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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.
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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.
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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
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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.
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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
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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.
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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.
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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.
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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.
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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
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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.
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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
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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.
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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.
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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
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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.
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The short-run aggregate supply
schedule
SAS
0
A
SAS1
B
SAS2
2
A2
Y
Y*
Output
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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.
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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*.
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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
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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
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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.
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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
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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