For
these reasons, many economists believe that nominal wages are sticky in the short run.
The sticky-wage model shows what a sticky nominal wage implies for aggregate supply. To
preview the model, consider what happens to the amount of output produced when the price level
rises:
1. When the nominal wage is stuck, a rise in the price level lowers the real wage, making
labor cheaper.
2. The lower real wage induces firms to hire more labor.
3. The additional labor hired produces more output.
This positive relationship between the price level and the amount of output means that the
aggregate supply curve slopes upward during the time when the nominal wage cannot adjust.
Kurabachew M.(PhD)
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To develop this story of aggregate supply more formally, assume that workers and firms bargain
over and agree on the nominal wage before they know what the price level will be when their
agreement takes effect. The bargaining parties— the workers and the firms—have in mind a target
real wage. The target may be the real wage that equilibrates labor supply and demand. More likely,
the target real wage is higher than the equilibrium real wage: union power and efficiency-wage
considerations tend to keep real wages above the level that brings supply and demand into balance.
The workers and firms set the nominal wage W based on the target real wage 𝜔 and on their
expectation of the price level 𝑃𝑒 .The nominal wage they set is
𝑊 = 𝜔 × 𝑃𝑒
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑊𝑎𝑔𝑒 = 𝑇𝑎𝑟𝑔𝑒𝑡 𝑅𝑒𝑎𝑙 𝑊𝑎𝑔𝑒 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙.
After the nominal wage has been set and before labor has been hired, firms learn the actual price
level P. The real wage turns out to be
𝑊/𝑃 = 𝜔 × (𝑃𝑒 /𝑃)
Expected Price Level
𝑅𝑒𝑎𝑙 𝑊𝑎𝑔𝑒 = 𝑇𝑎𝑟𝑔𝑒𝑡 𝑅𝑒𝑎𝑙 𝑊𝑎𝑔𝑒 ×
Actual Price Level
This equation shows that the real wage deviates from its target if the actual price level differs from
the expected price level. When the actual price level is greater than expected, the real wage is less
than its target; when the actual price level is less than expected, the real wage is greater than its
target.
The final assumption of the sticky-wage model is that employment is determined by the quantity
of labor that firms demand. In other words, the bargain between the workers and the firms does
not determine the level of employment in advance; instead, the workers agree to provide as much
labor as the firms wish to buy at the predetermined wage. We describe the firms’ hiring decisions
by the labor demand function
𝐿 = 𝐿𝑑 (𝑊/𝑃),
which states that the lower the real wage, the more labor firms hire and Output is determined by
the production function
𝑌 = 𝐹(𝐿),
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which states that the more labor is hired, the more output is produced.
a. Labor Demand b. Production function c. aggregate supply
Real wage Income, output Price level
P2
W/P1 Y2
Y1
W/P2 P1
L1 Labor labor Output

L2 L1 L2 Y1 Y2
The Sticky-Wage Model Panel (a) shows the labor demand curve. Because the nominal wage W
is stuck, an increase in the price level from P1 to P2 reduces the real wage from W/P1 to W/P2.
The lower real wage raises the quantity of labor demanded from L1 to L2. Panel (b) shows the
production function. An increase in the quantity of labor from L1 to L2 raises output from Y1 to
Y2. Panel (c) shows the aggregate supply curve summarizing this relationship between the price
level and output. An increase in the price level from P1 to P2 raises output from Y1 to Y2.
Because the nominal wage is sticky, an unexpected change in the price level moves the real wage
away from the target real wage, and this change in the real wage influences the amounts of labor
hired and output produced. The aggregate supply curve can be written as
𝑌 = 𝑌̅ + 𝑎(𝑃 − 𝑃𝑒 ).
Output deviates from its natural level when the price level deviates from the expected price level.
5.3.2 Imperfect information model
Assumes each supplier produces a single good and consumes many goods When the price level rises
unexpectedly all suppliers in the economy observe increase in the price of the goods they produce. They all
infer, rationally but mistakenly, that the relative prices of the goods they produce have risen. Thus they
produce more. This model says that when ACTUAL prices exceed EXPECTED prices, suppliers raise their
output.
Unlike the sticky-wage model, this model assumes that markets clear—that is, all wages and prices
are free to adjust to balance supply and demand. 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. They monitor closely the prices of what they produce but less closely
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the prices of all the goods they consume. Because of imperfect information, they sometimes
confuse changes in the overall level of prices with changes in relative prices. This confusion
influences decisions about how much to supply, and it leads to a positive relationship between the
price level and output in the short run.
Consider the decision facing a single supplier—a wheat farmer, for instance. Because the farmer
earns income from selling wheat and uses this income to buy goods and services, the amount of
wheat she chooses to produce depends on the price of wheat relative to the prices of other goods
and services in the economy.
If the relative price of wheat is high, the farmer is motivated to work hard and produce more wheat,
because the reward is great. If the relative price of wheat is low, she prefers to enjoy more leisure
and produce less wheat.
Unfortunately, when the farmer makes her production decision, she does not know the relative
price of wheat. As a wheat producer, she monitors the wheat market closely and always knows the
nominal price of wheat. But she does not know the prices of all the other goods in the economy.
She must, therefore, estimate the relative price of wheat using the nominal price of wheat and her
expectation of the overall price level.
Consider how the farmer responds if all prices in the economy, including the price of wheat,
increase. One possibility is that she expected this change in prices. When she observes an increase
in the price of wheat, her estimate of its relative price is unchanged. She does not work any harder.
The other possibility is that the farmer did not expect the price level to increase (or to increase by
this much).When she observes the increase in the price of wheat, she is not sure whether other
prices have risen (in which case wheat’s relative price is unchanged) or whether only the price of
wheat has risen (in which case its relative price is higher).The rational inference is that some of
each has happened. In other words, the farmer infers from the increase in the nominal price of
wheat that its relative price has risen somewhat. She works harder and produces more.
Our wheat farmer is not unique. When the price level rises unexpectedly, all suppliers in the
economy observe increases in the prices of the goods they produce. They all infer, rationally but
mistakenly, that the relative prices of the goods they produce have risen. They work harder and
produce more. To sum up, the imperfect-information model says that when actual prices exceed
expected prices, suppliers raise their output. The model implies an aggregate supply curve that is
now familiar:
PDFelement
𝑌 = 𝑌̅ + 𝑎(𝑃 − 𝑃𝑒 ).
Output deviates from the natural rate when the price level deviates from the expected price level.
5.3.3 The sticky price model
This model emphasizes that firms do not instantly adjust the prices they charge in response to
changes in demand. Sometimes prices are set by long-term contracts between firms and customers.
Even without formal agreements, firms may hold prices steady in order not to annoy their regular
customers with frequent price changes. Some prices are sticky because of the way markets are
structured: once a firm has printed and distributed its catalog or price list, it is costly to alter prices.
To see how sticky prices can help explain an upward-sloping aggregate supply curve, we first
consider the pricing decisions of individual firms and then add together the decisions of many
firms to explain the behavior of the economy as a whole. Notice that this model encourages us to
depart from the assumption of perfect competition. Perfectly competitive firms are price takers
rather than price setters. If we want to consider how firms set prices, it is natural to assume that
these firms have at least some monopoly control over the prices they charge.
Consider the pricing decision facing a typical firm. The firm’s desired price p depends on two
macroeconomic variables:
 The overall level of prices P. A higher price level implies that the firm’s costs are higher.
Hence, the higher the overall price level, the more the firm would like to charge for its
product.
 The level of aggregate income Y. A higher level of income raises the demand for the firm’s
product. Because marginal cost increases at higher levels of production, the greater the
demand, the higher the firm’s desired price.
We write the firm’s desired price as
𝑝 = 𝑃 + 𝑎(𝑌 − 𝑌̅).
This equation says that the desired price p depends on the overall level of prices
P and on the level of aggregate output relative to the natural rate 𝑌 − 𝑌̅.The parameter a (which
is greater than zero) measures how much the firm’s desired price responds to the level of aggregate
output.
Now 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
Kurabachew M.(PhD)
PDFelement
based on what they expect economic conditions to be. Firms with sticky prices set prices according
to
𝑝 = 𝑃𝑒 + 𝑎(𝑌 𝑒 − 𝑌̅ 𝑒 ),
where, as before, a superscript “e’’ represents the expected value of a variable. For simplicity,
assume that these firms expect output to be at its natural rate, so that the last term, 𝑎(𝑌 𝑒 − 𝑌̅ 𝑒 ), is
zero. Then these firms set the price
𝑝 = 𝑃𝑒
That is, firms with sticky prices set their 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 aggregate supply equation. To do this,
we find the overall price level in the economy, which is the weighted average of the prices set by the two
groups. If s is the fraction of firms with sticky prices and 1 − 𝑠 the fraction with flexible prices, then the
overall price level is
𝑃 = 𝑠𝑃𝑒 + (1 – 𝑠)[𝑃 + 𝑎(𝑌 − 𝑌̅)].
The first term is the price of the sticky-price firms weighted by their fraction in the economy, and the second
term is the price of the flexible-price firms weighted by their fraction. Now subtract (1 − 𝑠)𝑃 from both
sides of this equation to obtain
𝑠𝑃 = 𝑠𝑃𝑒 + (1 – 𝑠)[𝑎(𝑌 − 𝑌̅)].
Divide both sides by s to solve for the overall price level:
𝑃 = 𝑃𝑒 + [(1 – 𝑠)𝑎/𝑠](𝑌 – 𝑌̅)].
The two terms in this equation are explained as follows:
 When firms expect a high price level, they expect high costs. Those firms that fix prices in advance
set their prices high. These high prices cause the other firms to set high prices also. Hence, a high
expected price level 𝑃𝑒 leads to a high actual price level P.
 When output is high, the demand for goods is high. Those firms with flexible prices set their prices
high, which leads to a high price level. The effect of output on the price level depends on the
proportion of firms with flexible prices.
Hence, the overall price level depends on the expected price level and on the level of output.
Algebraic rearrangement puts this aggregate pricing equation into a more familiar form:
𝑌 = 𝑌̅ + 𝛼(𝑃 − 𝑃𝑒 ),
where 𝛼 = 𝑠/[(1 − 𝑠)𝑎]. Like the other models, the sticky-price model says that the deviation of output
from the natural rate is positively associated with the deviation of the price level from the expected price
level.
PDFelement
Although the sticky-price model emphasizes the goods market, consider briefly what is happening in the
labor market. If a firm’s price is stuck in the short run, then a reduction in aggregate demand reduces the
amount that the firm is able to sell. The firm responds to the drop in sales by reducing its production and
its demand for labor. Note the contrast to the sticky-wage model: the firm here does not move along a fixed
labor demand curve. Instead, fluctuations in output are associated with shifts in the labor demand curve.
Because of these shifts in labor demand, employment, production, and the real wage can all move in the
same direction. Thus, the real wage can be procyclical.
Price level
LRAS LRAS SRAS2
P>𝑃𝑒
SRAS P3=𝑃3∗ C SRAS1
B AD2
P=𝑃𝑒 P2
A AD1
P<𝑃𝑒 P1=𝑃1𝑒 = 𝑃2∗
Y Y
Y1=Y3=𝑌̅ Y2
The first graph shows that output deviates from the natural rate 𝑌̅ if the price level P deviates from
the expected price level. The second graph also shows here the economy begins in a long-run
equilibrium, point A. When aggregate demand increases unexpectedly, the price level rises from
P1 to P2. Because the price level P2 is above the expected price level 𝑃2 𝑒 , output rises
temporarily above the natural rate, as the economy moves along the short-run aggregate supply
curve from point A to point B. In the long run, the expected price level rises to 𝑃3 𝑒 , causing the
short-run aggregate supply curve to shift upward. The economy returns to a new long-run
equilibrium, point C, where output is back at its natural rate.
5.3.4 The worker Misperception model
The worker-misperception model is similar to the imperfect-information model presented in the

text in that both models rely on temporary misperceptions about prices to generate an upward-
sloping short-run aggregate supply curve, while maintaining price and wage flexibility. A main
difference between these models is that the imperfect-information model assumes that all people
in the economy are equally misinformed, while the worker-misperception model assumes that only
some people—workers—have imperfect information.
PDFelement
The key feature of the worker-misperception model is that unexpected movements in the price
level influence labor supply because workers temporarily confuse real and nominal wages. To
develop this model, we start with the labor demand and labor supply functions:
𝐿𝑑 = 𝐿𝑑(𝑊/𝑃)
𝐿𝑠 = 𝐿𝑠(𝑊/𝐸𝑃),
where, as in the sticky-wage model, labor demand depends on the real wage paid by firms and
labor supply depends on the real wage expected by workers. Workers are assumed to know the
nominal wage, W, but not the overall price level, P. In choosing how much labor to supply, workers
base their decision on the expected real wage, W/Pe. The expected real wage can be rewritten as:
𝑊/𝑃𝑒 = 𝑊/𝑃 × 𝑃/𝐸𝑃
which shows how the expected real wage is related to the degree of misperception about the price
level. When P/Pe is greater than one, workers will believe, incorrectly, that their real wage is
higher than it actually is, and when P/EP is less than one, workers will mistakenly believe that
their real wage is lower than it actually is. Substituting into the labor supply function gives
𝐿𝑠 = 𝐿𝑠((𝑊/𝑃) × (𝑃/𝐸𝑃)).
Labor supply thus depends on the real wage and worker misperceptions of the price level.
To see what this model says about aggregate supply, consider the equilibrium in the labor market,
shown in Figure 1. As is usual, the labor demand curve slopes downward, the labor supply curve
slopes upward, and the wage adjusts to equilibrate supply and demand. Note that the position of
the labor supply curve and thus the equilibrium in the labor market depend on worker
misperception P/EP.
Whenever the price level P rises, the reaction of the economy depends on whether workers
anticipate the change. If they do, then EP rises proportionately with P. In this case, workers’
perceptions are accurate, and neither labor supply nor labor demand changes. The nominal wage
rises by the same amount as prices, and the real wage and the level of employment remain the
same.
By contrast, if the price increase catches workers by surprise, then EP remains the same when P
rises. The increase in P/EP shifts the labor supply curve to the right, as in Figure 2, lowering the
real wage and raising the level of employment. In essence, workers believe that the price level is
lower, and thus the real wage is higher, than actually is the case. This misperception induces them
PDFelement
to supply more labor. Firms are assumed to be better informed than workers and to recognize the
fall in the real wage, so they hire more labor and produce more output.
1. Equlibrum in workers misperception model 2. An expected in price Ls1
Real wage (W/P) real wage
Ls Ls2
Equilibrium
w/p1
w/p2
Real wage
Ld Ld
Equilibrium Labor
L1 L2 Labor
Employment
To sum up, the worker-misperception model says that deviations of prices from expected prices
induce workers to alter their supply of labor and that this change in labor supply alters the quantity
of output firms produce. The model implies an aggregate supply curve of the form
𝑌 = ̅𝑌 + 𝛼(𝑃 – 𝐸𝑃).
One shortcoming of the worker-misperception model is that, like the sticky wage model, it predicts
a countercyclical real wage—a prediction that is not confirmed in data.

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