MiniModule:

1
Keynesian Model
Real Business Cycle
Mini-Module Expectations
Rational E ions
New Classical Model
Monet odel
2
Expectations-Augmented Aggregate Supply Curve
y y b (P-Pe)
3
Expectations-Augmented Aggregate Supply Curve in
ACTION.
y y b (P-Pe)
Start at point A the economy is at full
employment y and the actual price level is P0.
Here the actual price level equals the expected
price level. Now lets suppose we increase the
price level to 2P0.
Since P (the actual price level) is now greater
than Pe (the expected price level) y will rise,
and we slide along the ASSR (PeP0) curve to A'
.
Still puzzled?
Remember that our new ASSR (PeP0) curve is
defined by the presence of fixed expectations (in
this case at P0). So in terms of the ASe
equation, when P rises to 2P0, holding Pe
constant at P0, y must rise.
The long-run will be defined when the expected
price level equals the actual price level. So, as
price level expectations adjust, Pe?2P0, well
end up on a new short-run aggregate supply curve,
ASSR(Pe2P0) at point B.
Hooray! We made it back to AS, a situation
characterized by perfect information where the
actual price level (now 2P0) equals the expected
price level (also, 2P0).
In terms of the ASe equation, we can see that as
Pe catches up with P, that entire expectations
gap disappears and we end up on the long run AS
curve at full employment where y y.