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Diploma Macro Paper 2

Monetary Macroeconomics

Lecture 6

Aggregate supply

and putting AD and AS together

Mark Hayes

Goods marketKX and IS

(Y, C, I)

Moneymarket (LM)

(i, Y)

IS-LM(i, Y, C, I)

AD

Labour market(P, Y)

ASAD-AS

(P, i, Y, C, I)

Phillips Curve(,u)

Foreign exchange market(NX, e)

AD*-AS(P, e, Y, C, NX)

Exogenous: M, G, T, i*, πe

IS*-LM*(e, Y, C, NX)

AD*

Goods marketKX and IS

(Y, C, I)

Moneymarket (LM)

(i, Y)

IS-LM(i, Y, C, I)

AD

Labour market(P, Y)

ASAD-AS

(P, i, Y, C, I)

Phillips Curve(,u)

Foreign exchange market(NX, e)

AD*-AS(P, e, Y, C, NX)

Exogenous: M, G, T, i*, πe

IS*-LM*(e, Y, C, NX)

AD*

4

Y1Y2

Deriving the AD* curve

Y

Y

P

IS*

LM*(P1)LM*(P2)

AD*

P1

P2

Y2 Y1

2

1

Why AD* curve has negative slope:

P

LM shifts left

NX

Y

(M/P)

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Mundell-Fleming and the AD* curve

Previously P was fixed, now we are changing it.

NX is a function of , not e.

We now write the M-F equations as:

This means that the diagram does not show us the eq’m for e but we do not need this explicit for AD*

𝑰𝑺∗ :𝒀=𝒄𝟏(𝒀 −𝑻 )+𝑰 (𝒊∗)+𝑮+𝑵𝑿 ()

𝑳𝑴 ∗ :¿¿

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The effect of an increase in demand in the ‘short run’ and the ‘long run’

Y

P

AD1

LRAS

Y

SRAS1

P2

Y2

A = initial (full employment) equilibrium

AB

CB = new short-run

eq’m after a boom in confidence

C = long-run equilibrium

AD2

SRAS2

P1

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Keynes’s original AD-AS model

employment, N

D

expected

income

AS

AD

Equilibrium employment

D*

Effective demand

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P

Y_

Y

LRAS

AD

SRAS

A post-Keynesian AD-AS model in P, Y space

Y

9

P

Y_

Y

LRASAD

SRAS

𝒀 −𝒀=𝜶 (𝑷−𝑷𝒆 )

Pe

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Three models of aggregate supply

1. The imperfect-information model

2. The sticky-price model

3. The sticky-wage model

All three models imply:

( )eY Y P P

natural rate of output

a positive paramet

er

the expected price level

the actual price level

agg. outpu

t

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Three models of aggregate supply

1. The imperfect-information model

2. The sticky-price model

3. The sticky-wage model

All three models imply:

a positive paramet

er

Deviations in price level

from expectation

Deviations in

output

𝒀 −𝒀=𝜶 (𝑷−𝑷𝒆 )

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The imperfect-information model

Assumptions: All wages and prices are perfectly flexible,

all markets clear Each supplier produces one good, consumes

many goods. Supply of each good depends on its relative

price: the nominal price of the good divided by the overall price level.

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The imperfect-information model

All suppliers know the nominal price of the good they produce, but do not know the general price level.

Supplier does not know general price level at the time of the production decision, so uses the expected price level, P e.

Suppose P rises but P e does not. Supplier thinks it is their own relative price which

has risen, so produces more. With many producers thinking this way,

Y will rise whenever P rises above P e.

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The sticky-price model

Assumption: Firms set their own prices

(monopolistic competition).

Reasons for sticky prices: long-term contracts between firms and

customers menu costs firms not wishing to annoy customers with

frequent price changes

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The sticky-price model

An individual firm’s desired price is

where a > 0.

Suppose two types of firms:• firms with flexible prices, set prices as

above• firms with sticky prices, must set their

price before they know how P and Y will turn out:

( )p P Y Y a

( )e e ep P Y Y a

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The sticky-price model

Assume sticky price firms expect that output will equal its natural rate. Then,

( )e e ep P Y Y a

ep P

To derive the aggregate supply curve, we first find an expression for the overall price level.

Let s denote the fraction of firms with sticky prices. Then, we can write the overall price level as…

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The sticky-price model

(1 )[ ( )]eP sP s P Y Y a

price set by flexible price

firms

price set by sticky price

firms

( ),eY Y P P where ( )

ss

1

a

(1 )( )e s

P P Y Ys

a

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The sticky-wage model

Assumes that firms and workers negotiate contracts and fix the money wage before they know what the price level will turn out to be.

The money wage they set is the product of a target real wage and the expected price level:

eW ω P eW P

ωP P

Target real

wage

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The sticky-wage model

If it turns out that

eW Pω

P P

eP P

eP P

eP P

then

Unemployment and output are at their natural rates.

Real wage is less than its target, so firms hire more workers and output rises above its natural rate.

Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate.

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Chart 4.6 Real product wages, labour market slack and productivity

Sources: ONS (including the Labour Force Survey) and Bank calculations.

(a) Headline unemployment rate less the central Bank staff estimate of the medium-term equilibrium unemployment rate. For details, see the box on pages 28–29 of the August 2013 Report.(b) Private sector AWE total pay deflated by the market sector gross value added deflator.(c) Market sector output per worker.

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Summary & implications

Each of the three models of agg. supply imply the relationship summarized by the SRAS curve & equation.

Each of the three models of agg. supply imply the relationship summarized by the SRAS curve & equation.

Y

P LRAS

Y

SRAS

( )eY Y P P

eP P

eP P

eP P

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Summary & implications

Suppose a positive AD shock moves output above its natural rate and P above the level people had expected.

Y

P LRAS

SRAS1

SRAS equation: eY Y P P ( )

1 1eP P

AD1

AD22eP

2P3 3

eP P

Over time, P

e rises, SRAS shifts up,and output returns to its natural rate.

1Y Y 2Y3Y

SRAS2

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Goods marketKX and IS

(Y, C, I)

Moneymarket (LM)

(i, Y)

IS-LM(i, Y, C, I)

AD

Labour market(P, Y)

ASAD-AS

(P, i, Y, C, I)

Phillips Curve(,u)

Foreign exchange market(NX, e)

AD*-AS(P, e, Y, C, NX)

Exogenous: M, G, T, i*, πe

IS*-LM*(e, Y, C, NX)

AD*

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Inflation, Unemployment, and the Phillips CurveThe Phillips curve states that depends on expected inflation,

e.

cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate

supply shocks, (Greek letter “nu”).

( ) e nu uwhere > 0 is an exogenous constant.

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The Phillips Curve and SRAS

SRAS curve: Deviations in output are related to unexpected movements in the price level.

Phillips curve: Deviations in unemployment are related to unexpected movements in the inflation rate.

𝒀 −𝒀=𝜶 (𝑷−𝑷𝒆 )SRAS

Phillips curve 𝒖−𝒖𝒏=−𝟏 /𝜷 (𝝅 −𝝅𝒆−𝒗 )

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28

29

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Goods marketKX and IS

(Y, C, I)

Moneymarket (LM)

(i, Y)

IS-LM(i, Y, C, I)

AD

Labour market(P, Y)

ASAD-AS

(P, i, Y, C, I)

Phillips Curve(,u)

Foreign exchange market(NX, e)

AD*-AS(P, e, Y, C, NX)

Exogenous: M, G, T, i*, πe

IS*-LM*(e, Y, C, NX)

AD*

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Next term

Policy effectiveness and inflation targeting

Origins of the North Atlantic and Euro crises