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Macroeconomics 123 Chapter V. AS-AD Chapter V. Aggregate Supply & Aggregate Demand Curve Analysis 1. Aggregate Demand 1) Algebraic Derivation You may remember that the equilibrium national income from the IS-LM curve is * Y = h b M ( C 0 - c1 T 0 + I 0 + G0 ) + ( - u) h(1 - c1 ) + kb 1 - c1 + kb P0 Let’s focus on the relationship between Y and P. If all variables are constant except for Y and P, we can get an equation showing the relationship between the two variables Y and P, such as Y = 500 + 200/P. This equation carves up the relationship between two variables, Y and P, is called the Aggregate Demand Curve. P ( C 0 ; T 0 ; I 0 ; G 0 ; M ) s h i f t p a r a m e t e r s AD YP In the discussion of monetary policy which involves a change in money supply M and its impact on P and Y, we deliberately drop the intercept A, which is related to fiscal policies, and frequently use Y = B/P = B’ (M/P) to carve up the relationship between the three key variables, M, P, and Y (real income). If we draw the graph of the above equation with Y on the horizontal axis and P on the vertical axis, this is a hyperbola. We know that Y = 1/X is a rectangular hyperbola. Y = A + B/X is simply Y = 1/X shifted up by A and outward along the Y =X line by B. Macroeconomics 124 Chapter V. AS-AD The quantity theory of money postulates that the equation of exchange is M V = P Y, or Y = V (M/P), where M is the supply of money, and V the velocity of circulation of money. This equation is exactly the same as Y = B’ (M/P). This is a special case, featuring monetary aspects, of the AD curve which embodies the impact of fiscal policies along the others (∆C, ∆I) in the first term and that of monetary policies along with monetary shocks (∆u) in the second term of the equation Y 2) Graphic Derivation We derive the AD curve by examining the impact of a changing price level on the LM curve and consequently on the AD. When the price level falls from P1 to P2, the real money supply rises from M/P1 to M/P2. This shifts the LM curve to the right. The equilibrium national income level rises in the IS-LM curve. The corresponding point shifts in the AD setting. By linking the two points, we get the AD curve. LM (M/P1) LM (M/P2) P1 P2 AD 3) Shift of AD curve ∆ C0, ∆I0, ∆G0, - ∆T0 ∆IS ∆AD ∆ M ∆LM ∆AD Macroeconomics 125 Chapter V. AS-AD ∆ md = ∆u ∆LM ∆AD In summary, the AD has six shift-parameters, C0, I0, G0, T0, M, and u. Out of them, C0, I0 and u are beyond the control of the government; C0, I0 and u are called Aggregate Demand Shocks; specifically, C0 and I0 (X0 and M0 as well in the open economy) are goods market shocks, and u is a monetary shock; G and T are fiscal policy instruments; M is monetary policy instrument. To countervail the Aggregate Demand Shocks and thus to eliminate any impact on the equilibrium national income, the government may control G, T, and M in counter-cyclical ways. This is called ‘the Counter-cyclical policy’ or ‘Income stabilization policy’. 2. Aggregate Supply 1) What is the aggregate supply? AS versus YS The aggregate output is the sum of all the supplies of goods and services in the economy. You may remember the 45 degree line of YS = Y in the Keynesian Cross Diagram. When the aggregate output YS is drawn against a particular price level, that is the aggregate supply. The only difference is that the AS is drawn again at the price level while YS is not. In a sense, AS comes from YS. Then, our next question is, what determines YS? 2) Aggregate Production Function AS is the aggregate outputs at a particular price level. Output results through production process from inputs. The production function shows the relationship between the inputs and the outputs: production combines production factors with a certain technology. The production function summarizes all three aspects of the supply: Inputs, outputs, and technology. (1) Functional Form Macroeconomics 126 Chapter V. AS-AD In microeconomics theories, an individual production function, say, a hamburger or i th industry, is given by Qi = f (K,L), where K and L are capital and labor inputs, and Q output at the firm or industry level. Technology is implied in the functional form. The aggregate production function is obtained by summing up the production functions of all industries. The aggregate production function shows the aggregate output YS as an increasing function of capital and labor inputs. Again technology is implied in the functional form. We use notation K for the capital stock or the amount of capital, and N for labor input at the aggregate level of economy. YS = F (K, N; T ). Note that unlike the microeconomics which uses L for labor input, we use N for the aggregate labor inputs, which is called the ‘level of employment’ in an economy. N may be measured in total hours worked for a given period of time, which is equal to the number of workers employed times the number of hours worked by each worker. Here T stands for Technology employed in production. (2) Derivation of the Aggregate Production Curve Note that in the short-run, K remains fixed and T does not change. Thus the short-run aggregate production function can be expressed as an increasing function of one variable N or the level of employment of existing workers: the more workers employed for longer hours, and then more aggregate output. YS Aggregate Production Curve N Let’s take a numerical example for the Short-run Aggregate Production Function: YS = 100N – 0.3 N2 Macroeconomics 127 Chapter V. AS-AD If the level of employment is given at 40 (say, million hours worked for a year), what is YS? The answer is YS = 100 x 40 – 0.3 (40)2 = 3520. If N increases up to N = 60, then the aggregate outputs rise to a new level: 100X60 – 0.3 (60)2 = 4920. These two points give us an aggregate production curve. It is upward sloping, and is convex upwards. In the short-run, there is a one-to-one relationship between the level of employment and the aggregate outputs: N*’ – AS* t in the short-run. An increase in the level of employment leads to a movement along the given aggregate production function. Note that the slope of the tangent line to the Aggregate Production Curve is the Marginal Product of Labor. The shape of the above Aggregate Production Curve is part of a so-called ‘S curve’ of the total (aggregate) production curve: YS N The first phase or Phase I shows the concave upward and implies that as the input of labor force or the level of employment goes up, the output increases by more than proportion due to an increase in efficiency coming from specialization and cooperation, etc. That is an increasing marginal product of labor or MPL increases in this phase. Then there occurs a point of inflection. The curve become convex upwards and implies that as the input(labor forces or level of employment) rises, the output increases by less than proportion: This is the area where the diminishing marginal product of labor takes place. As the level of N increases by one unit, the output increases but it does so by less and less. It is Macroeconomics 128 Chapter V. AS-AD called ‘Decreasing Marginal Product of Labor’. This is due to some imbalance between the size of (given) capital (equipment and facilities) and the number of workers working in and with them, and the resultant inefficiency such as congestion(too many workers collide and crowd, free-riders(some workers are not carrying their fair work load)etc. Our earlier aggregate product curve is a cut out of the above S curve from and beyond the inflection point. Why cut here? Because Phase I is important and beneficial for the producer, but it is uninteresting. All the decision to be made is trivially to keep expanding the employment (N up). When the inflection point comes, now the entrepreneur has to start thinking of a very critical question: When to stop? He has to weigh the inefficiency, which has started setting in, against other benefits, and has to make a decision to stop at the right level of N. Thus, this part of S curve is important in terms of the entrepreneur’s corporate decision making, and we are only looking at this part of the S curve of the total production curve. YS N (3) Shift of Aggregate Production Function In the long-run, i) an increase in N, ii) an increase in K, and iii) the enhanced level of technology are all possible, leading to an increase in Aggregate Output. However, an increase in N leads to a movement along the Aggregate Output Curve, and the two others, such as an increase in K or/and T leads to a shift of the Aggregate Output Curve. Macroeconomics 129 Chapter V. AS-AD i) Capital Accumulation: ∆K With more capital inputs, each level of employment will lead to a larger amount of aggregate outputs: With more capital equipment, each worker can produce more outputs. This will send the Aggregate Production Curve outward, or upward. YS Let’s take a numerical example, N Before: Y* = 100 N – 0.3 N2 (a Old production function) N = 40 – Y* = 3520; N = 60 – Y* = 4920. After: Y* = 250 N – 0.2 N2 (a New production function) N = 40 – Y* = 5680; N = 60 – Y* = 8280. Therefore, capital accumulation (∆K) leads to a upward shift of the production curve. When the Aggregate Production Curve shifts up, at each level of N, the slope of the tangent line gets steeper: The slope is equal to the marginal product of labor, and thus the MP of labor rises. Think about the decrease in capital, which will send the Aggregate Production Curve downward. Capital naturally wears and tears over time and it is called ‘Depreciation’ Capital can be destroyed during a war. ii) Technical Innovation, or Technological Advances: ∆T With an improved production technology, each level of employment will lead to a larger amount of aggregate outputs. Let’s take a numerical example: Macroeconomics 130 Chapter V. AS-AD Before: Y* = 100 N – 0.3 N2 ( a Old production function) N = 40 – Y* = 3520; N = 60 – Y* = 4920. After: Y* = 150 N – 0.2 N2 ( a New production function) N = 40 – Y* = 5680; N = 60 – Y* = 8280. Therefore, technological advances also lead to a upward shift of the production curve. The marginal product of labor rises, too. YS N iii) A Growing Number of Workers: ∆Ns This is a rightward shift of the labor supply curve. The equilibrium nominal wage rates fall: So does the real wage rate. The equilibrium level of employment rises, which increases the aggregate outputs along the aggregate production function. This can happen in the long run due to population growth, or open-door immigration policies. As N is on the horizontal axis, this leads to a movement along the aggregate production curve. 3) Aggregate Labor Supply and Demand Curve: Labor Market Then, the question in order is how the level of employment or N* is determined to enter the aggregate production function. N* is determined in the labor market through the interplay of the aggregate labor supply and aggregate labor demand. Now, we note that we are introducing one more market into the picture, and that is the labor market. The supply of labor is an increasing function of real wages, which are money wage over the price level ( w = W/P), and the demand for labor a decreasing function of real wages. (1) Aggregate Labor Supply Macroeconomics 131 Chapter V. AS-AD The labor supply is an increasing function of real wages, which are equal to nominal wages divided by the price level; Ns = f (W/P; other variables) For a given level of P, as W rises, Ns rises as well. If you put Ns on the horizontal axis and W on the vertical axis, the curve should be positively sloped. And P becomes a shift parameter. W/P Ns Numerical Example: Ns = 100 + 3 (W/P). If the nominal wage or money wage (rate per hour) is $10 per hour and the price level is equal to 1, then the real wage (rate per hour) is 10/1 = 10, and the aggregate labor supply would be 100+ 3 times 10/1 = 130. The above is sufficient for the labor supply curve in macro. Note that the vertical axis is in the real wage W/P. The labor supply is an increasing function of real wage. However, in the macroeconomics, we would further separate real wage W/P into nominal wage W and price level P. If we draw the aggregate labor supply curve Ns against the nominal wage W, we can see impacts of P more clearly. How can we do that? First, hold P = 1 constant, then W/P becomes W, and draw the Ns curve of the same shape: W/1 = W Ns (for P=1) Macroeconomics 132 Chapter V. AS-AD Note that now the vertical axis is W or nominal wage, and the horizontal axis is the level of employment or N, and finally that the Ns curve or the aggregate labor supply curve is drawn with the fixed price level of 1. Thus we should note that the price level is now the shift variable of the Ns curve. What will happen to the Ns curve for P =1 if the price level rises from 1 to, say, 2 while the nominal wage (rate for hour) is held constant? A Shift of the Ns curve: In the short-run, a change in the price level shifts the Ns curve. As P rises, the Ns curve shifts up as well; As P rises, for a given level of W, the real wage of W/P falls, and thus labor supply falls. When P rises from P=1 to P=2, Ns (for P=2) Ns (for P=1) W Ns decreases There are other variables that shift the Ns curve. For example, in the long-run, as population grows the labor supply curve may shift to the right. Macroeconomics 133 Chapter V. AS-AD In summary, for the dimension of W and N, we can write the aggregate labor supply curve as: Ns = f (W(+) : P(-) , other variables such as population, immigration, etc.) All other variables, except W and Ns, become shift variables. A change in these shift variables leads to a shift of the Ns curve. Remember that an increase in the price level or P leads to the visually upward movement of the Ns curve or a decrease in Ns. (2) Aggregate Labor Demand: Let us examine the labor demand first: The aggregate labor demand is a decreasing function of real wages: Nd = g (W/P; other variables). If we draw a curve which shows the relationship between Nd and W. It will be downwardsloping; as W goes up, the entrepreneurs demand for labor falls. The third variable P becomes a shift parameter. W/P Nd By holding P = 1 constant, we can get a Nd curve corresponding to P=1. W/1 Macroeconomics 134 Chapter V. AS-AD Nd (P=1) Nd Background-You may recall the following Microeconomics theory of labor demand: The entrepreneur does demand labor and hires workers. If s/he is maximizing profits, at the margin or for the last worker hire, the cost is equal to the benefit. The cost of hiring the last worker in monetary terms is the money wage W, and the benefit from hiring the worker is the marginal product MP (units of output the worker produces) times the price of the output P. So at the profit maximizing level of employment, W = P x MPL. Numerical example) It costs $10 to hire a worker because W = $10. The last worker increases the total products or outputs by 5 (5 units of outputs), and each unit of output has the price of $2 in the market. The cost of hiring the last worker is $10, and the benefit from hiring her/him is 5 times $2, being equal to $1. We now know that at the equilibrium for the profit maximizing firm W = P x MPL in dollar terms, or W/P = MPL in physical terms. MPL is a decreasing function of the amount of labor inputs. The real wage w= W/P is set by market forces, and is paid uniformly to all workers, regardless of whether there are many or few workers. When the real w = W/P is set at a certain level in the labor market, the entrepreneur who is a price taker will hire workers in such a number that the last worker’s marginal product is equal to the real wage set in the market. The entrepreneur is making profits from hiring intra-marginal workers (all the workers except the last worker hired) as their marginal products are higher than the real wage. S/he is not marking any profit from hiring the last or marginal worker (MP = W/P) This implies that the MPL curve itself drawn against real wages is the labor demand curve. A Shift of the Nd curve: Macroeconomics 135 Chapter V. AS-AD As P or the price level rises, the real wages (W/P) falls for a given level of W. And thus Nd rises: this is a rightward movement or upward movement of Nd curve. As P rises, say from 1 to 2, while W is held constant, W Nd(P’) Nd(P) N Nd rises where P =1, and P’ = 2 in this case. Of course, there are other variables that shift the Nd curve: In the long run, ∆K or an enhanced technology increases each worker’s productivity or marginal product. The MPL shifts up, and the labor demand curve shifts up (or to the right). There is an increase in labor demand. In summary, for the dimension of W and N, we can write the aggregate labor supply curve as: Nd = g(W (-) : P(+) , other variables such as population, immigration, etc.) All other variables, except W and Ns, become shift variables. A change in these shift variables leads to a shift of the Nd curve. Remember that an increase in the price level leads to the visually upward movement of both Nd and Ns curves. Macroeconomics 136 Chapter V. AS-AD (3) Labor Market Equilibrium The interplay of the Nd and NS determines the equilibrium level of employment N* and the equilibrium level of real wages w*; At equilibrium, f(W/P) = g(W/P), or f(W: P ) = g (W: P) We can solve for the real wages or W/P at this equilibrium in the labor market. And then, for a given price level, we can also get the nominal wages W for this equilibrium. Graphically, W W* N* Nd By plugging the value of W* back into the aggregate labor supply or demand function, we can get N* In summary, As – YS – N*- w* - W for a given level of P. We would revisit the question of what will happen to the equilibrium real wage W/P = w when the price level rises? This depends on what will happen to nominal wage or W when the price level rises. In the microeconomics, which belongs to the world of classical economics, there is an assumption of flexibility of nominal wage. In other words, the nominal wage W will rise in Macroeconomics 137 Chapter V. AS-AD an exact proportion to the increase in P. As P rises, W rises by the same amount. Thus, W/P = w or real wage does not change. There will be no change in the level of employment N, and thereby no change in aggregate output YS or real national income Y. The flexibility of nominal wage W ensure the separation of the world of nominal variables such as W and P, and the world of the real variables such as N, YS, and Y. There is a dichotomy between the real and the nominal variables. However, in macroeconomics, there are different schools which have different assumptions about the degree of flexibility of nominal wage. And the different degrees of flexibility of nominal wage opens up the possibility of W not exactly following the movement of P and thus lead to a change in real wage or w =W/P, level of employment N, aggregate output YS, and real national income Y. An increase in the price level, which is a change in nominal variable, can affect the real variables. Let’s elaborate on this point: If W is viewed to be flexible, just as assumed in the classical economics, and follows the movement of P, a change in P will be accompanied by an equal movement of W, leaving w unchanged. First, the rising P shifts both the labor supply and demand curves up; The new equilibrium occurs at E; The new equilibrium nominal wages are proportionally higher than the previous one: In other words, the increase in W is proportional to the increase in P; Therefore the real wages (w= W/P) do not change; The level of employment is the same as before. W W1 W0 E Macroeconomics 138 Chapter V. AS-AD Nd This flexibility of money wages and thus the consequent constancy of real wages belong to the classical world, where i) there is no information asymmetry between the entrepreneurs and the workers: There is no money illusion on the part of workers (it goes without saying that any working, let along successful, entrepreneurs should NOT have any money illusion at all); ii) there is no structural rigidity which hinders flexible changes of money wages in response to a change in price level, particularly of downwards changes or falls to a falling price level in the case of recession, such as labour unions, and finally iii) it is in the long-run – enough of time has passed to make a full adjustment of money wages to a changing price level. However, John Maynard Keynes saw the real world differently: First, he argues that yes, in the long-run, the money wages will adjust fully to a changing price level and everything will be fair and square, but that in the long-run ‘we are all dead’. We may live through a series of short-terms, and constant changes in equilibrium. In the short-run, money wages can be rigid for many reasons. For one thing, it may be confusion on the part of the workers, such as money illusion. Even in the long-run, money wages can be rigid even amid recession, and they are so mainly due to institutional elements such as labor unions. Why did the Great Depression last for such a long period of time – 10 years or so? It was mainly due to the rigidity of money wages backed by labor unions, and also due to ‘confusion’ by a political leader. Let’s listen to Professor G. Smiley in her contribution of ‘The Great Depression” in the Concise Encyclopedia of Economics: “….In previous depressions, wage rates typically fell 9-10 percent during a one- to two-year contraction; these falling wages made it possible for more workers than otherwise to keep their jobs. However, in the Great Depression, manufacturing firms kept wage rates nearly constant into 1931, something commentators considered quite unusual. With falling prices and constant wage rates, real hourly wages rose sharply in 1930 and 1931. Though some spreading of work did occur, firms primarily laid off workers. As a result, unemployment began to soar amid plummeting production, particularly in the durable manufacturing sector, where production fell 36 percent between the end of 1929 and the end of 1930 and then fell another 36 percent between the end of 1930 and the end of 1931. Macroeconomics 139 Chapter V. AS-AD Why had wages not fallen as they had in previous contractions? One reason was that President Herbert Hoover prevented them from falling. He had been appalled by the wage rate cuts in the 1920-1921 depression and had preached a “high wage” policy throughout the 1920s. By the late 1920s, many business and labor leaders and academic economists believed that policies to keep wage rates high would maintain workers’ level of purchasing, providing the “steadier” markets necessary to thwart economic contractions. When President Hoover organized conferences in December 1929 to urge business, industrial, and labor leaders to hold the line on wage rates and dividends, he found a willing audience……” Perhaps, it wasn’t Mr. Hoover who found the audience, but it was the general public (workers) that found Mr. Hoover as a populist politician. He meant to have represented the workers by supporting an artificially high money wages, but in the end, he prolonged the depression into the Great one in history. Thus the Keynesian world goes as follows: If W is fixed, particulary downwardly rigid: An increase in P may or may not be accompanied with a commensurate increase in money wages or W, and thus may lead to a decrease in real wages or w. However, more apparently, a decrease in P during the recession may not lead to a corresponding fall in money wages or W. It may be due to three things: money illusion on the part of workers; labor unions, and/or in the short-run. In any case, it will lead to an increase in real wages or w: an increase in the real labor cost on the part of entrepreneurs and thus their demand for labor decreases. First, the increasing P shifts both the labor supply and demand curves visually up. However, the nominal wages are set at a fixed level, shown by the horizontal line; nominal wages cannot be nothing other than the fixed level. The new equilibrium should come at E where the labor demand curve and the horizontal nominal wage line (effective labor supply curve) intersect. At the new equilibrium, compared with the previous equilibrium, the nominal wages are the same, and the equilibrium level of employment N is higher. Macroeconomics 140 Chapter V. AS-AD Ns W E E (effective labour supply) Nd N * N * 0 Nd The first position is taken by the classical economics, which is the same as the microeconomics, and the second is by the Keynesian economists. The second is true when there is structural impediment to the flexible mobility of W or nominal wage. This is the case when there is a union which insists on having fixed nominal or monetary amount of wage. In other words, when workers’ unions have ‘money illusion’ and thereby focus on the nominal value of wage instead of real value or purchasing power of the wage. This is also the case when the time-period of observation is too short. In a very short-run, the change in the price level is not reflected in the wage level. The third possibility is when the people (= the workers) have some kind of ‘money illusion’. The money illusion refers to the situation where, being faced with a changing price level P, the people really should focus on the real wages w = W/P but they in fact have ‘hang-up’ on the nominal wages, and thus they try to stick to the fixed nominal wage( W bar). The end result is that real wage instead changes and so do N*, YS, and Y. On the other hand, if there are no impediments on the mobility of nominal wage W and workers are more or less fully employed W will move in the same direction as the changing P in the long-run. ∆P means an increase in living –costs for workers, and workers will eventually demand a higher money wage or ∆W. Basically, the AS analysis hinges upon what is happening when the price level changes: What is the impact of a change in the price level on real wages and on the equilibrium employment level? 4) Derivation of Aggregate Supply Curve (1)Different Aggregate Supply Curves You may remember that the AS is assumed to be vertical in the classical economics, and horizontal or upward sloping in the Keynesian economics. Macroeconomics 141 Chapter V. AS-AD You may recall that the classical AS curve is vertical; the AS is fixed at a certain level. The fixed level of AS is called ‘the full employment level’. Note: The full employment does not mean zero unemployment, but a low yet positive rate of unemployment. A certain positive rate of unemployment is inevitable for an economy where new comers are looking for best-fitting jobs and some workers are upgrading their skills and consequently searching for another jobs. Some unemployment is even desirable as it provides some reserves in the economy; without it the man/women-power situation is too tight, and a firm which is faced with even temporary rise in the demand for its products would have extreme difficulties in hiring extra workers. As a consequence, we will observe a shortage of the good or a rise in its price. We need a small ‘buffer’ of unemployed workers. This positive rate of unemployment compatible with a smooth working economy at the ‘full employment level’ is called ‘the natural rate of unemployment’. The corresponding national income is the ‘natural real national income.’ In the short-run, there may be some temporary deviation of the actual national income from the full employment N.I., but the price level will adjust to push the economy back to the equilibrium. The Business Cycles can occur due to the demand shocks. However, it is only temporary, and is of no big concern as the economy, if left alone, automatically gravitates toward a unique equilibrium N.I. What is the role of the government in the economy? If there is no factor in the economy which blocks the above tatonnement, the government should not create anything which can get in the way of this natural adjustment process of recovering the equilibrium. Actually it should eliminate any impediments in this process and facilitate the adjustment process by promoting competition. You may also recall that the Keynesian Aggregate Supply curve is upward-sloping; the AS responds positively to the (output) price level. (2) Fundamental Cause of Different AS curves. Flexible Nominal/Money Wages A vertical AS curve. (Neo Classical) Rigid Nominal./Money Wages a Positively Sloping AS curve. (Keynesian) The reasons for rigidity: Money Illusion; a kind of stupidity at the individual level Union, etc: a kind of ‘social’ and ‘structural’ rigidity To derive the Aggregate Supply Curve, first you need a Four-Panel graph of AS-AD, Ns and Nd, and Aggregate Production Curve and a 45 degree-line of converting YS into Y. Macroeconomics 142 Chapter V. AS-AD The AS curve shows the relationship between the different levels of prices, or Ps, and the corresponding levels of real national income, orYs. Thus, you have to kick up and down the price level or P, and to find the corresponding Y. (3) Classical Aggregate Supply Curve: A Vertical AS Curve Under what circumstances would the money wage be flexible? i) The economy is at full employment level: all available workers are fully employed; there are no other workers who are willing to work for the real wage lower than the prevailing rate; ii) There is no structural rigidity of money wage: no impediment on the equilibrating force in the labor market; iii) The workers are free of ‘Money Illusion’; iv) In the long-run: an enough amount of time has elapsed since ∆P. This is a graphic and somewhat mechanical derivation: 1.) Choose a price level, say, P1. 2.) For this given price level, we can have the labor supply and demand curves; Ns = f (W/P); and Nd = g (W/P) become Ns = f (W: P1); and Nd = g (W: P1). Or, by simply showing the shift variables, we can write down Ns (P1); and Nd (P1). 3.) The intersection of the labor supply and demand curves gives the equilibrium real wage w= W/P, in the labor market; N* and W* for a given P (thus w*). 4.) The equilibrium N* feeds into the aggregate production function of YS = F (K, N*; T) for a given K and T in the short-run. 5.) YS = Y the third panel. 6.) Y goes down to the fourth panel and matches the starting price level P1. Macroeconomics 143 Chapter V. AS-AD 7.) Suppose that the price level goes up to P2. 8.) As P rises, both labor supply and demand curves shift up. Now we get Ns (P2); and Nd (P2). These are shown with broken lines in the graph below. 9.) We get the new equilibrium. At this new equilibrium, the new nominal wages are higher than the previous nominal wage by the same proportion of the increase in P. And thus, the real wages do not change; the level of employment does not change, either. 10.) The same level of employment feeds into the aggregate production function, and leads to the same level of YS. 11.) The same level of Y in the third panel. 12.) The same Y goes down to the fourth panel and matches the new price level P2. 13.) By linking the two points in the fourth panel, we get the AS curve. YS YS N Y W P Ns(P1 ) W*2 AS P2 P1 W*1 Nd(P1) P N* Y Y* Macroeconomics 144 Chapter V. AS-AD An intuitive explanation is as follows: When P rises, W will rise proportionately. The revenues (P Q) and the costs (W L) are increasing proportionately, and thus the profit margin does not change. There is no reason for entrepreneurs to attempt to expand production scale. The AS remains constant at the macroeconomic level, too. P increases and W increases W/P remains unchanged N remains unchanged YS remains unchanged Y remains unchanged, and thus a vertical AS we get. (Supplement: Why does W/P determine the profit margin?) Production decisions are made ultimately by producers, or entrepreneurs who weigh the situations in the output market (which determines revenues) and the input market (which determines costs). Entrepreneurs make supply decisions by weighing the ratio of output price to input price, which is the key variable for their profits which constitute their prime motivation. Entrepreneurs are orchestrating production processes (borrowing capital, hiring workers, etc.) in order to earn profits. Formally, the aggregate production function shows the relationship between inputs such as capital (K) and labor (L), and outputs. These aggregate outputs are the aggregate supply or Y in Y – YS: Y = F (K,L) We know that an increase in K and L leads to an increase in Y. However, it does not happen by itself. In order to have a larger amount of inputs and consequently more outputs, entrepreneurs should exert themselves to organize more K and L. What would be the incentive for entrepreneurs to produce more? They respond to a larger profit margin. Profit is revenues minus costs. Revenues are Output Price times Quantity. Costs are Input Price times Input Quantity. Profit = Total Revenue – Total Cost = P Q – ( r K + W L). In the short-run, P and W determines the magnitude of profits; an increase in P increases profits, and an increase in W decreases profits. (4) Keynesian Aggregate Supply Curve Basic assumptions are as follows: i) ii) iii) The time is too short for W to change, There are impediments on the flexibility of W, or There is unemployment; there are other workers other than the present employees, who are willing to work for less than the present real wage. Graphic Derivation is as follows: Macroeconomics 145 Chapter V. AS-AD Start with P1. For the given price level, get the labor supply and labor demand curve in the second panel. The intersection of the labor supply and demand curves gives the equilibrium level of employment N1. This feeds into YS1 in the aggregate production function. YS1 = Y1 in the third panel. Now in the fourth panel, Y1 matches with P1. Suppose that the price level goes up to P2. This sends both the labor supply and demand curves up. However, the level of nominal wages does not change due to unions or money illusion. It is the effective labor supply curve; note that it replaces the shift labor supply curve, which is meaningless. The new equilibrium level of employment is given at N2. This feeds into the aggregate production function to give YS2 = Y2. Y2 goes down to match P2. By linking the two points of Y in the fourth panel, we get the Keynesian Aggregate Supply Curve. It is upward-sloping. P2 E’ Fixed W* N1* N2* P1 Y1 Y2 Macroeconomics 146 Chapter V. AS-AD Along the Keynesian AS curve, the nominal wage rates are fixed at W*. If the level of nominal wages changes, then the Keynesian AS curve shifts as well. Refer to Appendix of this chapter for this illustration. Intuitive Explanation is as follows: When P rises, W remains constant. The revenues increase while the costs are fixed, and thus the profits increases. The larger profits will give a greater incentive for entrepreneurs or employers to expand production scale by hiring more workers. If this expansion of output happens to all firms, the aggregate supply will increase. P increase and W W/P decreases Nd increase N* increases AS = y = F (K, N) increases The opposite can happen, too. P decreases and W W/P increase Nd decrease N* decrease AS = y = F (K, N) decrease Let us explain the same thing in terms of real wages, which is nothing but the ratio of W and P or W/P. The profitability is related to the ratio of W to P (=W/P), which is real wage or constitutes ‘real’ cost of hiring workers. 1) When W/P falls, the real cost of hiring workers is falling, the profit margin widens, and thus more (incentive for) production (on the part of the entrepreneurs): W/P decrease Nd increase Actual N* increases AS = y = F (K, N) increases 2) When W/P rises, the real cost of hiring workers is rising, the profit margin is reduced, and thus less (incentive for) production (on the part of the entrepreneurs). W/P increase Nd decrease Actual N* decrease AS = y = F (K, N) decrease Note: a larger W/P sounds like good news for the workers. You may wrongly reason: “a larger W/P means a larger incentive for the workers to work. The longer and harder the workers are working, the larger the output.” But it is not workers but entrepreneurs that make production decision. In the above case, who will hire the larger number of more willing workers at such a high real wage level? The willing workers will not be hired as they cannot force the entrepreneurs to hire them above and beyond the latter want to. So we are assuming that the actual amount of employment is determined along an entrepreneur’s labor demand curve not along the worker’s labor supply curve. Macroeconomics 147 Chapter V. AS-AD Can you mathematically express the AS curves of the Keynesian and the Classical economists? Classical AS curve: Y = F(K, Nf) = Yf, say, 1000. Keynesian AS curve: Y = F(K, Nf + dN) = Y – a (W/P), say = 1500 – 100 (W/P): (W/P) increase then dN <0, so N < Nf and Y decrease, (W/P) decrease then dN >0, so N > Nf and Y increase. If W/P goes up, the real cost of hiring workers is higher now, and thus entrepreneurs would like to hire less workers. The resultant output or AS will be smaller. If W/P falls, the real cost of hiring workers is lower now, and thus more workers will be put into production process and the resultant AS will be larger than the previous equilibrium or the full employment level national income. Some may argue that the Classical AS curve is valid in the long-run; and the Keynesian AS curve is valid in the short-run; Short-run AS = Keynesian AS Long-run AS = Classical AS One might have the SAS curve in the short-run when the time is too short for W to change and the LAS curve in the long-run when enough time elapses for the adjustment of W. 5) Shift of Aggregate Supply Curves i) ii) iii) iv) The Long-run AS shifts(to the right) when ∆K ∆Technology ∆Population Positive Supply shocks Macroeconomics 148 Chapter V. AS-AD As the long-run AS shifts to the right, the level of long-run real national income or full-employment real income rises. The first two shifts the Aggregate Production Curve up and, at the same time, the Aggregate Labor Demand curve up. Population growth shifts the aggregate labor supply curve to the right (downward visually). The last one, positive supply shocks, may send the aggregate production curve up. Combined or not, the shifts of the aggregate production curve and the corresponding aggregate labor supply or demand lead to an increase in YS and Y as we can easily illustrate on the 4 panel graph. Over time, the first three happen to a growing economy. And it is called ‘economic growth’, and the annual economic growth rate is measured by a percentage change in real national income. These issues will be examined in details in a later chapter of economic growth theories. The Short-run AS shifts (to the right) when The above four shift factors, and v) ∆ Decreases in Money Wage When the LRAS curve moves, the SRAS shifts, too, at all times. However, it is not necessarily the case that when the SRAS shifts, the LRAS shifts: When there is an increase in money wages, the SRAS shifts to the left (visually up), but the LRAS stays put. Macroeconomics 149 Chapter V. AS-AD See Appendix 1 for the shifts of the AS curve. 3. ‘Grand Equilibrium’ of Aggregate Demand and Supply 1) Grand Equilibrium P Long-run AS P* Short-run AS AD curve Y* Y The intersection of the AD curve and the Long-run Aggregate Supply curve gives the long-run equilibrium. The intersection of the AD curve and the Short-run Aggregate Supply curve gives the short-run equilibrium. There are the corresponding equilibrium national income and the equilibrium price level for the short-run and the long-run equilibrium respectively. Macroeconomics 150 Chapter V. AS-AD What if the long-run equilibrium and the short-run equilibrium do not coincide with each other? The short-run equilibrium Y < long-run equilibrium Yf; P AD LAS SAS -- deflationary gap Y leads to more competition among workers Y1 For instance, Yf is below the long-run equilibrium or full employment income Yf. The deflationary gap leads to a competition among unemployed workers and thus lower nominal wages. The falling nominal wages shift the short-run aggregate supply curve to the right. Eventually, a new short-run equilibrium will coincide with the long-run equilibrium. short-run Y*>long-run Yf* P --- inflationary gap Y Macroeconomics 151 Chapter V. AS-AD The short-run equilibrium national income exceeds the long-run or full employment national income. This inflationary gap leads to an increase in the price level. The labor supply in the market is tight. The competition for workers leads to a rising nominal wage. Thus the labor supply curve will shift to the left until it passes through the long-run equilibrium point where the AD and the Long-run AS curves intersect. Applications of the AS-AD curves: The Economic History of the U.S. 4. Rational Expectations Revolution and New Classical Model 1) Assumptions (1)Revised Labor Supply and Demand Curves The entrepreneurs make a decision on labor demand on the basis of the actual real wages, which are equal to nominal wages divided by the actual price level; Nd = f (W: P, other variables). This is the same as any previous models. On the other hand, the workers make a labor-supply decision on the basis of their ‘perceived real wages’, which are equal to nominal wages divided by the ‘expected price level’ of the current period, being carried from the last period. Ns = g (W: Pe, other variables). We draw Ns curve with W or money wages on the vertical axis and N on the horizontal axis. Pe becomes a shift parameter. Macroeconomics 152 Chapter V. AS-AD Ns (Pe1) W W1 Nd (P1) N1 Y (2)Information Asymmetry is a norm for Unannounced Policies. At time period t-1, workers and employers do form expectations as to the price level to prevail at time period t, that is, Pe. At time t, the actual price level turns out to be equal to P. Of course, there is no guarantee that Pe = P. As soon as the price level reveals, the employers or entrepreneurs are updated, and do have correct information about the current price level P. On the other hand, the workers do not have information about it. The workers do have just the expected price level Pe, which is carried from the last period. Information Asymmetry and the New Classical Labor Supply and Demand Curve: Suppose that there is an unexpected increase in P. In this case, what will happen to the Nd (P1) and Ns (Pe1) curves? This increase in P is unexpected on the part of workers, and thus Pe remains unchanged. Thus the labor supply curve stays put. However, the entrepreneurs are updated on the increase in P. Thus the labor demand curve shifts up. Macroeconomics 153 Ns (Pe1) W Nd (P2) Nd (P1) Y Chapter V. AS-AD Macroeconomics 154 Chapter V. AS-AD Information Asymmetry and the New Classical AS Curve: P > 0 Pe = 0 W* >0 P > W* > Pe = 0 YS YS YS = Y 450 N Y W P P2 W* Lucasis AS P1 N1* N2* P Y Y1 Y 2 Along the Keynesian AS curve, the nominal wage rates are fixed at W*. The resultant AS is called “Lucas’s AS curve” or “Expectations-Augmented AS curve”. Note that along this AS curve, the expectations are constant. In other word, the expected price level is the shift parameter. As the workers or the general public revise their expectations as to the price level, Lucas’s AS curve shifts. Macroeconomics 155 Chapter V. AS-AD Note that the increase in the nominal wages W is smaller than the increase in P. As a result, in the mind of a worker, the perceived real wages have gone up: The expected price level remains unchanged while the actual nominal wages have gone up somehow. The labor supply rises along the curve. However, the actual real wages, the nominal wages divided by the actual price level, have gone down; the numerator has changed less than the denominator has. (3) Policy Invariance Theorem for Fully Anticipated Government Policies How convincing is the assumption of Information Asymmetry as assumed above? Generally it did make a sense in the 1980s. However, in today’s world of the post-informationrevolution society where the general public has access to all kinds of information including government policies, information asymmetry may not be sustainable. The assumption of information asymmetry between the employers(entrepreneurs) and employees(workers) is unsustainable in a democratic society where every has equal access to all kinds of information and information is efficiently propagated. This is particularly so when government announces its proposed policy and its forecast economic impacts in advance. The ‘honest’ government may be educating the general public in this case. A well-announced economic policy with deterministic rules will not have any impact on the real variables such as real national income- Policy Invariance Theorem Suppose that even the workers are fully updated on a change in the price level. What will happen to the labor supply and demand curves? Ns (Pe2) Ns (Pe1) W Nd (P2) Nd (P2) P Macroeconomics 156 Chapter V. AS-AD Note that P = Pe = W* > 0 in this case. What is the resultant AS curve in this case? AS P2 W* P1 N1* N2* Y1 Y2 Along the Keynesian AS curve, the nominal wage rates are fixed at W*. The resultant AS is the same as the long-run AS curve. Note that the increase in the nominal wages W is proportional to the increase in P. This happens when the workers are fully updated on what is happening to the price level. Macroeconomics 157 Chapter V. AS-AD The government may make a full announcement of the policy. Or, it may be following a deterministic rule in policy making. The resulting price level is fully anticipated. The fully anticipated government policy is not achieving the intended goal of controlling the national income. This is “Policy Invariance Theorem”, or “Policy Ineffectiveness Theorem” Fully anticipated government policies do not have any impacts on real variables such as the real national income, or the level of employment.. We can think of the above vertical long-run AS curve as Lucas’s AS curve shifts up as the expectations are revised as given below:. LAS (Pe2) P2 LAS (Pe1) W* P1 N1* N2* Y1 Y2 Along the Keynesian AS curve, the nominal wage rates are fixed at W*. Macroeconomics 158 Chapter V. AS-AD 4. New Keynesian AS curves 1) Assumptions i)Rigidity of Nominal Wages; In the New Keynesian model of labor market, the nominal wage is set at t-1 through labor contracts, and the level of employment is to be determined at time period t. ii) Long-term Non-indexed Labor Contract: Just like the Keynesian AS curve model, the wages are set in advance through the long-term non-indexed contract. iii) The labor contract sets nominal wages at time t-1. The workers are bound by the contract to work at the set wage rates as much as is required by the entrepreneurs. The level of employment is flexible to be determined according to the labor demand at time t. Ex-post revisions of expected price levels do happen, and shift the labor supply and demand curves around. However, the labor supply curve is redundant as it is effectively replaced with the wage line, which is set through the contract. The equilibrium takes place where the horizontal nominal wage line intersects the newly shifted labor demand curve. 2) Derivation of New Keynesian AS curve Graphic Derivation is as follows: Start with P1. For the given price level, get the labor supply and labor demand curve in the second panel. The intersection of the labor supply and demand curves gives the equilibrium level of employment N1. This feeds into YS1 in the aggregate production function. YS1 = Y1 in the third panel. Now in the fourth panel, Y1 matches with P1. Suppose that the price level goes up to P2. This sends both the labor supply and demand curves up. However, the level of nominal wages does not change due to unions or money illusion. It is the effective labor supply curve; note that it replaces the shift labor supply curve, which is meaningless. The new equilibrium level of employment is given at N2. This feeds into the aggregate production function to give YS2 = Y2. Y2 goes down to match P2. Macroeconomics 159 Chapter V. AS-AD By linking the two points of Y in the fourth panel, we get the New Keynesian Aggregate Supply Curve. It is upward-sloping. YS = Y 450 (New Classical) NKAS P2 Fixed W* P1 N1* N2* Y1 Y2 Note that the slope of New Keynesian AS curve is flatter than the corresponding New Classical AS curve: if we look at the labor market only for a unexpected rise in the price level, the comparison is as follows: New Classical Eq. Ns (Pe1) New Keynesian Eq. Nd P2) Nd (P1) Macroeconomics 160 Chapter V. AS-AD Comparison of New Classical and New Keynesian equilibriums: YS = Y 450 New Classical NKAS P2 Fixed W* P1 N1* N2* Y1 Y2 Note that the slope of New Keynesian AS curve is flatter than the corresponding New Classical AS curve: if we look at the labor market only for a unexpected rise in the price level, the comparison is as follows: 5. Putting them all together in a complete macroeconomic model with the AS and AD curves. So far we just assume that there is an increase in the price level P. Why or how does it happen, or what causes this rise in the price level? In reality a rise in the price level or inflation is most likely the result of government’s expansionary fiscal or monetary policies, which shift the AD curve. Macroeconomics 161 Chapter V. AS-AD Suppose that government increases nominal money supply or MS. It will put a train of economic sectors in motion: First, the real money supply curve ms will shift to the right. Second, the LM curve will shift to the right. Third, the AD curve will shift to the right. Now, when it comes to the response of the AS side, there are different assumptions for different circumstances: 1)If the increase in MS is unanticipated, then the SAS curve does not move at all in the short-run. Macroeconomics 162 Chapter V. Appendix Appendix Shifts of AS curve 1)An Increases in Money Wages or W: Suppose that unions raise the fixed nominal wages to a higher level; YS YS N Y P2 W P1 P2 New Fixed W*’ P2 * Fixed W P1 Ns Nd N N1* Y1 N2* Along the AS curve, the nominal wage rates are fixed at W*. 2)Technical Innovation Y2 Y Macroeconomics 3)An Increase in Production Cost 163 Chapter V. Appendix Macroeconomics 164 Chapter V. Appendix 2. Applications of the AD and AS Analysis: Economic History of the U.S. American Economic History (with the AS-AD framework) 1. Industrial Revolution (1869 – 1897) 1869 1897 P Y* 100.00 299.00 Y* LAS0 LAS1 P* 100.00 63.40 P* SAS0 SAS1 SAS2 P1869 (100.00) P1897 (63.40) Yf1869 (100.00) - Yf1897 AD Y (299.00) mainly due to LAS (SAS), which was in turn due to K, L, T during the American Industrial Revolution AD was stable due to no (slow) increase in (gold) money supply 2. The Great Depression (1929 – 1939) 1929 1933 1939 Y* 100.00 70.00 105.00 P* 100.00 75.00 100.00 Macroeconomics 165 P Chapter V. Appendix LAS SAS AD193 Y* << Yf AD193 AD9192 3 9 Y - puzzling question: Why SAS did not shift to the right when P level fell between 1929 and 1933? If it had done so, YSR* would not have decreased: P LAS SAS0 SAS1 AD192 AD193 9 3 Y f YSR YLR * Y * (This situation did not happen in 1929-1939) 3. Pax Americana (1945 – 1962) Macroeconomics - 166 Chapter V. Appendix a resumed economic growth, shifting LAS and SAS (and is coupled with an increase in AD) LAS 0 L A S1 P SAS 0 SAS1 E' e Y 1* Yf Y f' Y 4. Evolution of Inflationary Spiral (1968 – 1969 – 1980’s) Where people to do not have inflationary expectations, the economy -: moves from (a) to (b) in the SR, and from (b) to (c) in the LR When people have inflation expectations: one movement is from (c) to : (d) When inflation expectations are excessive and are put into practice by : strong union power, one movement is from (a) to (e) STAGFLATION Macroeconomics P 167 LA S 0 Chapter V. Appendix SAS3 LAS1 e SAS2 d SAS1 SAS 0 c b a AD3 AD0 Y * AD2 AD1 Yf Y 5. Oil Shocks (1972 – 1975) Oil shocks – permanent (negative) AS shocks, shift LAS and SAS to : the left : Additional adjustment of AS curve P LAS1 LA S 0 SAS2 SAS1 SAS 0 AD0 Y ' f Yf Y