Aggregate demand and aggregate supply. Lecture 6 1

Two macroeconomic models 1. Keynesian model: sticky prices and unemployed factors of production. Increase in demand (fiscal and monetary policy) increases output and income. 2. Classical model: wages and prices flexible. Equilibrium means full employment of factors of production. Fiscal and monetary policy has an impact on prices. No impact on level of production. Short run: not enough time to adjust wages and prices to the change in demand. Keynesian approach more close to reality Long run: adjustment of wages and prices takes place. Classical model more useful Transition of the economy from the short run to the long run crucial in macroeconomic analysis 2

Two parts of analysis: aggregate demand and aggregate supply Aggregate demand depends on the relation between goods market and money market Aggregate supply depends on thre relation between goods market and labor market 3

The aggregate demand curve (standard framework) The relation between prices, real money supply, interest rate, investment and aggregate demand M is given, then: if P ↓, M/ P ↑, r ↓, I↑, Y↑ or If P↑, M/P↓, r↑, I↓, Y↓ AD curve shows different sets of the price level P and real income Y at the interest rate which guarantees equilibrium at money market 4

The aggregate demand curve (targeting inflation approach) 1 growing instability of money demand → CB stopped to control supply of money Majority of CB is targeting inflation rate targeting inflation policy: CB is changing the interest rate to keep inflation rate close to the target inflation rate 5

The aggregate demand curve (targeting inflation approach) 2 It means that inflation rate is not controlled directly CB makes the forecast of the inflation rate and sets nominal interest rate (r) at the level which makes the real interest rate (i) close to required level i=r- π, where π- the inflation rate The increase in nominal interest rate has to be higher than the increase in inflation rate If current inflation rate higher than π C B increases nominal interest rate to achieve higher real interest rate. Higher i diminishes aggregate demand → prices go down (lower inflation) Aggregate demand curve shows that increase in inflation rate results in lower output. Lower output caused by the increase in interest rate 6

Shift of AD curve Shift of AD curve caused by the change in any of aggregate demand parts: C, I, G Increase in G for example shifting the IS curve to the right – new level of Y, but price level does not change AD curve shifts parallel to the right 7

Rotation of the AD curve Change in price level shifting LM curve (new level of M/P) The slope of IS curve depends on the sensitivity of investment to the changes of the interest rate: more flatter IS curve means „I” more sensitive to the change in „r” The change in „r” caused by change in M/P makes „I” and „Y” higher than in case of more steeper IS curve AD curve rotates 8

Pigou effect Pigou effect: change in consumption of households due to change in M/P Lower prices: households may buy more goods with the same amount of money, C goes up Change in M/P shifts LM curve and change in C shifts IS curve AD curve rotates 9

Aggregate supply curve AS shows the amount of output firms want to supply at each price level. It summarizes the interactions of the goods and factor markets. P = aW(1 + m), P- price level, a-labor requirement per unit of output, m – capital cost assumed to be a relative markup over labor costs (constant), W- money wages Prices going up, other things equal, because of the cost of labor: the money wage W; a- labor requirement, The price at which firms are willing to sell is likely to increase as output rises because: Higher output – more labor needed, higher labor demand increases the wages and the price level The slope of AS curve depends on that how responsible wages are to an expansion in output and employment, it can be vertical (fully flexible wages), horizontal (sticky wages) or positively slopped (wages partially flexible) Long-run aggregate supply curve (LAS) and short-run aggregate supply curve (SAS) 10

Determinants of long-run aggregate supply Shifts in LAS reflect the growth in the potential level of output Sources of this growth include: - increases in capital and labor input - increases in productivity growth 11

Supply and prices in the short-run short run: prices (including wages) inelastic Aggregate supply curve flat (horizontal in some cases) Why wages inelastic (sticky)? -a) minimum wage legislation, b) unemployment benefits, c) labor unions, d) other labor market rigidities Inflexible prices the reason of the difference between „Y” high enough to reach full employment and „Y” economy produces Full employment means unemployment rate 2%-5% 12

Output and prices in long run equilibrium Yp – the potential, full employment output level. Changes in wages and prices maintain a continuous full employment AT E equilibrium on all 3 markets: goods, money and labor 13

What makes prices (wages) flexible No institutional arrangements on the labor market such as long term labor union contracts Labor market „frictionless” Firms compete for labor (demand) Workers compare the wage for an extra hour of effort (income-leisure trade-off) at the equilibrium wage everybody who wants to work can have a job 14

Monetary or fiscal policy impact on aggregate demand (classical model) AD (MDS) curve shifts to the right because of the increase: a) in nominal money supply: prices ↑, but real money supply (M/P) constant→interest constant→new equilibrium E” at the same output or b) increase in government spending, rising the price level →real money supply (M/P)↓, the ineterest rate ↑, full crowding out of private investment, output level does not change and remains at the full employment level Yp. 15

Short run supply curve SAS Each SAS curve responds to the inherited rate of nominal wages growth If inflation below πo (or decrease in demand resulting in fall of prices) real wages higher than anticipated Labor more costly, firms cut output: move to the point B along SAS Lower output: the growth rate of wages falls Prices do not have to rise (lower inflation) – shift to SAS1 (lower prices and increase in demand) If still not full employment – shift to SAS2: equilibrium restored with lower prices (lower inflation) 16

Short run supply curve An adverse supply shock Oil prices rise, any given level of output supplied at higher prices, SAS curve shifts up The increase in price lowers real money stock (M/P), raises the interest rate, reduces aggregate spending New equilibrium at lower output and higher prices Growing unemployment – pressure to lower wages SAS curve shifts back 17

Short run supply curve Increase in potential output level (standard approach ) Caused by the increase in the labor supply (more women want to work) The long run supply curve AS shifts to the right As long as no decrease of wages, no change in output, prices and employment; equilibrium at initial SAS, but unemployment higher Pressure on decrease in wages, shift from SAS to SAS1: lower prices higher demand and output If unemployment still exists, further decrease in wages and prices. New equilibrium at SAS2: lower prices and higher output and full employment restored 18

Increase in potential output level (targeting inflation approach) Increase in labor supply shifts AS In the long run increase in AS has to cause increase in AD Central bank lowers the interest rate, AD curve shifts up If monetary policy easy enough, AD curve shifts to the right compensating the shift of AS curve Inflation target reached at the new equilibrium level: lower interest rate and higher level of ouput= new potential output 19

Demand shock (targeting inflation approach) Fluctuations of the demand, demand curve shifts to the right or to the left The economy can not keep the inflation target Fast reaction of Central Bank may compensate demand shocks CB may change the nominal interest rate in a way which makes possible return to initial demand curve Economy comes back to the former equilibrium point Stabilization of the inflation rate and the output level achieved 20

Transitory supply shock: a choice between stability of output and stable inflation rate Short run supply fluctuates, achieving higher or lower than initial supply level (shifts of SAS curve) Stabilization of inflation means large changes in output Monetary policy unable to stabilize both: inflation and output Good solution: the interest rate at the level allowing for certain changes in inflation to diminish changes in output The policy of flexible inflation target 21

Classical (a) model versus Keynesian model (b) 22

Supply side and demand side policies Supply side economics – theoretical justification of the policy stimulating the aggregate supply: a reduction in payroll taxes (taxes paid by firms on the wages they pay their employees) or better information on job availability) Demand side economics – fiscal and monetary policy to stabilize output and employment at close to potential level 23

summary The Keynesian AS curve horizontal, Shifts in aggregate demand affect only output. The slope of the Keynesian AS curve based on the assumption that wages do not change when the level of employment changes The classical AS curve vertical. Classical model – wages and prices fully flexible. The wage adjusts to maintain continuous full employment in the labor market Full employment in the labor market equals the full employment level of output (potential output) Classical approach: Shifts in AD have their effects in prices and not in output Keynesian approach: shifts in AD change the level of output, sticky prices Keynesian model useful to explain short-run adjustments in the economy (AS curve slope between vertical and horizontal position), Classical model useful to describe long-run adjustments 24