The labor market does not adjust quickly to disturbances. Rather, the adjustment
process takes time. The Phillips curve shows that nominal wages change slowly in
accordance with the level of employment. Wages tend to rise when employment is
high and fall when employment is low.
Expectations of inflation are built into the Phillips curve. When actual inflation and
expected inflation are equal, the economy is at the natural rate of unemployment.
Expectations of inflation adjust over time to reflect the recent levels of inflation.
Stagflation occurs when there is a recession plus a high inflation rate. That is,
stagflation occurs when the economy moves to the right along a Phillips curve that
includes a substantial component of expected inflation.
The short-run Phillips curve is quite flat. Within a year, one point of extra unemployment
reduces inflation by only about one-half of a point of inflation.
Rational expectations theory argues that the aggregate supply curve should shift
very quickly in response to anticipated changes in aggregate demand, so output
should change relatively little.
The frictions that exist as workers enter the labor market and look for jobs or
shift between jobs mean that there is always some frictional unemployment. The
amount of frictional unemployment that exists at the full-employment level of
unemployment is the natural rate of unemployment.
The theory of aggregate supply is not yet settled. Several explanations have been
offered for the basic fact that the labor market does not adjust quickly to shifts in
aggregate demand: the imperfect-information–market-clearing approach; coordination
problems; efficiency wages and costs of price changes; and contracts and
long-term relationships between firms and workers.
In deriving the supply curve in this chapter, we emphasize the long-run relationships
between firms and workers and the fact that wages are generally held fixed
for some period, such as a year. We also take into account the fact that wage
changes are not coordinated among firms.
The short-run aggregate supply curve is derived from the Phillips curve in four
steps: Output is assumed proportional to employment; prices are set as a markup
over costs; the wage is the main element of cost and adjusts according to the Phillips
curve; and the Phillips curve relationship between the wage and unemployment is
therefore transformed into a relationship between the price level and output.
The short-run aggregate supply curve shifts over time. If output is above (below)
the full-employment level this period, the aggregate supply curve shifts up (down)
next period.
A shift in the aggregate demand curve increases the price level and output. The
increase in output and employment increases wages somewhat in the current
period. The full impact of changes in aggregate demand on prices occurs only over
the course of time. High levels of employment generate increases in wages that
feed into higher prices. As wages adjust, the aggregate supply curve shifts until the
economy returns to equilibrium.
The aggregate supply curve is derived from the underlying assumptions that wages
(and prices) are not adjusted continuously and that they are not all adjusted together.
The positive slope of the aggregate supply curve is a result of some wages being
adjusted in response to market conditions and of previously agreed-on overtime
rates coming into effect as employment changes. The slow movement of the supply
curve over time is a result of the slow and uncoordinated process by which wages
and prices are adjusted.
Materials prices (oil price, for example), along with wages, are determinants of
costs and prices. Changes in materials prices are passed on as changes in prices
and, therefore, as changes in real wages. Materials price changes have been an
important source of aggregate supply shocks.
Supply shocks pose a difficult problem for macroeconomic policy. They can be
accommodated through an expansionary aggregate demand policy, with increased
prices but stable output. Alternatively, they can be offset, through a deflationary
aggregate demand policy, with prices remaining stable but with lower output.
Favorable supply shocks appear to explain rapid growth at the end of the 20th
century. Wise aggregate demand policy in the presence of favorable supply shocks
can provide rapid growth with low inflation.
