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AS - AD

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Aggregate Supply –relates output and price level –labor market Aggregate Demand –relates output and price level –IS - LM

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Aggregate Supply As output rises…. P = W(1 + ) W = P e F(u,z) P = P e (1 + )F(u,z) For fixed P e, as Y rises, u falls so P rises why? Hiring pushes up wages. Note: P e fixed in the short run.

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AS (in detail) U – number of workers unemployed N – workforce (constant) L - workers employed U = N - L Unemployment rate u = (N - L)/N =1-L/N Production function Y=ALA – productivity u = 1-Y/(AN)

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AS (in detail) P = P e (1 + )F(u,z) u = 1-Y/(AN) P = P e (1 + )F(1-Y/(AN),z) AS relation, as Y ↑ u↓ u ↓ F(u,z) ↑ F(u,z) ↑ P↑ So AS is upward sloping

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AS Slopes up Shifts –Change in P e Rise in expectations Shifts AS up –Productivity A ↑ AS shifts right/down –Markup ↑ AS shifts up –Change in z, labor market conditions

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Aggregate Demand How does a price increase affect equilibrium GDP on an IS – LM graph. –LM shifts up (left) –Y * falls AD slopes down Shifts – anything else that affects IS – LM –Autonomous spending –Policy (both kinds) Exception – supply side tax effects

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Problems Show how an increase in the money supply would affect the equilibrium level of output, interest rates and prices using and IS – LM and AS – AD diagram. The 1990s saw an increase use of IT in business which improved productivity. Show the short run effect on an AS- AD graph.

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Problems Show how an decrease in government spending would affect the equilibrium level of output, interest rates and prices using and IS – LM and AS – AD diagram. Show the effect of an increase in oil prices has on an AS-AD graph.

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Medium Run Expectations adjust P=P e Unemployment at its natural rate 1 = (1 + )F(u n,z) Output at its natural rate u n = 1-Y n /(AL) AS? 1 = (1 + )F(1-Y n /(AL),z) Vertical at the natural rate of output

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Medium run What if Y * < Y n ? –P < P e (short run) – medium run, P e falls to P –AS shifts down/right –Y * rises to Y n Labor Market interpretation – u * > u n – as P e falls, wages bid down –lower cost to production –AS shifts right Medium run Y * = Y n

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Monetary policy: short and medium run Fed increase M s –AD shifts right –Y * and P * both rise –short run (P > P e ) Medium run – P e rises –AS shifts up/left – Y * falls back to Y n – P * rises further Money neutrality (med run) –changes in M s affect nominal variables not real variables

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Problem Show how a decrease in the money supply would affect the equilibrium output and price levels on an AS-AD graph in the short and medium run. What happens on the IS-LM graph in the short and medium run?

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Problems AS-AD Show the short and medium run effects of an increase in productivity. Show the short and medium effects of a decrease in consumer confidence. Show the short and medium run effects of an increase in oil prices.

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Recessionary Gap Y * < Y n Inflationary Gap Y * > Y n Show an inflationary gap on an AS-AD graph, then show how the government could use tax policy to close the gap. Show a recessionary gap on an AS-AD graphs, then show how monetary policy could be used to close the gap.

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Gov’t Spending How does an increase in government spending affect the AS-AD graph in the short & medium run? Does Gov’t spending affect productivity? Show the changes in the graph for both cases.

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Key Equations P = W(1 + )(PS) W = P e F(u,z)(WS) 1 = (1 + )F(u n,z) u = 1-Y/(AL) P = P e (1 + )F(1-Y/(AL),z)(AS)

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Phillip’s Curve

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Unemployment & Inflation Inverse relation Can the Fed lower U? Increase M S If inflation is caused by AD shift to the right output rises, unemployment falls Fed can lower U at a cost of higher True? Check the data.

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Inflation versus Unemployment in the United States, 1948-1969

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Inflation versus Unemployment in the United States since 1970

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PC relation to WS W = P e F(u,z)(WS) P = W(1 + )(PS) Let F(u,z) = 1 – u + z So WS & PS become P = P e (1 + )(1 – u + z) Do some math…. e + u + z inverse relation does exist

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Wage – Price Spiral Explains inverse relation u falls wages bid up prices rise workers demand higher wages –etc. etc. higher “Tight labor market” – late 1990s

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Shifts in PC Expectations markup –input costs –market power labor market condtions Anything that shifts AS, shifts PC

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Medium Run PC equation in the medium run? expectations equal inflation u n depends only on , z,

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Monetary Policy and the PC The Fed tries to lower u below the natural rate….. Show on AS-AD and the PC for the short and medium run.

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Review Problems Show a Phillips curve graph and an AS-AD graph starting from an inflationary gap. Show the medium run adjustment. If the Fed acts to close an inflationary gap, what would they do? Show the result on an AS-AD graph and a PC graph.

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Story of the Great Inflation Productivity falls oil prices rise –Effect on Y n, u n –Monetary policy reaction Fed tried to keep u at the old level expectations rose Both shifts and a return to the natural rate

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Mr. Burn’s brain What’s behind the Fed’s decisions in the 70’s? Bad thinking –Ignoring natural rates –Expectations –“old” PC Bad data –Couldn’t see the change in the natural rates Cared more about unemployment than inflation

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Intellectual history & the PC “Old” PC (1940-50s) –Empirical relationship –Use in Cowles commission models Edmund Phelps / Milton Friedman (late 60s) –Argue against the permanent output/inflation tradeoff –70s proved them right –“Old Keynesian” econometric models abandoned

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Expectations and the PC t t e + u t + z Static expectations t e = t Rational expectations t e = t + t t – forecast error

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Policy Effectiveness Under rational expectations, what happens when the Fed increases the money supply? PC and AS vertical (with an error term) P & rise, not real effect Money is neutral. Policy is ineffective. Why?

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Problem Starting from the natural rate of unemployment, if the Fed acts to lower inflation, show the SR & MR effects.

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P=P e (1 F(u,z) W = P e F(u,z) e + u + z P = W(1 M/P = L(i,Y) u n = ( + z)/ Equations

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P=P e (1 F(u,z)AS (sort of) W = P e F(u,z)WS e + u + zSRPC P = W(1 PS M/P = L(i,Y)Money Demand u n = ( + z)/ MRPC/natural rate of u Equations

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More Review The government becomes more aggressive about breaking up monopolies lowering the pricing power of firms. Show the impact on the following graphs. real wage / unemployment AS – AD Phillips curve IS – LM

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More Review The recent housing market decline led to an decrease in autonomous consumption and investment. Show that short run change and the medium run adjustment, assuming passive policy on the following graphs: IS-LM AS-AD Phillips Curve

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Review problem Show an inflationary gap on graphs of AS-AD and IS-LM. Use the graph to explain how tax policy could be used to close the gap..

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Review Problem Show the short run effect of a tax increase on an expenditure diagram. Show the short and medium effects on IS-LM and AS-AD diagrams.

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Review Problem Keynes once advocated that the government should bury boxes of money and let people dig them up to stimulate to economy. Starting from the natural rates or unemployment and output, show the short and medium run effects of an increase in government spending that does not change the natural rates for AS-AD and the Phillip’s curve.

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Review Problem Currently the Fed is increasing the money supply and keeping interest rates low to mitigate the recession. Starting from a recessionary gap, show the effect of an increase in the money supply on an AS- AD graph and the Phillip’s Curve.

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Practice Problem The financial crisis has led to a decrease in lending and therefore an fall in the money supply. Starting from the natural rates of output and unemployment, show the resulting change on AS-AD and Phillips curve graphs in the short run.

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A small macro model

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Goals Connect output, unemployment and inflation Use equations Explain both short and medium runs y, u and Actually, we’ll use g y – growth rate

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The U.S. unemployment rate, 1890–2002

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Okun’s law in the U.S.: 1951–2002

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Okun’s Law Connects u and y u t – u t-1 = - (g y,t – g n ) g n - “normal” or natural growth rate of output - growth rate of potential GDP

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Phillips Curve Connects and u e + u + z or t e t = u n - u t ) Related to AS

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and Y Focus on AD and monetary policy M/P rises, LM & AD shift right Y rises Let Y = (M/P) Assumes fiscal policy and autonomous expenditures are fixed. Log differencing the equation: g y,t = g m,t - t

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small macro model u t – u t-1 = - (g y,t – g n ) t e t = u n - u t ) g y,t = g m,t – t MR implications: e ; u = u n ; g y,t = g n t = g m,t – g n

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Problem Let g n = 3%, u n = 6%, g m,t = 8% Find the medium run values of g y,t, u t and t Using those as starting values, find the short run (one period) values if g m,t rises to 9%. Find the new medium run values after expectations adjust to the new g m,t.

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Problem Let g n = 3%, u n = 6%, g m,t = 7% Find the medium run values of g y,t, u t and t Using those as starting values, if the Fed wants to lower inflation to 2% in the medium run, to what level should they set g m,t ? Find the short run (after one period) values if they make this change. Show these changes including the medium run adjustment on a graph of AS-AD and a PC graph.

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Sacrifice Ratio Lowering t in the MR has a cost of higher u t in the SR. To measure this cost Sacrifice Ratio = - u/ excess unemployment/ decrease in inflation For the previous problem…. Credibility

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Problem Let g n = 3%, u n = 5%, g m,t = 5% Find the medium run values of g y,t, u t and t Using those as starting values, the Fed increases g m,t to 8%. Find the new SR values (one period). Find the new medium run values. Show these changes on a graph of AS- AD and a PC graph.

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Time Consistency TC problem: conflict between long term plan/policy and short term incentive - grading - dieting - shutting down failed banks - monetary policy Long term goal: maintain inflation target Short term incentive: lower unemployment Reason for an independent Fed.

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Expectations and the PC t e t = u n - u t ) Static expectations t e = t Rational expectations t e = t + t t – forecast error

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Policy Ineffectiveness Policy does not have real effects if Expectations are rational. Wages and prices adjust immediately. –MR is short –Contracts? Sacrifice ratio? –Credibility –Evidence?

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Problem Let g n = 2%, u n = 7%, g m,t = 8% Find the medium run values of g y,t, u t and t The Fed wants to reduce inflation to 2% in the medium run. What value should they choose for g m,t ? Find the new SR values (one period) if they do this. Find the new medium run values. Show these changes on a PC graph. What is the sacrifice ratio?

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Review Questions The strong growth in the 1990s is often attributed to technology use by firms. Show the short and medium run changes on an AS-AD graph. One story explaining the Great Depression is the stock market crash reduced consumer spending. The government then tried to boost the economy with increased spending. Show both changes on an AS-AD graph explaining changes in equilibrium prices and output. Show how a change in the markup would affect the graph of the Phillip’s curve in the short and medium run.

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A small macro model

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Goals Connect output, unemployment and inflation Use equations Explain both short and medium runs y, u and Actually, we’ll use g y – growth rate

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The U.S. unemployment rate, 1890–2002

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Okun’s law in the U.S.: 1951–2002

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Okun’s Law Connects u and y u t – u t-1 = - (g y,t – g n ) g n - “normal” or natural growth rate of output - growth rate of potential GDP

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Phillips Curve Connects and u e + u + z or t e t = u n - u t ) Related to AS

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and Y Focus on AD and monetary policy M/P rises, LM & AD shift right Y rises Let Y = (M/P) Assumes fiscal policy and autonomous expenditures are fixed. Log differencing the equation: g y,t = g m,t - t

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small macro model u t – u t-1 = - (g y,t – g n ) t e t = u n - u t ) g y,t = g m,t – t MR implications: e ; u = u n ; g y,t = g n t = g m,t – g n

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Problem Let g n = 3%, u n = 6%, g m,t = 8% Find the medium run values of g y,t, u t and t Using those as starting values, find the short run (one period) values if g m,t rises to 9%. Find the new medium run values after expectations adjust to the new g m,t.

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Problem Let g n = 3%, u n = 6%, g m,t = 7% Find the medium run values of g y,t, u t and t Using those as starting values, if the Fed wants to lower inflation to 2% in the medium run, to what level should they set g m,t ? Find the short run (after one period) values if they make this change. Show these changes including the medium run adjustment on a graph of AS-AD and a PC graph.

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Sacrifice Ratio Lowering t in the MR has a cost of higher u t in the SR. To measure this cost Sacrifice Ratio = - u/ excess unemployment/ decrease in inflation For the previous problem…. Credibility

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Problem Let g n = 3%, u n = 5%, g m,t = 5% Find the medium run values of g y,t, u t and t Using those as starting values, the Fed increases g m,t to 8%. Find the new SR values (one period). Find the new medium run values. Show these changes on a graph of AS- AD and a PC graph.

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Time Consistency TC problem: conflict between long term plan/policy and short term incentive - grading - dieting - shutting down failed banks - monetary policy Long term goal: maintain inflation target Short term incentive: lower unemployment Reason for an independent Fed.

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Expectations and the PC t e t = u n - u t ) Static expectations t e = t Rational expectations t e = t + t t – forecast error

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Policy Ineffectiveness Policy does not have real effects if Expectations are rational. Wages and prices adjust immediately. –MR is short –Contracts? Sacrifice ratio? –Credibility –Evidence?

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Problem Let g n = 2%, u n = 7%, g m,t = 8% Find the medium run values of g y,t, u t and t The Fed wants to reduce inflation to 2% in the medium run. What value should they choose for g m,t ? Find the new SR values (one period) if they do this. Find the new medium run values. Show these changes on a PC graph. What is the sacrifice ratio?

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Review Questions The strong growth in the 1990s is often attributed to technology use by firms. Show the short and medium run changes on an AS-AD graph. One story explaining the Great Depression is the stock market crash reduced consumer spending. The government then tried to boost the economy with increased spending. Show both changes on an AS-AD graph explaining changes in equilibrium prices and output. Show how a change in the markup would affect the graph of the Phillip’s curve in the short and medium run.

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Problem Starting from the natural rate of output, show the short and medium run effects of a tax cut that leads to increased productivity. Is it possible that the equilibrium price level rises? Do tax cuts pay for themselves?

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Taxes & Revenue

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Laffer Curve Tax revenue vs. tax rates –Tax rate = 0%? –Tax rate = 100%? Laffer curve peaks somewhere in between. Cross country analysis says ~50%

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Tax Cuts Can pay for themselves if rates are very high Can improve productivity –Labor incentives Less effective as short run stimulus than spending increases –Some is saved

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22 Aggregate Supply and Aggregate Demand

22 Aggregate Supply and Aggregate Demand

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