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Review of Aggregate Supply & Aggregate Demand Overview of AS-AD • Simple model of Aggregate Supply and Aggregate Demand • Same idea as supply and demand • AD slopes down: – As price rises AD falls – summarizes the whole of the IS-LM-BP model • AS slopes up: – As price rises AS increases – Expectations are important AS P AD Y Example: Fiscal Policy P AS B A AD1 ADo Y • If G increases then AD shifts to right • At any P, AD will be higher because G is higher • P and Y rise • Why P rise? – Need to pay higher w to get higher output Aggregate Supply • Q: What underlies the Aggregate Supply Curve? • A: Labour market • Why? – to increase production – hire more people – Pay higher wages • More of other inputs also – Focus on labour market Labour Market W D1 Do L • Firms have a demand for labour • Decreases as wage rises • Increases as Price of output rises – Curve shifts to the right – At any wage firm will want more workers • Workers supply labour • Form expectation about cost of living W – Price expectation (Pe) • Higher wage will induce more work(ers) • Increased (Pe) L – Curve shifts up – Higher wage for any level of work Labour market Equilibrium W S(Pe) • Put two curves together • Lab Mkt eqm – Firms and workers plans agree – Wage and employment • Also agree on price D(P) L – P=Pe – Rational expectations • Implies agree on real wages Derive the Aggregate Supply Curve • We can use the labour market to derive the AS curve in short run and in the long run • First the short run: – Assume that expectations do not change – Pe = P – SL will not move • Suppose start at A which represents lab mkt eqm – P level rises – DL increases – New eqm at B • Employment increases • Wage increases – Goods market • Output increases – Upward sloping supply curve • Note that AS depends on expectations SL(Pe) W P AS(Pe) B B A DL(P1) DL(P0) A L Y • Note that all this implies something weird about workers – The work more, for less! • W has increased, but P has increased by more – Real wages have declined – See diagram • Supply of labour was conditional on prices being at a certain level – Pe = P – But this no longer true • With P>Pe we have • Demand w increase to restore living standards – they adjust expectations upwards – Supply curve shifts up – Shifts up so that increase in W is same as increase in P • New equilibrium is a point C – Real wage same at C as at A – Employment same at C as at A SL(Pe) W C SL(Pe) P AS(Pe) C B A AS(Pe) B DL(P1) DL(P0) A L Y • As expectations change there is a new AS curve • Eqm at C has same output as A – Reflects the fact that employment is the same • Net effect is that output and employment remain the same • P and W go up by the same amount Summary of AS • We have a distinction between short run and long run • The Short run is for fixed expectations – AS(Pe) – SRAS – Quite flat: Explains why ISLM works as approx • LR is how long it takes for real wages to adjust – Expectations adjust – Workers to act on exp – ISLM wont work in LR • In LR Y is unaffected by P LRAS P AS(Pe) Y* Y • What determines Y*? – – – – – Natural rate Incentives Technology “growth” Not anything that just affects price Policy in AS-AD Model • Suppose there is an increase in G • AD shifts right – For all P, there is higher AD, because govt component has risen – Could derive this from IS-LM – Same for MP • For fixed expectations i.e. SR – – – – Move along AS New (temp) eqm at B Y increases P increases (but not by much) • P rising implies real wage falling – P>Pe • Pe will adjust upwards – W increase – SRAS shifts up • Keep going until output returns to “natural level” • How long does transition take? – Theory: depends. Instantaneous? – Empirics: about 2 years – see diagram LRAS P C AS(Pe) B A AD0 Y* Y AD1 • Be clear on the reasons why there is no long run effect – In order to get more output need to pay more people higher wages – Higher wages imply firms need to charge higher prices – Higher prices negate the higher wages as far as workers are concerned – We go back to original values of real variables – Only affect nominal variables • Policy is ineffective! • We can only get an increase in Y in long run i.e. increase in Y* – – – – – If induce people to work more Need increase in real wage Technology Efficiency Lower taxes? • Reganomics • Supply side economics • Voodoo economics Reagan Style Tax Cut • Cut personal taxes – – – – – Idea is that this will improve incentives People will work more Shift the LRAS to the right Increase Y* and reduce P Note that SRAS shifts also as expectations adjust to the new lower level • But cutting taxes will shift the AD curve to right – SR boom – LR return to Y* with higher P • Which happened? – Both – Demand effect larger P LRAS AS(Pe) AS(Pe) A B AD0 Y* Y Dealing With Shocks • The AS-AD diagram shows how an economy will automatically adjust to a shock • Re-adjust to be in terms of inflation • Start from LR eqm – Y=Y* – pe=p • Suppose there is a fall in AD – Eqm moves from A to B – Y<Y* • This can only be a temporary eqm • At B, p<pe – Real wages are higher than expected • Prices fall, but by more than nominal wages • See labour market diagram – Workers are expensive – Explains the decline in output – Over time workers will • Reduce price expectations • Reduce wage demands • SRAS shifts down • Process continues until LR eqm is restored at C – Real wage returns to original level – Y=Y* pe=p but at new lower level LRAS p SRAS(pe) A B C AD0 AD1 Y* Y • So the economy will automatically work itself out of recession • Mechanism depends on wage adjustment – Mirror image of previous discussions – Workers respond to lower prices by demanding lower wages – Reasonable? • Yes real wages return to normal • No long term decline in real wages – Realistic? • No! see data • Nominal wages are rigid • Have to wait for productivity – Have lower wage increases than otherwise • All this takes time – 3+ years • Alternative is for Government to expand AD – Shift AD back – Return to long run equilibrium A • Rationale for stabilization policy – After WTC, cut interest rates – Enough? Or too much? • Debate over which is best – Policy: “long and variable lags” – Automatic: “long run we are all dead” – Calls for “flexibility” after EMU Disinflation • We can use the model to analyse the issue of deflation – i.e. how do we lower inflation without causing (much) unemployment (lower output) • This is the flip-side of what we just looked at – What happens when we try to reduce unemployment • We already know part of the answer – LR there is no trade-off • No LR increase in unemployment (or loss of output) – SR there is a trade off • Reducing inflation will mean higher U (lower Y) – Expectations play a role LRAS p SRAS(pe) A B C AD0 AD1 Y* Y • Suppose we are at A – Unemployment equals its natural rate (6%) – Inflation is 12% – Too high want to reduce it • Reduce AD (increase interest rates) – Unemployment rises: 8% > 6% – Move down the SRAS to B – Actual inflation falls • B cannot be LR eqm (why?) – – – – Actual Inflation (9%) is lower than expected (12%) Real wages higher than expected Expectations adjust down – New SRAS • New SR eqm at C – Still not a LR equilibrium – Inflation will keep falling for as long as U is kept above the natural rate • When the gov. is satisfied with the level of inflation, – allow unemployment to return to the natural rate – Inflation stable • Disinflation achieved at a cost – Y<Y* for several years – Sacrifice ratio • The increase in unemployment (above the natural rate) needed to reduce inflation by one percentage point in one year. • My example: 0.66 • Example Volker disinflation – Inflation fell by 6.7% over 4 years (1982-85) – Unemployment was 9.5%, 9,5%, 7.4% and 7.1% – Natural rate was 6% – Sacrifice ratio 1.4 Painless Disinflation • Previous example assumed expectations adjust gradually • In reality expectations could adjust a lot quicker • Think of extreme case – Expectations adjust fully and immediately – Full immediate fall in inflation without any increase in unemployment – Sacrifice ration of zero • What is required for this? – Policy must be announced – Policy must be credible • Willing to cause pain • Intermediate case is more realistic – More credible policy maker faces a lower sacrifice ratio