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Economics TENTH EDITION by David Begg, Gianluigi Vernasca, Stanley Fischer & Rudiger Dornbusch Chapter 21 Aggregate supply, prices and adjustment to shocks ©McGraw-Hill Companies, 2010 The classical model of macroeconomics • The classical model of macroeconomics is the polar opposite of the extreme Keynesian model. • It analyses the economy when wages and prices are fully flexible. • In this model, the economy is always at its potential level. ©McGraw-Hill Companies, 2010 The classical model of macroeconomics (2) • Excess demand or supply are rapidly eliminated by wage or price changes so that potential output is quickly restored. • Monetary and fiscal policy affect prices but have no impact on output. • In the short run, before wages and prices have adjusted, the Keynesian position is relevant, whilst the classical model is relevant to the long run. ©McGraw-Hill Companies, 2010 Real Interest Rate A simple monetary policy rule This shows how monetary policy works when interest rates are set in pursuit of an inflation target. r i When inflation is above (below) the target Π*, real interest rates are set higher (lower) than normal. i* Along the schedule ii a given monetary policy is being pursued. i Π* Inflation ©McGraw-Hill Companies, 2010 If the inflation rate is Π* , the corresponding real interest rate will be i* A simple monetary policy rule (2) • The central bank is interested in the real interest rate, which affects aggregate demand, • But the central bank does not directly control the price of output or the inflation rate. • Hence, to achieve the ii schedule, the central bank first forecasts inflation, then sets a nominal interest rate r to achieve the real interest rate i ( = r – ) that it desires. ©McGraw-Hill Companies, 2010 The aggregate demand schedule • The aggregate demand schedule (AD) shows that higher inflation reduces aggregate demand by inducing the central bank to raise real interest rates. AD Output ©McGraw-Hill Companies, 2010 The aggregate demand schedule (2) • The slope of the schedule is determined by: – the reaction of interest rate decisions to inflation – and the responsiveness of aggregate demand to interest rate changes • Consequently: – It will be flat when • interest rate decisions respond a lot to inflation, • and aggregate demand is highly responsive to interest rate changes. – It will be steep when • interest rate decisions do not respond much to inflation, • and aggregate demand responds little to interest rate changes. ©McGraw-Hill Companies, 2010 Aggregate supply and potential output • Potential output depends upon: – the level of technology – the quantities of available inputs (labour, capital, land energy) – the efficiency with which resources and technology are used • In the short run we can treat potential output as given. ©McGraw-Hill Companies, 2010 The classical aggregate supply schedule • The classical model has an aggregate supply curve which is vertical at potential output. • This means that equilibrium output can be reached at different levels of inflation. • In the classical model, people do not suffer from money illusion. • Consequently, only changes in real variables influence other real variables. ©McGraw-Hill Companies, 2010 The classical aggregate supply schedule (2) This schedule shows the output firms wish to supply at each inflation rate. AS When wages and prices are flexible, output is always at its potential level (Y*). Y* Output Potential output is the economy’s long-run equilibrium output. ©McGraw-Hill Companies, 2010 The classical aggregate supply schedule (3) • Better technology will shift AS to the right and hence increase potential output. • Increased employment will also shift AS to the right and increase potential output, • as will the use of more capital. ©McGraw-Hill Companies, 2010 Equilibrium AS * Overall equilibrium is shown, where AD = AS at the potential output level Y* and inflation level *. A AD Y* At A, the goods, money and labour markets are all in equilibrium. Output ©McGraw-Hill Companies, 2010 Equilibrium: A supply shock 0 * AS0 AS1 A C D 2 * Y 0* A beneficial supply shock raises potential output by shifting AS0 to AS1and lowers inflation to 2* at D. Y 1* AD1 AD0 Output If the central bank pursues a target of 0* when the economy is at potential output, it must respond by reducing its target real interest rate. This will lead to an increased amount of money being demanded: to achieve money market equilibrium at this interest rate, the bank must supply more money. ©McGraw-Hill Companies, 2010 Equilibrium inflation: a demand shock Beginning at A, an increase in aggregate demand brought by an increase in investment say, would shift AD0 to AD1 moving us to a new equilibrium B. At B, potential output is the same but is higher at 1* AS0 1 * B 0 * A AD1 AD0 Y 0* The central bank will raise interest rates to shift AD1 back to AD0 . Thus restoring equilibrium at A. Output ©McGraw-Hill Companies, 2010 The speed of adjustment • Adjustment in the Classical world is rapid, so the economy is always at potential output (full employment). • If wages and prices are sluggish, then output may deviate from the potential level. • A Keynesian world of fixed wages and prices may describe the short run period before adjustment is complete. ©McGraw-Hill Companies, 2010 Supply-side economics • The pursuit of policies aimed not at increasing aggregate demand, but at increasing aggregate supply. • A way of influencing potential output, seen as critical in the classical view of the economy. ©McGraw-Hill Companies, 2010 Adjustment in the labour market Short-run First few months Medium-run 2 years Long-run 4-6 years Largely given Beginning to adjust Clearing the labour market Flexible Flexible Normal work week WAGES HOURS EMPLOYMENT Largely given Beginning to adjust ©McGraw-Hill Companies, 2010 Full employment Short-run aggregate supply • If adjustment is not instantaneous, output may diverge from its potential level in the short run. • Firms may vary labour input – via hours of work (overtime or layoffs). • Wages may be sluggish in failing to restore full employment in response to a fall in aggregate demand. • The short-run aggregate supply schedule (SAS) shows how desired output varies with inflation, for a given inherited growth of nominal wages. ©McGraw-Hill Companies, 2010 The short-run aggregate supply schedule SAS 0 A SAS1 B SAS2 2 A2 Y Y* Output ©McGraw-Hill Companies, 2010 Firms raise prices when wage costs rise. Each SAS function reflects a different rate of inherited nominal wage growth. For any given rate, higher inflation moves firms up a given short-run supply schedule. A persisting boom or slump gradually bids nominal wage growth up or down shifting short run supply schedules. The adjustment process • When SAS and AD are combined, changes in AD lead mainly to a change in output in the short run. • Over time, deviations from full employment gradually change wage growth and shortrun aggregate supply. • The economy, therefore, gradually works its way back to potential output. ©McGraw-Hill Companies, 2010 A lower inflation target Starting from long-run equilibrium at E: AS SAS * 1 2 3* E E' SAS' E2 SAS3 E3 AD' Y* AD Output the inflation target is cut from * to 3*: the raising of interest rates to achieve this shifts AD to AD'. Given wage levels, firms adjust to E' in the short run. With inflation at ' but wages unchanged, the real wage rises, bringing involuntary unemployment. As the labour market (wage) adjusts, SAS shifts e.g. to SAS’. Equilibrium is eventually reached at E3, back at Y*. ©McGraw-Hill Companies, 2010 A temporary supply shock e.g. an increase in the price of oil SAS' ' SAS E' * AD Y* Equilibrium moves from E to E’. Higher inflation reduces aggregate demand as the cent bank raises real interest rates E Y' Higher oil prices force firms to raise prices, so SAS shifts to SAS’. Output ©McGraw-Hill Companies, 2010 Lower output and employment at E' gradually reduce inflation and nominal wage growth, shifting SAS' back to SAS so Y* is restored. Output Gaps Output gaps 1998-2010 (%) Germany United Kingdom United States 4.0 3.0 2.0 1.0 0.0 -1.0 1998 2000 2002 2004 -2.0 -3.0 -4.0 -5.0 -6.0 -7.0 ©McGraw-Hill Companies, 2010 2006 2008 2010 Tradeoffs in monetary objectives • Inflation targeting works well when all shocks are demand shocks. • When shocks are supply shocks, stabilizing inflation may lead to highly variable output. • Conversely, a policy of stabilizing output may lead to highly variable inflation. ©McGraw-Hill Companies, 2010 Tradeoffs in monetary objectives (2) • One way round this is to steer a middle course by using a Taylor Rule, i.e. a rule that takes into account deviations of both inflation and output from their long-run levels. • Another is to allow flexible inflation targeting – because the inflation target is a mediumrun one, this allows some discretion for reducing variability in output ©McGraw-Hill Companies, 2010 The Taylor Rule • Formally, the Taylor rule implies that real interest i obeys i – i* = a(π- π*) +b (Y-Y*) • In the long run, the real interest rate is i*, inflation is π*, and real output is Y*. • Inflation above target, or output above target, is a signal to raise interest rates and vice versa. ©McGraw-Hill Companies, 2010