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ECON 305

Econ 13  Aggregate supply  Y=Y+∝(P−EP),∝>0  Y= output  Y = natural level of output  P=pricelevel  EP = expected price level • Output deviates from its natural level when the price level deviates from the expected price level • 1/ ∝ = slope of AS curve  Sticky price model: emphasizes the slow adjustment of the prices of goods and services.  Firms so not instantly adjust prices to change in demand • Long term contracts, loyal customers, costs to alter prices, sticky wages  Some monopolistic control  The firm’s price depends on… • Overall level of prices (P) ♦ Higher price level means costs are higher • Level of aggregate income Y ♦ Higher level of income raises demand for the product  Means increased production and higher prices • p=P+a(Y−Y) ́ **flexible prices ♦ The desired price (p) depends on the overall level of prices (P) and on the level of aggregate output relative to the natural level ♦ a measures how much the firm’s desired price responds to the level of aggregate output.  Firms with sticky prices set their prices based on p = EP  Overall price level  P=EP+ (1−s) a (Y−Y) [ (s ] • Ahigh expected price level leads to a high actual price level ♦ Because firms that expect high costs set theirs high, so then their competitors do too • When output is high, demand is high, so prices are set high ♦ The effect of output on prices depends on how many have flexible prices  Overall price level depends on the expected price level and level of output  Alternative theory  Imperfect information model: markets clear and prices are free to adjust to balance supply and demand • Individuals do not always know the overall price level because they cannot observe the prices of all goods and services in the economy. ♦ Unsure if the overall price level has changed (don’t produce more) or the price of just your selling item has changed (produce more)  When actual prices exceed expected prices, suppliers raise their output  Implications  If the price level is higher than the expected price level, output exceeds its natural level  If AD increases
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