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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