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Lecture 20: Aggregate Supply -Price level P, Inflation π, & Wages W
Aggregate Demand (AD)
& Aggregate Supply (AS)
1.
2.
3.
4.
5.
6.
Ultra-Keynesian A.S. case
Neoclassical A.S. case
Intermediate A.S. curve
Expectations-augmented A.S. curve
Rational-expectations A.S.
Real Business Cycle models (RBC)
Appendices -- 7. Labor market rigidities.
Aggregate Demand curve slopes down.
Why?
p
Say P ↑ (e.g., because W↑)
=> M1 / P ↓ (“real balance effect”)
=> LM shifts left
=> Y ↓
AD
y
ITF220 - Prof.J.Frankel
A monetary expansion shifts AD to the right.
By how much?
By the answer to IS-LM.
Or it shifts AD up.
p
By how ●
much?
{
In proportion to Δ M1.
Equilibrium outcome
(Y vs. P) depends on AS.
●
●
●
AD′
AD
y
ITF220 - Prof.J.Frankel
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 𝒀
is often measured by the point beyond which
inflation begins to accelerate;
• and the natural rate of unemployment ū
is measured as the rate below which
inflation begins to accelerate.
ITF220 - Prof.J.Frankel
US output fell sharply below potential in 2008-09.
𝒀
𝒀
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
Inflation fell in the 2008-09 global recession.
WORLD ECONOMIC OUTLOOK (WEO)
Uneven Growth: Short- and Long-Term Factors
April 2015
IMF
ALTERNATIVE SUPPLY RELATIONSHIPS
All-purpose supply function: 𝑌/𝑌 = (ω 𝑃/𝑊)σ
where:





𝑌 ≡ potential output
W ≡ nominal wage
W/P ≡ real wage
ω ≡ “warranted real wage”
σ ≡ elasticity of aggregate supply .
Can readily be derived from aggregation of supply decisions
by individual firms that maximize profits and
operate in competitive goods & labor markets.
Then ω ≡ MP of Labor at full employment.
(See graphs in Appendix I.)
ITF220 - Prof.J.Frankel
Two polar extreme cases
 1) Ultra-Keynesian case:
AS flat, at 𝑃
=> AD expansion goes entirely into Y.
AD'
p
AS
Realistic in Very Short Run.
y
 2) Classical case
AS vertical at 𝑌
=> AD expansion goes entirely into P.
AS
p
Realistic in Long Run.
Only AS shocks move Y ,
e.g., productivity shocks.
API-120 - Prof. J. Frankel, Harvard University
AD'
𝑦
y
AGGREGATE SUPPLY (continued)
● 3) Intermediate case:
W = 𝑊 => AS has some slope, even in the SR.
SR supply relationship:
𝑌
𝑌
=
ω𝑃
σ
𝑊
AS
p
●
AD'
y
Implication:
Demand expansion goes partly into P, partly into Y.
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 
AS long run
=> r 
=> A  .
Either way,
IS-LM shifts right
=> AD shifts right:
p
AS short run
●
pe
AD expanded
Result is higher Y
and higher P.
AD initial
y
ITF220 - Prof.J.Frankel
AGGREGATE SUPPLY (continued)
SR supply relationship:
𝑌
𝑌
=
ω𝑃
σ
𝑊
● 4) Friedman-Phelps supply curve:
W is set in line with Pe,
which adjusts over time.
Yearly wage contract 𝑊 = ω 𝑃𝑒.
𝑌
or in logs,
𝑌
=
𝑃
𝑃𝑒
σ
Milton Friedman
y - 𝑦 = σ (π − π𝑒 )
where π ≡ p – p-1
and πe ≡ pe – p-1 .
But over time πe adjusts to actual π, so Y = 𝑌. In LR, AS is vertical.
SR: Point B in Figure 26.4.
MR: Point C.
LR: Point D.
26.4
●
●●
●
Initially –
Point A.
Then monetary
expansion.
SR -- Point B:
before W has had
time to adjust.
MR -- Point C: Pe adjusts
partway => W does too.
LR -- Point D:
Pe, and so W, have
fully adjusted.
ITF220 - Prof.J.Frankel
OVERVIEW OF AGGREGATE SUPPLY (continued)
● 5) Lucas supply relationship
𝑌
or in logs,
𝑌
=
𝑃
𝑃𝑒
σ
y - 𝑦 = σ (π − π𝑒 )
Robert Lucas
= σ ε,
where ε is the forecast error.
Rational expectations => ε is unforecastable.
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.
 Committing monetary policy to a nominal anchor
would reduce inflation at little cost in terms of output.
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
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)
ITF220 - Prof.J.Frankel
6. Real business cycle (RBC) theory
• Y= Y
• N= 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
Appendix I:
Derivation of general AS relationship
Appendix II: Another AS relationship
• 7. Indexed wages
– Application: real wage rigidity in Europe, vs. US.
Appendix III: Measures of output gap
Appendix IV:
An example of rational expectations
ITF220 - Prof.J.Frankel
Appendix I
If a firm’s Marginal Product of Labor
> W/P => hire more N.
If M P of Labor
< W/P => cut N.
●
Employment determines output,
via the production function.
And the real wage
determines employment,
via the demand for labor.
Sum labor
demand
across all
firms.
●
Then set
equal to
supply of
labor.
Determines w.
ITF220 - Prof.J.Frankel
An alternative approach:
The New Keynesian Phillips curve
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.
ITF220 - Prof.J.Frankel
Appendix II: Labor market rigidities
Explicit wage indexation:
Examples in 1970s-80s -• US: Cost of Living
Adjustment clauses
• Italy: scala mobile
• Argentina: complete
indexation of everything
7.
Implicit real
wage rigidity:
Example -- thought to
characterize Europe.
ITF220 - Prof.J.Frankel
If actual real wage w > warranted real wage ω,
• Y < 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 w continued to rise, but employment did not.
ITF220 - Prof.J.Frankel
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
One view: Europeans prefer job security; Americans prefer job growth.
The Netherlands may have found a “middle way.”
ITF220 - Prof.J.Frankel
“Labor market
rigidities” in Europe
go beyond
sticky real wages;
Employment Protection Legislation
often does not raise overall employment.
If anything, the reverse.
They include also,
e.g., laws against
laying off workers,
which discourage hiring.
One view of the divergence
Between Germany & Greece:
Labor market reforms enacted
by Gerhard Schröder 2003-05
improved labor market efficiency.
source: Giuseppe Bertola (2001)
ITF220 - Prof.J.Frankel
Appendix III: Measures of output gap
Three measures of
excess supply tend
to move together.
Source: IMF,
World Economic Outlook.
.
ITF220 - Prof.J.Frankel
Inflation turned negative in 1930-33,
along with the output gap,
and again in 1938-39
ITF220 - Prof.J.Frankel
Jobs vary with GDP
though usually less-than-proportionately , in practice.
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.
”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,
Appendix IV
An example
of rational
expectations:
Mexican
sexenio
From 1976
through 1994,
inflation would
shoot up and/or
the peso would
devalue, every 6th
year (presidential
election years).
ITF220 - Prof.J.Frankel