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P A R T I V
Business Cycle Theory: The Economy in the Short Run
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 asparagus, she is not sure whether other prices have risen (in which case
asparagus’s relative price is unchanged) or whether only the price of asparagus
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 asparagus that its relative price has risen somewhat. She
works harder and produces more.
Our asparagus farmer is not unique. Her decisions are similar to those of her
neighbors, who produce broccoli, cauliflower, dill, endive, . . . , and zucchini.
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 aggre-
gate supply curve with the familiar form
Y
= Y− +
a
(P
−
EP).
Output deviates from the natural level when the price level deviates from the
expected price level.
The imperfect-information story described above is the version developed
originally by Nobel Prize–winning economist Robert Lucas in the 1970s.
Recent work on imperfect-information models of aggregate supply has taken
a somewhat different approach. Rather than emphasizing confusion about rel-
ative prices and the absolute price level, as Lucas did, this new work stresses the
limited ability of individuals to incorporate information about the economy
into their decisions. In this case, the friction that causes the short-run aggre-
gate supply curve to be upward sloping is not the limited availability
of information but is, instead, the limited ability of people to absorb and
process information that is widely available. This information-processing con-
straint causes price-setters to respond slowly to macroeconomic news. The
resulting equation for short-run aggregate supply is similar to those from the
two models we have seen, even though the microeconomic foundations are
somewhat different.
3
3
To read Lucas’s description of his model, see Robert E. Lucas, Jr., “Understanding Business
Cycles,” Stabilization of the Domestic and International Economy, vol. 5 of Carnegie-Rochester Con-
ference on Public Policy (Amsterdam: North-Holland, 1977), 7–29. Lucas was building on the
work of Milton Friedman, another Nobel Prize winner. See Milton Friedman, “The Role of Mon-
etary Policy,” American Economic Review 58 (March 1968): 1–17. For the recent work emphasizing
the role of information-processing constraints, see Michael Woodford, “Imperfect Common
Knowledge and the Effects of Monetary Policy, in P. Aghion, R. Frydman, J. Stiglitz, and M. Wood-
ford, eds., Knowledge, Information, and Expectations in Modern Macroeconomics: In Honor of Edmund S.
Phelps (Princeton, N.J.:Princeton University Press, 2002); and N. Gregory Mankiw and Ricardo
Reis, “Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips
Curve,” Quarterly Journal of Economics 117 (November 2002): 1295–1328.
C H A P T E R 1 3
Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment
| 385
International Differences in the
Aggregate Supply Curve
Although all countries experience economic fluctuations, these fluctuations are
not exactly the same everywhere. International differences are intriguing puzzles
in themselves, and they often provide a way to test alternative economic theo-
ries. Examining international differences has been especially fruitful in research
on aggregate supply.
When Robert Lucas proposed the imperfect-information model, he derived
a surprising interaction between aggregate demand and aggregate supply:
according to his model, the slope of the aggregate supply curve should depend
on the volatility of aggregate demand. In countries where aggregate demand
fluctuates widely, the aggregate price level fluctuates widely as well. Because most
movements in prices in these countries do not represent movements in relative
prices, suppliers should have learned not to respond much to unexpected
changes in the price level. Therefore, the aggregate supply curve should be rela-
tively steep (that is,
a
will be small). Conversely, in countries where aggregate
demand is relatively stable, suppliers should have learned that most price changes
are relative price changes. Accordingly, in these countries, suppliers should be
more responsive to unexpected price changes, making the aggregate supply
curve relatively flat (that is,
a
will be large).
Lucas tested this prediction by examining international data on output and
prices. He found that changes in aggregate demand have the biggest effect on
output in those countries where aggregate demand and prices are most stable.
Lucas concluded that the evidence supports the imperfect-information model.
4
The sticky-price model also makes predictions about the slope of the
short-run aggregate supply curve. In particular, it predicts that the average rate of
inflation should influence the slope of the short-run aggregate supply curve.
When the average rate of inflation is high, it is very costly for firms to keep prices
fixed for long intervals. Thus, firms adjust prices more frequently. More frequent
price adjustment in turn allows the overall price level to respond more quickly
to shocks to aggregate demand. Hence, a high rate of inflation should make the
short-run aggregate supply curve steeper.
International data support this prediction of the sticky-price model. In coun-
tries with low average inflation, the short-run aggregate supply curve is relative-
ly flat: fluctuations in aggregate demand have large effects on output and are only
slowly reflected in prices. High-inflation countries have steep short-run aggre-
gate supply curves. In other words, high inflation appears to erode the frictions
that cause prices to be sticky.
5
CASE STUDY
4
Robert E. Lucas, Jr., “Some International Evidence on Output-Inflation Tradeoffs,” American Eco-
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