Aggregate Demand (AD) & Aggregate Supply (AS) 1. Neoclassical A.S. curve

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Aggregate Demand (AD) & Aggregate Supply (AS) 1. Ultra-Keynesian A.S. 2. Neoclassical A.S. 3. Intermediate A.S. curve 4. Expectations-augmented A.S. 5. Rational expectations A.S. 6. Real Business Cycles (RBC) Appendices -- 7. Labor market rigidities. Lecture 20: Aggregate Supply -- Price level P, Inflation π, & Wages W ITF220 - Prof.J.Frankel

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Lecture 20: Aggregate Supply -- Price level P , Inflation π , & Wages W. Aggregate Demand (AD) & Aggregate Supply (AS) 1. Neoclassical A.S. curve 2. Modified Keynesian A.S. 3. Expectations-augmented A.S. 4. Rational expectations A.S . 5. Real Business Cycles (RBC ) - PowerPoint PPT Presentation

Transcript of Aggregate Demand (AD) & Aggregate Supply (AS) 1. Neoclassical A.S. curve

Page 1: Aggregate Demand  (AD) &  Aggregate Supply  (AS) 1. Neoclassical A.S. curve

Aggregate Demand (AD) & Aggregate Supply (AS)

1. Ultra-Keynesian A.S.2. Neoclassical A.S. 3. Intermediate A.S. curve4. Expectations-augmented A.S.5. Rational expectations A.S.6. Real Business Cycles (RBC)

Appendices -- 7. Labor market rigidities.

Lecture 20: Aggregate Supply --Price level P, Inflation π, & Wages W

ITF220 - Prof.J.Frankel

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Aggregate Demand curve slopes down.

ITF220 - Prof.J.Frankel

P ↑

=> LM shifts left(“real balance effect”)

=> Y ↓

=> M1 / P ↓

y

p

AD

Why?

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A monetary expansion shifts AD to the right.

ITF220 - Prof.J.Frankel

By how much?

y

p

AD

AD′

By the answer to IS-LM.

By how much?

Or it shifts AD up.

In proportion to Δ M1.{●

𝑦

Equilibrium outcome (Y vs. P) depends on AS.

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The notion of Aggregate Supply

• If demand rises too rapidly, it shows up in the price level, not output.

• In practice, the path of potential output is often measured by the point beyond which inflation begins to accelerate;

• and the natural rate of unemployment ūis measured as the rate below which inflation begins to accelerate.

ITF220 - Prof.J.Frankel

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US output fell sharply below potential in 2008-09.

Brad deLong, Jan. 2014 http://delong.typepad.com/delong_long_form/2014/01/the-relative-efficacy-of-fiscal-and-monetary-policy-at-the-zero-lower-bound-where-are-the-goalposts-anyway-the-honest-bro.html

𝒀

𝒀

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Inflation fell in the 2008-09 global recession.WORLD ECONOMIC OUTLOOK (WEO)Uneven Growth: Short- and Long-Term FactorsApril 2015 IMF

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Can readily be derived from aggregation of supply decisions by individual firms that maximize profits and

operate in competitive goods & labor markets.

ITF220 - Prof.J.Frankel

All-purpose supply function: = σ ≡ potential output W ≡ nominal wage W/P ≡ real wage ω ≡ “warranted real wage” σ ≡ elasticity of aggregate supply .

Then ω ≡ MP of Labor at full employment. (See graphs in Appendix I.)

ALTERNATIVE SUPPLY RELATIONSHIPS

where:

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API-120 - Prof. J. Frankel, Harvard University

Two polar extreme cases

1) Ultra-Keynesian case:

AS flat, at => AD expansion goes entirely into Y.

y

p

y

p

AD'

AD'

AS

AS 2) Classical case

AS vertical at => AD expansion goes entirely into P.

Realistic in Very Short Run.

Only AS shocks move Y ,e.g., productivity shocks.

Realistic in Long Run.

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AGGREGATE SUPPLY (continued)

=

● 3) Intermediate case:W = => AS has some slope, even in the SR.

SR supply relationship:

Implication:Demand expansion goes partly into P, partly into Y.

y

p

AD'

AS

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ITF220 - Prof.J.Frankel

Monetary expansion raises AD in the SR. A rise in the current level of M shifts LM curve out,

because M/P , in the SR. Alternatively, a rise in expected future growth rate of M shifts IS out,

because e => r => A .

Either way, IS-LM shifts right=> AD shifts right:

Result is higher Y and higher P.

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AGGREGATE SUPPLY (continued)

Milton Friedman

=

= or in logs, y -

where π ≡ p – p-1

and πe ≡ pe – p-1 .

W is set in line with Pe, which adjusts over time.

Yearly wage contract .

SR supply relationship:

● 4) Friedman-Phelps supply curve:

But over time πe adjusts to actual π, so Y = In LR, AS is vertical.SR: Point B in Figure 26.4. MR: Point C. LR: Point D.

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26.4

Initially – Point A.

Then monetary expansion.

MR -- Point C: Pe adjusts partway => W does too.LR -- Point D:

Pe, and so W, have fully adjusted.

SR -- Point B: before W has had time to adjust.

●●●

ITF220 - Prof.J.Frankel

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OVERVIEW OF AGGREGATE SUPPLY (continued)

Robert Lucas

● 5) Lucas supply relationship

=

or in logs, y -

,

Rational expectations => is unforecastable.where is the forecast error.

Implications: An unpredictable demand expansion goes partly into P, party into Y in the short run; but predictable demand expansions have no effect on Y.Þ Committing monetary policy to a nominal anchorwould reduce inflation at little cost in terms of output.

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Mexican sexenio

From 1976 through 1994,

inflation would shoot up

the peso would devalue,

and/or

every 6th year (presidential election years).

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Example of rational

expectations:

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If monetary policy cannot have a systematic effect on output anyway, the central bank might as well give up, and attain the only goal it can: price stability. But only if it“ties its hands”will its commitment not to inflate be credible.

Odysseus tied to

the mast

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ITF220 - Prof.J.Frankel

Alternative Nominal Anchors

Money supply targets (e.g., monetarism in 1980s.)

Pegged price of gold (e.g., classical gold standard)

Price level target (e.g., Inflation Targeting)

Fixed exchange rate (e.g., currency board)

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6. Real business cycle (RBC) theory

• Y = • N = .

• According to this theory, all fluctuations are due to real (supply) factors:– technology shocks &– shifts in preferences for work vs. leisure.– Not monetary policy.

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YN

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Appendix II: Another AS relationship• 7. Indexed wages– Application: real wage rigidity in Europe, vs. US.

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Appendix III: Measures of output gap

Appendix I: Derivation of general AS relationship

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Employment determines output,via the production function.

And the real wage determines employment,via the demand for labor.

If a firm’s Marginal Product of Labor > W/P

If M P of Labor< W/P

Sum labordemand

across all firms.

Then set equal to

supply of labor.

Determines w.

=> hire more N. => cut N.

ITF220 - Prof.J.Frankel

Appendix I

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An alternative approach:

ITF220 - Prof.J.Frankel

allows firms to be imperfectly competitive, with a profit mark-up over cost,but still has Y↑ => P ↑via firms’ demand for labor & marginal cost.

The New Keynesian Phillips curve

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Explicit wage indexation:

Examples in 1970s-80s -- • US: Cost of Living

Adjustment clauses• Italy: scala mobile• Argentina: complete

indexation of everything

Implicit realwage rigidity:

Example -- thought to characterize Europe.

Appendix II: Labor market rigidities

7.

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If actual real wage > warranted real wage ω,

• Y < permanently .

• Growth in demand will not show up in increased employment.– because it is “classical unemployment,”

not Keynesian unemployment.

• E.g., comparison of US vs. Europe: – In the 1970s the upward trend of warranted w slowed sharply

• <= productivity slowdown <= oil shocks.– In the US, employment continued to rise, but real w did not;– in Europe, real continued to rise, but employment did not.

Y

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w

w

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In the 1970s & 80s, the upward trend of warranted w slowed sharply, employment rose in US, while real wage contracts rose in Europe.

ITF220 - Prof.J.Frankel

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The Netherlands may have found a “middle way.”ITF220 - Prof.J.Frankel

One view: Europeans prefer job security; Americans prefer job growth.

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source: Giuseppe Bertola (2001)

“Labor market rigidities” in Europe go beyond sticky real wages;

They include also, e.g., laws against laying off workers,which discourage hiring.

One view of the divergenceBetween Germany & Greece:Labor market reforms enacted by Gerhard Schröder 2003-05 improved labor market efficiency.

Employment Protection Legislationoften does not raise overall employment.

If anything, the reverse.

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Three measures of excess supply tendto move together.

Source: IMF,World Economic Outlook.

.

Appendix III: Measures of output gap

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Inflation turned negative in 1930-33, along with the output gap,

and again in 1938-39

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Jobs vary with GDPthough usually less-than-proportionately , in practice.

”G20 labour markets: outlook, key challenges and policy responses,” Sept. 2014, ILO, OECD, World Bank Group, Report prepared for the G20 Labour and Employment Ministerial Meeting, Melbourne, Australia,

Data: OECD Quarterly National Accounts Database; OECD Labour Force Statistics Database, Eurostat, Annual national accounts for the European countries, ILO, ILOSTAT Database and results from national labour force surveys for Argentina and India.