Presentation on theme: "Diploma Macro Paper 2 Monetary Macroeconomics Lecture 6 Mark Hayes"— Presentation transcript:
1 Diploma Macro Paper 2 Monetary Macroeconomics Lecture 6 Mark Hayes Aggregate supplyand putting AD and AS togetherMark Hayes
2 Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market KX and IS(Y, C, I)Labour market(P, Y)ASAD-AS(P, i, Y, C, I)Moneymarket (LM)(i, Y)IS-LM(i, Y, C, I)ADForeign exchangemarket(NX, e)IS*-LM*(e, Y, C, NX)AD*AD*-AS(P, e, Y, C, NX)
3 Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market KX and IS(Y, C, I)Labour market(P, Y)ASAD-AS(P, i, Y, C, I)Moneymarket (LM)(i, Y)IS-LM(i, Y, C, I)ADForeign exchangemarket(NX, e)IS*-LM*(e, Y, C, NX)AD*AD*-AS(P, e, Y, C, NX)
4 Deriving the AD* curve Why AD* curve has negative slope: P (M/P) LM*(P2)LM*(P1)Why AD* curve has negative slope:IS*21P (M/P) LM shifts leftY2Y1YP P2 NXP1 YAD*Y2Y1
5 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)
6 The effect of an increase in demand in the ‘short run’ and the ‘long run’ AD2AD1A = initial (full employment) equilibriumYPLRASCP2SRAS2B = new short-run eq’m after a boom in confidenceBP1SRAS1AY2C = long-run equilibrium
7 Keynes’s original AD-AS model expectedincomeASADD*Effective demandEquilibrium employmentemployment, N
8 A post-Keynesian AD-AS model in P, Y space LRASADSRASYY
10 Three models of aggregate supply The imperfect-information modelThe sticky-price modelThe sticky-wage modelAll three models imply:agg. outputnatural rate of outputa positive parameterthe actual price levelthe expected price level
11 Three models of aggregate supply The imperfect-information modelThe sticky-price modelThe sticky-wage modelAll three models imply:𝒀− 𝒀 =𝜶 𝑷− 𝑷 𝒆Deviations in outputa positive parameterDeviations in price level from expectation
12 The imperfect-information model Assumptions:All wages and prices are perfectly flexible, all markets clearEach 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.
13 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.
14 The sticky-price model Assumption:Firms set their own prices (monopolistic competition).Reasons for sticky prices:long-term contracts between firms and customersmenu costsfirms not wishing to annoy customers with frequent price changes
15 The sticky-price model An individual firm’s desired price iswhere a > 0.Suppose two types of firms:firms with flexible prices, set prices as abovefirms with sticky prices, must set their price before they know how P and Y will turn out:
16 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…
17 The sticky-price model price set by sticky price firmsprice set by flexible price firms
18 The sticky-wage modelAssumes 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
19 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.
20 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.
21 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.
22 Summary & implications Figure 13-3, p.357Idiosyncracy 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).YPLRASSRASThe 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.
23 Summary & implications Suppose a positive AD shock moves output above its natural rate and P above the level people had expected.SRAS equation:SRAS2YPLRASAD2SRAS1AD1This 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.
24 Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market KX and IS(Y, C, I)Labour market(P, Y)ASAD-AS(P, i, Y, C, I)Moneymarket (LM)(i, Y)IS-LM(i, Y, C, I)ADForeign exchangemarket(NX, e)IS*-LM*(e, Y, C, NX)AD*AD*-AS(P, e, Y, C, NX)
25 Inflation, Unemployment, and the Phillips Curve The Phillips curve states that depends onexpected inflation, e.cyclical unemployment: the deviation of the actual rate of unemployment from the natural ratesupply shocks, (Greek letter “nu”). measures the responsiveness of inflation to cyclical unemployment.where > 0 is an exogenous constant.
26 The Phillips Curve and SRAS 𝒀− 𝒀 =𝜶 𝑷− 𝑷 𝒆Phillips curve𝒖− 𝒖 𝒏 =−𝟏/𝜷 𝝅− 𝝅 𝒆 −𝒗SRAS 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.
30 Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market KX and IS(Y, C, I)Labour market(P, Y)ASAD-AS(P, i, Y, C, I)Moneymarket (LM)(i, Y)IS-LM(i, Y, C, I)ADForeign exchangemarket(NX, e)IS*-LM*(e, Y, C, NX)AD*AD*-AS(P, e, Y, C, NX)
31 Policy effectiveness and inflation targeting Next termPolicy effectiveness and inflation targetingOrigins of the North Atlantic and Euro crises