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

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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

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Aggregate Demand (AD) & Aggregate Supply (AS)

Ultra-Keynesian A.S.Neoclassical A.S. Intermediate A.S. curveExpectations-augmented A.S.Rational expectations A.S.Real Business Cycles (RBC)

Appendices -- 7. Labor market rigidities. Lecture 20: Aggregate Supply --Price level P, Inflation , & Wages WITF220 - Prof.J.Frankel1Aggregate Demand curve slopes down.ITF220 - Prof.J.FrankelP => LM shifts left(real balance effect)=> Y => M1 / P ypAD Why?2A monetary expansion shifts AD to the right.ITF220 - Prof.J.FrankelBy how much? ypADADBy the answer to IS-LM.By how much?Or it shifts AD up.In proportion to M1.{ Equilibrium outcome (Y vs. P) depends on AS.3The notion of Aggregate SupplyITF220 - Prof.J.Frankel4US output fell sharply below potential in 2008-09.

Brad deLong, Jan. 2014 fell in the 2008-09 global recession.

WORLD ECONOMIC OUTLOOK (WEO)Uneven Growth: Short- and Long-Term FactorsApril 2015IMFCan readily be derived from aggregation of supply decisions by individual firms that maximize profits and operate in competitive goods & labor markets.ITF220 - Prof.J.FrankelThen MP of Labor at full employment. (See graphs in Appendix I.)ALTERNATIVE SUPPLY RELATIONSHIPSwhere: 7API-120 - Prof. J. Frankel, Harvard University Two polar extreme cases

ypypAD'AD'ASASRealistic in Very Short Run.Only AS shocks move Y ,e.g., productivity shocks.Realistic in Long Run. 8AGGREGATE SUPPLY (continued) SR supply relationship:Implication:Demand expansion goes partly into P, partly into Y.ypAD'AS9ITF220 - Prof.J.FrankelMonetary 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.

10AGGREGATE SUPPLY (continued)

Milton Friedmanwhere p p-1and e pe p-1 . W is set in line with Pe, which adjusts over time.SR supply relationship: 4) Friedman-Phelps supply curve:SR: Point B in Figure 26.4. MR: Point C. LR: Point D.11

26.4Initially 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.Frankel12OVERVIEW OF AGGREGATE SUPPLY (continued)

Robert Lucas 5) Lucas supply relationshipImplications: An unpredictable demand expansion goes partly into P, party into Y in the short run; but predictable demand expansions have no effect on Y.

Committing monetary policy to a nominal anchorwould reduce inflation at little cost in terms of output.13Mexican sexenio From 1976 through 1994, inflation would shoot up

the peso would devalue, and/or every 6th year (presidential election years).

ITF220 - Prof.J.FrankelExample of rationalexpectations:ITF220 - Prof.J.FrankelIf 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 itties its handswill its commitment not to inflate be credible.

Odysseus tied to the mast15ITF220 - Prof.J.FrankelAlternative Nominal AnchorsMoney 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)

166. Real business cycle (RBC) theoryY = 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.ITF220 - Prof.J.Frankel

17Appendix II: Another AS relationship7. Indexed wagesApplication: real wage rigidity in Europe, vs. US.ITF220 - Prof.J.FrankelAppendix III: Measures of output gapAppendix I: Derivation of general AS relationship18

Employment determines output,via the production function.And the real wage determines employment,via the demand for labor.

If a firms Marginal Product of Labor > W/P If M P of Labor< W/P Sum labordemandacross all firms. Then set equal to supply of labor.Determines w.=> hire more N.=> cut N.ITF220 - Prof.J.FrankelAppendix I19An alternative approach:

ITF220 - Prof.J.Frankelallows 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

ITF220 - Prof.J.FrankelExplicit 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. 21If actual real wage > warranted real wage , 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