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Aggregate Supply

7-1

- The aggregate supply relation captures the effects of output on the price level. It is derived from the behavior of wages and prices.

Deriving the AggregateSupply Relation

- How do we derive the Aggregate Supply Relation?
- The key is to remember that AS is a …
- … relation between the Price Level and Production
- And production is related to unemployment.
- So we need an equation with P on the left hand side and Y on the right hand side.

Deriving the AggregateSupply Relation

- Step 1: Combine

(by eliminating W from both equations):

and

to get:

- This has P on the LHS and u on the RHS.
- The price level depends on the expected price level and the unemployment rate. We assume that m and z are constant.
- Here allow P to be different from Pe.

Deriving the AggregateSupply Relation

- Step 2: Recall that the unemployment rate can be expressed in terms of output:

Therefore, for a given labor force, the higher is output, the lower is the unemployment rate.

Deriving the AggregateSupply Relation

- Step 3: Replace the unemployment rate (u=1-Y/L) in the equation obtained in step one:

In words, the price level depends on the expected price level, Pe, and the level of output, Y

(and also m, z, and L, but we take those as constant here).

Deriving the AggregateSupply Relation

- This is an AS relation. How do we know that?
- AS is a relation between P and production.
- Here we have a relation between P and Y.
- And Y, here, means output produced.
- How do we know that?
- The “Y” comes in here through a production relation, that is, through the labor market.

Properties of the AS Relation

- The AS relation has two important properties:
- An increase in output leads to an increase in the price level. This is the result of four steps:

This gives the slope of the AS curve.

Properties of the AS Relation

- Y↑ P↑.
- If society wants more production, more people must be hired.
- This lowers the unemployment rate.
- Lower unemployment strengthens workers’ bargaining power, leading to higher nominal wages (at a given expected price level).
- Higher nominal wages raises firms’ marginal cost, so prices rise.

Aggregate Supply

The Aggregate Supply Curve

Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level.

Wages and Unemployment

W

P

Lower u, higher W

Higher W, higher P

(Pe constant)

WS

Pe < P

u

- Higher output (lower u) strengthens workers, who demand a higher nominal wage W (at given P).
- Firms raise prices to keep a constant markup, so P rises above Pe (and W/P falls).

So an increase in output leads to an increase in the price level.

WS

Pe = P

u

un

Properties of the AS Relation

What about SHIFTS of the AS curve?

- An increase in the expected price level leads, one for one, to an increase in the actual price level. This effect works through wages:

If prices are expected to rise, workers demand higher wages, which raises firms’ marginal cost and prices.

Aggregate Supply

An increase in the expected price level shifts the aggregate supply curve up.

The Effect of an Increase in the Expected Price Level on the Aggregate Supply Curve

Wages and Unemployment

W

P

W’

P’

WS

Pe > P

Pe’ = P’

1. Higher expected prices (Pe) make workers demand a higher nominal wage W.

2. Firms raise prices P until P = Pe to keep a constant m (and W/P). Now we have a higher W and P at any u, for the same W/P and un.

Higher W, higher P=higher Pe

So an increase in Pe leads to an increase in P for any Y.

WS

Pe = P

u

un

Properties of the AS curve

- The AS curve will SHIFT upward
- if Pe rises,
- if m rises,
- m includes monopoly power, costs of inputs other than labor, etc.
- if L falls,
- (which would raise unemployment, given the same level of output)
- if z and the function F change in ways that make the same natural unemployment rate consistent with higher wage demands.

Properties of the AS curve

- The AS curve is upward sloping. An increase in output leads to an increase in the price level.
- The AS curve goes through point A, whereY = Yn and P = Pe. This property has two implications:
- When Y > Yn, P > Pe.

If output is above the natural level, prices will rise above expected prices.

- When Y < Yn, P < Pe.
- An increase in Pe shifts the AS curve up, and a decrease in Pe shifts the AS curve down.

Wages and Unemployment

W

P

Lower W, lower P

(Pe constant)

Higher u, Lower W

WS

Pe > P

When P= Pe, u = un.

Lower output (higher u) weakens workers, who accept a lower nominal wage W.

When P < Pe, u > un,so Y< Yn.

Firms lower prices to keep aconstant markup, so P falls below Pe.

WS

Pe = P

When P > Pe, u < un,so Y> Yn.

u

un

u

Aggregate Supply

The Aggregate Supply Curve

- The AS curve is upward sloping.
- The AS curve goes through point A, whereY = Yn and P = Pe.
- WhenY > Yn, P > Pe.
- An increase in Pe shifts the AS curve up.

Aggregate Demand

7-2

- The aggregate demand relation captures the effect of the price level on output. It is derived from the equilibrium conditions in the goods and financial markets.
- Recall the equilibrium conditions for the goods and financial markets described in chapter 5:

Aggregate Demand

Ms/P’

Ms/P

Lower M/P, at the same level of income, raises interest rates lower Investment.

(Sure, the fall in I lowers Y, and Md falls, which moderates the rise in i. But Y still falls and i rises, for most normal parameter values.)

i

Md/P

M/P

- Now, what will happen if P rises?
- At given M, M/P will contract.

Aggregate Demand

- P M/P i (LM shifts) spending falls (movement along IS)

LM’

i

LM

- LM curves shifts up, raising interest rates and lowering equilibrium output.

IS

IS’

Y

Aggregate Demand

An increase in the price level leads to a decrease in output.

The Derivation of the Aggregate Demand Curve

Aggregate Demand

- Summarizing:
- A rise in P reduces real money supply MS/P, increasing interest rates.
- The LM curve shifts up, for any Y.
- The economy moves along the IS curve to a lower equilibrium level of Y.
- Therefore, higher P means lower Y demanded:
- The AD curve is downward sloping.

Aggregate Demand

Changes in monetary or fiscal policy—or more generally in any variable, other than the price level, that shift the IS or the LM curves—shift the aggregate demand curve.

Aggregate Demand and Monetary Policy

Ms’/P

LM’

Md(Y’)/P

Y’

AD’

Ms/P

i

i

LM

- Expansionary Monetary Policy lowers interest rates and raises output at any given level of prices, so the AD curve shifts right.
- Higher Y raises Md a bit, which moderates the rise in i.

Md(Y)/P

IS

Y

M/P

Y

P

AD

Y

Aggregate Demand and Fiscal Policy

Z

Y

Z’(T’,i’)

Z’(T’,i)

i’

IS’

Z(T,i)

- Contractionary Fiscal Policy lowers demand for goods and lowers output at any given level of prices, so the AD curve shifts right.
- Lower Y lowers Md, which reduces i. This causes I to increase (“crowding out” in reverse), which moderates the fall in Y.

Y

i

LM

i

IS

Y

P

AD

AD’

Y

Aggregate Demand

Shifts of the Aggregate Demand Curve

An increase in government spending increases output at a given price level, shifting the aggregate demand curve to the right.

A decrease in nominal money decreases output at a given price level, shifting the aggregate demand curve to the left.

AS, AD, and Causality

- In the Aggregate Supply relation, causality runs from Y to P
- Higher Y lowers u which raises W/P. This causes firms to raise P.
- In the Aggregate Demand relation, causality runs from P to Y.
- Higher P lowers M/P which lowers expenditure, lowering Y.

AS, AD, and Causality

- In the Aggregate Supply relation, causality runs from Y to P
- An exogenous change in costs causes prices to change for any output level, causing the AS curve to shift vertically.
- In the Aggregate Demand relation, causality runs from P to Y.
- An exogenous change in expenditure causes output to change for any price level, causing the AD curve to shift horizontally.

Equilibrium in the ShortRun and in the Medium Run

7-3

- Equilibrium depends on the value of Pe. The value of Pe determines the position of the aggregate supply curve, and the position of the AS curve affects the equilibrium.

Equilibrium in the Short Run

The Short Run Equilibrium

The equilibrium is given by the intersection of the aggregate supply curve and the aggregate demand curve.

Equilibrium in the Short Run

The Short Run Equilibrium

At point A,the labor market,the goods market, and financial markets are all in equilibrium.

Equilibrium in the Short Run

The Short Run Equilibrium

Notice that at point A, P > Pe. What will happen over time?

From the Short Runto the Medium Run

P’

Pe

B

- At point A,

- Wage setters will revise upward their expectations of the future price level. This will cause the AS curve to shift upward.
- Expectation of a higher price level also leads to a higher nominal wage, which in turn leads to a higher price level.

=Pe’

P > Pe leads to higher Pe, which raises W. This raises P above Pe, which eventuallyleads to higher Pe, which …

From the Short Runto the Medium Run

B’

- The adjustment ends once .Wage setters no longer have a reason to change their expectations.
- In the medium run, output returns to the natural level of output.

B’’=

Notice that as AS shifts and P rises, we move along the AD curve.

(Higher P reduces M/P and lowers Y.)

From the Short Runto the Medium Run

If output is above the natural level of output, the AS curve shifts up over time, until output has decreased back to the natural level of output.

The Adjustment of Output over Time

From the Short Runto the Medium Run

- To Summarize:
- In the short run , output can be below or above the natural level of output.
- The reason is that in the short run, price expectations are sticky and therefore wages are sticky.
- In the medium run, output returns to its natural level.
- The reason is that prices adjust:
- Prices P fall if Y<Yn, lowering wages (shift AS down) and raising M/P (move along AD).
- Prices P rise if Y>Yn, raising wages (shift AS up) and lowering M/P (move along AD).

The Effects of aMonetary Expansion

7-4

- In the aggregate demand equation, we can see that an increase in nominal money, M, leads to an increase in the real money stock, M/P, leading to an increase in output. The aggregate demand curve shifts to the right.

The Dynamics of Adjustment

- The increase in the nominal money stock causes the aggregate demand curve to shift to the right.
- In the short run, output and the price level increase.
- The difference between Y and Yn sets in motion the adjustment of price expectations.

The Dynamics of Adjustment

- Stop for a second.
- Assume an economy where dollar bills are used only once a year (velocity = 1); and where annual real GDP = 10 million houses.
- Suppose Ms=$10bn. What will P be?

- MV = PY
- $10bn x 1 = P x 10 million houses
- P = $1 thousand / house

The Dynamics of Adjustment

- Now suppose Ms=$20bn. What will P be?

- MV = PY
- $20bn x 1 = P x 10 million houses
- P = $2 thousand / house

- If M doubles, P doubles. M/P doesn’t change.
- Why doesn’t this happen in the short run?
- Because M affects P through the goods, money, and labor market, over time, esp. through changes in Pe.

The Dynamic Effects ofa Monetary Expansion

- In the medium run, the AS curve shifts to AS’’ and the economy returns to equilibrium at Yn.
- The increase in prices is proportional to the increase in the nominal money stock.

The Dynamics of Adjustment

A monetary expansion leads to an increase in output in the short run, but has no effect on output in the medium run.

The Dynamic Effects ofa Monetary Expansion

Going Behinds the Scenes

- The impact of a monetary expansion on the interest rate can be illustrated by the IS-LM model.
- The short-run effect of the monetary expansion is to shift the LM curve down. The interest rate is lower, output is higher.

Going Behinds the Scenes

LM’’

- Notice that, even in the short run, prices change slightly.
- If the price level had not increased at all, the shift in the LM curve would have been larger—to LM’’.

Going Behinds the Scenes

- Over time, the price level increases, the real money stock decreases and the LM curve returns to where it was before the increase in nominal money.

- In the medium run, the real money stock and the interest rate remain unchanged.

Going Behinds the Scenes

The Dynamic Effects of a Monetary Expansion on Output and the Interest Rate

The increase in nominal money initially shifts the LM curve down, decreasing the interest rate and increasing output. Over time, the price level increases, shifting the LM curve back up until output is back at the natural level of output.

Monetary Policy is Neutral in the long run

- In other words, monetary policy is
- Effective in the short run
- In the short run, a monetary expansion increases M/P and output, moving the economy along the AS curve.
- A monetary contraction would reduce M/P and reduce output along the AS curve.
- Neutral in the medium run
- In the medium run, DP = DM, so output returns to Yn
- In the medium run, Yn is consistent with any level of P.

Anticipated versus Unanticipated Policies

- We have assumed that workers do not anticipate monetary expansions, so Pe remains constant for a long time.
- Output takes a lot time to return to Yn.
- The conclusion is that monetary surprises can affect output, but not predicted monetary expansions.

Anticipated versus Unanticipated Policies

- But what if workers do anticipate the monetary expansion? Pe will rise very soon after, so this whole process will take little time.
- In most economies, the Central Bank increases the money supply constantly. The public watches the Central Bank because it is used to predictable rates of monetary expansion, and price expectations increase all the time.
- But the public can still be surprised.
- In some economies, expectations catch up so quickly that monetary policy is ineffective even in the short run, leading to high rates of inflation.

A Decrease inthe Budget Deficit

7-5

The Dynamic Effects of a Decrease in the Budget Deficit

A decrease in the budget deficit leads initially to a decrease in output. Over time, output returns to the natural level of output.

Deficit Reduction, Output,and the Interest Rate

- Since the price level declines in response to the decrease in output, the real money stock increases. This causes a shift of the LM curve to LM’.
- Both output and the interest rate are lower than before the fiscal contraction.

Deficit Reduction, Output,and the Interest Rate

- AS the AS curve shifts down, P falls and M/P rises.
- The LM curve continues to shift down until output is back to to the natural level of output.
- The interest rate is lower than it was before deficit reduction.

Deficit Reduction, Output,and the Interest Rate

The Dynamic Effects of a Decrease in the Budget Deficit on Output and the Interest Rate

Deficit reduction leads in the short run to a decrease in output and to a decrease in the interest rate. In the medium run, output returns to its natural level, while the interest rate declines further.

Deficit Reduction, Output,and the Interest Rate

- The composition of output is different than it was before deficit reduction.

- Income and taxes remain unchanged, thus, consumption is the same as before.
- Government spending is lower than before, but Y is the same
- Therefore, investment must be higher than before deficit reduction—higher by an amount exactly equal to the decrease in G. This can only happen if
- Interest rates fall in the SR, and even more in the medium run.
- In the medium run, budget deficit reduction leads to a decrease in the interest rate and an increase in investment.

Changes in the Price of Oil

7-6

The Price of Crude Petroleum, 1960-2001

There was two sharp increases in the relative price of oil in the 1970s, followed by a decrease in the 1980s and the 1990s.

Changes in the Price of Oil

- Recall that, for Price Setting, P=(1+m)W
- In Chapter 6 we assumed firms had no costs besides wages, and that m was entirely due to monopoly power.
- Here we have to add another input (oil). We could re-derive the entire AS curve.
- Or we could say that (1+m) captures any reason for a difference between P and W, reflecting:
- Monopoly power,
- Marginal Cost of other inputs besides labor,
- (Such as oil)
- Taxes on business profits, labor regulation,
- Etc.

Effects on the NaturalRate of Unemployment

The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment

We can model the higher price of oil as an increase in the markup (of prices over wages) and a downward shift of the price-setting line.

The Dynamics of Adjustment

- An increase in the markup, m, caused by an increase in the price of oil, results in an increase in the natural unemployment rate, which reduces Yn for any P. The AS curve shifts left.
- Alternatively, we can think of a higher m causing an increase in the price level, at any level of output, Y, shifting the AS curve up.

The Dynamics of Adjustment

B

- After the increase in the price of oil, the new AS curve goes through point B, where output equals the new lower natural level of output, Y’n, and the price level equals Pe.
- The economy moves along the AD curve, from A to A’. Output decreases from Yn to Y’.
- But now P>Pe, so Pe will rise over time, and the AS curve will shift upwards even more.

The Dynamics of Adjustment

- Over time, the economy moves along the AD curve, from A’ to A”.
- At point A”, the economy has reached the new lower natural level of output, Y’n, and the price level is higher than before the oil shock.

B’’=

The Dynamics of Adjustment

An increase in the price of oil leads, in the short run, to a decrease in output and an increase in the price level. Over time, output decreases further and the price level increases further.

The Dynamic Effects of an Increase in the Price of Oil

B’’=

The Dynamics of Adjustment

- The combination of negative growth and high inflation, or stagnation accompanied by inflation, is called stagflation.

Conclusions

- If policy does not change output in the medium run, should we bother?
- This depends on
- How fast price expectations adjust,
- And this depends on whether the shock is anticipated/unanticipated, on whether it is well understood or not, on whether it affects relatively sophisticated agents or uneducated ones, etc.
- The shapes of the IS, LM, and labor market curves,
- How quickly policy can be carried out and how quickly it affects output.

Conclusions

- “Activists”, typically associated with the Keynesian school, believe Pe adjusts very slowly and policy affects output relatively quickly and accurately.
- If the economy takes a long time to move back to Yn and if government policy can make the right decisions,
- a lot of pain can be avoided by activist policy.
- Policy can improve welfare.

Conclusions

- “Non-activists”, typically New Classicals, believe Pe adjusts quickly, and policy is often wrongheaded or tardy.
- If the economy goes back to Yn quickly and if government policy is often wrongheaded,
- Policy will typically overreact or react to events too late,
- Leading to more instability and less welfare.

Shocks and Propagation Mechanisms

- Output fluctuations (sometimes called business cycles) are movements in output around its trend.
- The economy is constantly hit by shocks to aggregate supply, or to aggregate demand, or to both.
- Each shock has dynamic effects on output and its components. These dynamic effects are called the propagation mechanism of the shock.

Where we go from here

- In the next chapters, we’ll introduce sustained nominal money growth,
- Which explains sustained inflation.
- Inflation, its level and its change, affects (and is affected by) output and unemployment.

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