Download The New Classical model and Aggregate Supply

1. The Classical theory of employment
2. Labor supply and the expected real wage
3. Potential output and the “natural rate” of
unemployment.
4. The short-run aggregate supply curve
5. Adjustment to long-run equilibrium
6. Closing expansionary and contractionary gaps
7. Shifts of (long-run) aggregate supply
Market, industrialized
economies are selfadjusting and tend
automatically to fullemployment
3 pillars of the Classical system:
1. Say’s law
2. Classical labor market analysis
3. The quantity theory of money
A general glut of goods and services
cannot appear as result of deficiency
of aggregate spending power—
because, in the process of producing
goods and services firms will
distribute income sufficient to allow
for the purchase of all goods and
services produced during the same
period.
Postulates
1. Labor supply (Ns)depends on the expected real
wage)
2. Labor demand (Nd ) depends on the actual real
wage.
3. Employers can accurately forecast future prices;
suppliers of labor services make forecast errors.
pa
is the actual future price level
pe
is the expected future price level
w
is the nominal wage
w is the actual real wage
W a
p
w is the expected real wage
e
W  e
p
If p  p
e
a
then W e  W a
Short-run aggregate supply curve
Price
level
Potential
output
SRAS130
140
130
a
120
0
14.0
The SRAS curve is based on a given
expected price level, in this case,
130. Point a shows that if the actual
price level equals the expected
price level of 130, producers supply
potential output.
If the actual price level is below
130, firms supply less than
potential. Output levels that fall
short of the economy’s potential
are shaded red; output levels that
exceed the economy’s potential are
shaded blue.
Real GDP
(trillions of dollars)
7
Potential Output (GDP) is the economy’s sustainable
maximum output given the supply of resources, technology,
and the rules of the game; the output level where there are
no surprises about the price level.
The Natural Rate of Unemployment is the
unemployment rate when the economy produces
its potential output. It is the “full-employment
unemployment rate and consists of seasonal,
structural, frictional—but NOT cyclical—
unemployment.
Price Level
LRAS
p p
e
pe  pa
a
0
Potential
GDP
Real GDP
In macroeconomics, a period
during which some resource
prices, especially those for labor,
are fixed.
Alternative definition:
The short run is the
period during which the
expectations of labor do
not fully adjust to
changes in the price level.
Effects of a reduced real wage (W) in the
short run
 p  p e  p a  W  W e  N d
We will hire more
workers and
produce more
output if the real
wage (W) falls
•Labor contracts (implicit and explicit) are written in
money terms and typically are NOT indexed to inflation.
•Contracts are reset periodically –often only once per
year.
•If the price level over the term of the contract is higher
than expected by workers (suppliers of labor services),
the actual real wage will be less than expected real
wage.
•In this situation, firms are able to hire the same number
of workers at a lower real wage. Firms will react by hiring
more workers and expanding output (because it is
profitable to do so).
When We > W, output will
expand above the its
potential level. This is a
temporary situation,
however.
Short-run equilibrium when the price level
exceeds expectations
Price
level
Potential
output
140
LRAS
SRAS140
SRAS130
c
b
135
130
0
a
14.0
AD
Expected price level=130, SRAS130 If
actual price level turns out as
expected, the quantity supplied =
potential output of $14 trillion.
Given the AD curve, price level >
expected; output exceeds potential
(b); expansionary gap.
In the long-run, price-level
expectations and nominal wages will
be revised upward. Costs will rise and
the SRAS curve shifts leftward to
SRAS140. Eventually, the economy will
move to long-run equilibrium (c), thus
closing the expansionary gap.
Real GDP
14.2
(trillions of dollars)
14
 p  p  p  W  W  N
e
a
e
d
•Under these conditions, firms will scale back on
output and offer less employment.
•This situation may persist in nominal wages fail
to adjust downward when the price level falls.
Short-run equilibrium when the price level is
below expectations
Actual price level < expected
Price
level
Potential
output
LRAS
SRAS120
130
125
SRAS130
a
d
e
120
AD”
0
13.8 14.0
(intersection of AD” with SRAS130);
short-run equilibrium: (d). Production
below economy’s potential opens a
contractionary gap.
If prices and wages are flexible enough
in the long run, nominal wages will be
renegotiate lower. As resource costs
fall, the short-run aggregate supply
curve eventually shifts rightward to
SRAS120 and the economy moves to
long-run equilibrium at (e), with
output increasing to the potential level
of $14.0 trillion.
Real GDP
(trillions of dollars)
16
Experience shows that
workers will resist cuts in
money wages. Employers
fear employees will be
demoralized if their
money pay is cut, so they
may prefer to lay off
workers instead.
Long-run aggregate supply curve
Price
level
Potential output
LRAS
140
b
130
a
120
c
AD”
0
14.0
AD’
AD
In the long run, when the actual price
level equals the expected price level,
the economy produces its potential. In
the long-run, $14.0 trillion in real GDP
will be supplied regardless of the
actual price level. As long as wages
and prices are flexible, the economy’s
potential GDP is consistent with any
price level. Thus, shifts of the
aggregate demand curve will, in the
long-run, not affect potential output.
The long-run aggregate supply curve,
LRAS, is a vertical line at potential GDP.
Real GDP
(trillions of dollars)
18
US output gap measures actual GDP minus
potential output as percentage of potential
output
1984
1988
1992
1996
2000
2004
2008
19
Effect of a gradual increase in resources on
aggregate supply
LRAS
LRAS’
Price level
A gradual increase in the supply of
resources increases the potential
GDP – in this case, from $14.0
trillion to $14.5 trillion.
The long-run aggregate supply curve
shifts to the right.
0
14.0
Real GDP
14.5
(trillions of dollars)
20
Effects of a beneficial supply shock on aggregate
supply
LRAS
LRAS’
Price
level
SRAS130
SRAS125
130
a
b
125
AD”
Given the AD curve, a beneficial supply
shock that has a lasting effect, such as a
breakthrough in technology, will
permanently shift both the short-run
aggregate supply curve and the long-run
aggregate supply curve, or potential
output. A beneficial supply shock lowers
the price level and increases output, as
reflected by the change in equilibrium
from a to b.
Real GDP
14.2
(trillions of dollars)
A temporary beneficial supply shock (an unusually favorable growing season), will shift
the AS curves only temporarily. If the next growing season returns to normal, the AS
curves will return to their original equilibrium position at a.
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0
14.0
Effect of an adverse supply shock on aggregate
supply
LRAS”
LRAS
Price
level
SRAS135
SRAS130
130
c
125
a
AD”
0
13.8
Given the AD curve, an adverse
supply shock, such as an increased
threat of terrorism, shifts the shortrun and long-run aggregate supply
curves to the left, increasing the price
level and reducing real GDP, a
movement called stagflation. This
change is shown by the move in
equilibrium from a to c.
Real GDP
14.0
(trillions of dollars)
If the shock is just temporary, the shift of the aggregate supply curves will be
temporary.
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