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**Diploma Macro Paper 2 Monetary Macroeconomics Lecture 6 Mark Hayes**

Aggregate supply and putting AD and AS together Mark Hayes

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**Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market**

KX and IS (Y, C, I) Labour market (P, Y) AS AD-AS (P, i, Y, C, I) Money market (LM) (i, Y) IS-LM (i, Y, C, I) AD Foreign exchange market (NX, e) IS*-LM* (e, Y, C, NX) AD* AD*-AS (P, e, Y, C, NX)

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**Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market**

KX and IS (Y, C, I) Labour market (P, Y) AS AD-AS (P, i, Y, C, I) Money market (LM) (i, Y) IS-LM (i, Y, C, I) AD Foreign exchange market (NX, e) IS*-LM* (e, Y, C, NX) AD* AD*-AS (P, e, Y, C, NX)

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**Deriving the AD* curve Why AD* curve has negative slope: P (M/P)**

LM*(P2) LM*(P1) Why AD* curve has negative slope: IS* 2 1 P (M/P) LM shifts left Y2 Y1 Y P P2 NX P1 Y AD* Y2 Y1

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**Mundell-Fleming and the AD* curve**

Previously P was fixed, now we are changing it. NX is a function of , not e. We now write the M-F equations as: This means that the diagram does not show us the eq’m for e but we do not need this explicit for AD* 𝑰𝑺 ∗ :𝒀= 𝒄 𝟏 (𝒀− 𝑻 )+𝑰 𝒊 ∗ + 𝑮 +𝑵𝑿() 𝑳𝑴 ∗ :( 𝑴 𝑷 ) =𝑳( 𝒊 ∗ ,𝒀)

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**The effect of an increase in demand in the ‘short run’ and the ‘long run’**

AD2 AD1 A = initial (full employment) equilibrium Y P LRAS C P2 SRAS2 B = new short-run eq’m after a boom in confidence B P1 SRAS1 A Y2 C = long-run equilibrium

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**Keynes’s original AD-AS model**

expected income AS AD D* Effective demand Equilibrium employment employment, N

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**A post-Keynesian AD-AS model in P, Y space**

LRAS AD SRAS Y Y

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P LRAS AD 𝒀− 𝒀 =𝜶 𝑷− 𝑷 𝒆 Pe Y

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**Three models of aggregate supply**

The imperfect-information model The sticky-price model The sticky-wage model All three models imply: agg. output natural rate of output a positive parameter the actual price level the expected price level

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**Three models of aggregate supply**

The imperfect-information model The sticky-price model The sticky-wage model All three models imply: 𝒀− 𝒀 =𝜶 𝑷− 𝑷 𝒆 Deviations in output a positive parameter Deviations in price level from expectation

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**The imperfect-information model**

Assumptions: All wages and prices are perfectly flexible, all markets clear Each supplier produces one good, consumes many goods. Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level.

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**The imperfect-information model**

All suppliers know the nominal price of the good they produce, but do not know the general price level. Supplier does not know general price level at the time of the production decision, so uses the expected price level, P e. Suppose P rises but P e does not. Supplier thinks it is their own relative price which has risen, so produces more. With many producers thinking this way, Y will rise whenever P rises above P e.

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**The sticky-price model**

Assumption: Firms set their own prices (monopolistic competition). Reasons for sticky prices: long-term contracts between firms and customers menu costs firms not wishing to annoy customers with frequent price changes

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**The sticky-price model**

An individual firm’s desired price is where a > 0. Suppose two types of firms: firms with flexible prices, set prices as above firms with sticky prices, must set their price before they know how P and Y will turn out:

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**The sticky-price model**

Assume sticky price firms expect that output will equal its natural rate. Then, To derive the aggregate supply curve, we first find an expression for the overall price level. Let s denote the fraction of firms with sticky prices. Then, we can write the overall price level as…

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**The sticky-price model**

price set by sticky price firms price set by flexible price firms

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The sticky-wage model Assumes that firms and workers negotiate contracts and fix the money wage before they know what the price level will turn out to be. The money wage they set is the product of a target real wage and the expected price level: At the target real wage, the labor market is in equilibrium, meaning that unemployment equals its natural rate. This implies that output equals its natural rate (aka full-employment output). Target real wage

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I’ve included Figure 13-1 from the text here as a “hidden slide” in case you wish to “unhide” and include it in your presentation. This figure uses graphs to derive the aggregate supply curve under the assumption of sticky wages. As you can see, three-panel diagrams do not translate well to the big screen. Fortunately, though, most students readily grasp the intuition on the preceding slide, which sums up as follows: If the nominal wage is fixed, then increases in the price level cause the real wage to fall, which causes firms to hire more workers and produce more output.

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**The sticky-wage model If it turns out that then**

Unemployment and output are at their natural rates. Intuition for the positive relationship between P and Y, for a given value of the expected price level. Real wage is less than its target, so firms hire more workers and output rises above its natural rate. Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate.

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**Chart 4.6 Real product wages, labour market slack and productivity**

Sources: ONS (including the Labour Force Survey) and Bank calculations. (a) Headline unemployment rate less the central Bank staff estimate of the medium-term equilibrium unemployment rate. For details, see the box on pages 28–29 of the August 2013 Report. (b) Private sector AWE total pay deflated by the market sector gross value added deflator. (c) Market sector output per worker.

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**Summary & implications**

Figure 13-3, p.357 Idiosyncracy alert: If is constant, then the SRAS curve should be linear, strictly speaking. However, in the text, it is drawn with a bit of curvature (which I have reproduced here). Y P LRAS SRAS The following is not in the text, but you and your students may find it worthwhile: There are good reasons to believe that the SRAS curve is bow-shaped in the real world; that is, the curve is steeper at high levels of output than at low levels of output. And there are good reasons why we should care about this. Why the SRAS curve is bow-shaped: At low levels of output, there are lots of unutilized and under-utilized resources available, so it is not terribly costly for firms to increase output, and therefore firms do not require a big increase in prices to make them willing to increase output by a given amount. In contrast, at very high levels of output, when unemployment is below the natural rate and capital is being used at higher than normal intensity levels, it is relatively costly for firms to increase output further. Hence, a larger increase in prices is required to make firms willing to increase their output. Why the curvature matters: When policymakers increase aggregate demand, output rises (good) and prices rise (not good). An important question arises: how much of the bad thing (price increases) must we tolerate to get some of the good thing (an increase output)? The answer depends on how steep the SRAS curve is. When President Reagan cut taxes in the early 1980s, the economy was just coming out of a severe recession, and was on the flatter part of the SRAS curve; hence, the tax cuts affected output a lot and inflation very little. In contrast, when the current President Bush proposed huge tax cuts during the 2000 election season, we were on the steeper part of the SRAS curve, so the tax cuts would likely have been inflationary. Of course, by the time they were implemented, the economy was in recession, and in any case the bulk of the tax cuts were to be spread out over 10 or 11 years, so they have not proved inflationary. Each of the three models of agg. supply imply the relationship summarized by the SRAS curve & equation.

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**Summary & implications**

Suppose a positive AD shock moves output above its natural rate and P above the level people had expected. SRAS equation: SRAS2 Y P LRAS AD2 SRAS1 AD1 This graph has two lessons for students: First, changes in the expected price level shift the SRAS curve (this should be clear from the equation, as should the fact that a change in the natural rate of output will shift the SRAS curve). The second lesson concerns the adjustment of the economy back to full-employment output. Over time, P e rises, SRAS shifts up, and output returns to its natural rate.

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**Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market**

KX and IS (Y, C, I) Labour market (P, Y) AS AD-AS (P, i, Y, C, I) Money market (LM) (i, Y) IS-LM (i, Y, C, I) AD Foreign exchange market (NX, e) IS*-LM* (e, Y, C, NX) AD* AD*-AS (P, e, Y, C, NX)

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**Inflation, Unemployment, and the Phillips Curve**

The Phillips curve states that depends on expected inflation, e. cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate supply shocks, (Greek letter “nu”). measures the responsiveness of inflation to cyclical unemployment. where > 0 is an exogenous constant.

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**The Phillips Curve and SRAS**

𝒀− 𝒀 =𝜶 𝑷− 𝑷 𝒆 Phillips curve 𝒖− 𝒖 𝒏 =−𝟏/𝜷 𝝅− 𝝅 𝒆 −𝒗 SRAS curve: Deviations in output are related to unexpected movements in the price level. Phillips curve: Deviations in unemployment are related to unexpected movements in the inflation rate.

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**Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market**

KX and IS (Y, C, I) Labour market (P, Y) AS AD-AS (P, i, Y, C, I) Money market (LM) (i, Y) IS-LM (i, Y, C, I) AD Foreign exchange market (NX, e) IS*-LM* (e, Y, C, NX) AD* AD*-AS (P, e, Y, C, NX)

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**Policy effectiveness and inflation targeting **

Next term Policy effectiveness and inflation targeting Origins of the North Atlantic and Euro crises

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