Aggregate Demand (AD) & Aggregate Supply (AS) 1. Neoclassical A.S. curve

1. Lecture 20: Aggregate Supply -- • Price level P, Inflation π,& Wages W • Aggregate Demand (AD)& Aggregate Supply (AS) • 1. Neoclassical A.S. curve • 2. Modified Keynesian A.S. • 3. Expectations-augmented A.S. • 4. Rational expectations A.S. • 5. Real Business Cycles (RBC) • Appendix -- 6. Wage indexation. ITF220 - Prof.J.Frankel

2. p AD y Aggregate Demand curve slopes down Why? P ↑ => M1 / P ↓ (“real balance effect”) => Y ↓ => LM shifts left ITF220 - Prof.J.Frankel

3. p AD y A monetary expansion shifts AD to the right. By how much? Or it shifts AD up. By the answer to IS-LM. { ● By how much? Equilibrium outcome (Y vs. P) depends on AS. ● In proportion to Δ M1. ● ● AD´ ITF220 - Prof.J.Frankel

4. 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 is often measured by the point beyond which inflation begins to accelerate; • and the natural rate of unemployment ūis measured as the rate below which inflation begins to accelerate. ITF220 - Prof.J.Frankel

5. US output fell sharply below potential in 2008-09. 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

6. Inflation fell in the 2008-09 global recession. World Economic Outlook, p.6

7. ALTERNATIVE SUPPLY RELATIONSHIPS • All-purpose supply function: = σ • ≡ potential output. • W≡ nominal wage • W/P ≡ real wage • w ≡ “warranted real wage”. • where: Can readily be derived from aggregation of supply decisionsby individual firms thatmaximize profits and operate in competitive goods & labor markets. An alternative approach: The New Keynesian Phillips curve (allows firms to be imperfectly competitive, but still has Y↑ => P ↑ via firms’ demand for labor & marginal cost.) ITF220 - Prof.J.Frankel

8. If Marginal Productoflabor > W/P If M P of labor < W/P => hire moreN => cut N ● Employmentdeterminesoutput, via the production function. Sum labor demand across all firms. Then set equal to supply of labor. And the real wage determines employment, via the demand for labor. ● Determines w. ITF220 - Prof.J.Frankel

9. (w P/W )σ , In the all-purpose supply function , AS´ ● AD´ AS´ ● AD´ ITF220 - Prof.J.Frankel

10. 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 => r => A . Either way,IS-LM shifts right=> AD shifts right: Result is higher Yand higher P. ● ITF220 - Prof.J.Frankel

11. and in long run Pe adjusts to P . σ =1. Implications: Demand expansion goes partly into P, partly into Y in the short run; entirely into P in the long run SR: Point B in Figure 26.4. MR: Point C. LR: Point D. ITF220 - Prof.J.Frankel

12. 26.4 Initially – Point A. Then monetary expansion. MR -- Point C:Pe adjusts partway => W does too. LR -- Point D:Pe, and so W, have fully adjusted. SR -- Point B: before W has had time to adjust. ● ● ● ● ITF220 - Prof.J.Frankel

13. Bob Lucas • 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, even in the short run. • Committing monetary policy to a nominal anchor • Would reduce inflation at little cost in terms of output. ITF220 - Prof.J.Frankel

14. Example of rationalexpectations: 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

15. 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 ITF220 - Prof.J.Frankel

16. 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

17. 5. Real business cycle (RBC) theory • Y = • 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

18. Appendix I: Another AS relationship • 6. Indexed wages • Application: real wage rigidity in Europe, vs. US. Appendix II: Measures of output gap ITF220 - Prof.J.Frankel

19. Explicit wage indexation: • Examples in 1970s-80s -- • US: Cost of Living Adjustment clauses • Italy: scala mobile • Argentina: complete indexation of everything • Implicit real • wage rigidity: • Example -- thought to characterize Europe. ITF220 - Prof.J.Frankel

20. If actual real wage > warranted real wagew, • 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 wslowed sharply • <= productivity slowdown <= oil shocks. • In the US, employment continued to rise, but real w did not; • in Europe, real continued to rise, but employment did not. ITF220 - Prof.J.Frankel

21. In the 1970s, the upward trend of warranted w slowed sharply, employment rose in US, while real wage contracts rose in Europe. ITF220 - Prof.J.Frankel

22. One view: Europeans prefer job security; Americans prefer job growth. The Netherlands may have found a “middle way.” ITF220 - Prof.J.Frankel

23. “Labor market rigidities” in Europe go beyond sticky real wages; They include also, e.g., laws against laying off workers, which discourage hiring. ITF220 - Prof.J.Frankel

24. Appendix II: Measures of output gap Three measures of excess supply tendto move together. Source: IMF,World Economic Outlook.. ITF220 - Prof.J.Frankel

25. Output gap in eurozone peripherySource: IMF Economic Outlook, Sept. 2011 (note: data for 2012 are predictions)http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html Greece & Ireland overheated by 2007: Y >> and crashed in 2009-11: Y << Like Italy, Spain & Portugal in 1992. ITF220 - Prof.J.Frankel

26. Inflation turned negative in 1930-33, along with the output gap,and again in 1938-39 ITF220 - Prof.J.Frankel