Fluctuations and growth: the aggregate supply - aggregate demand model École des Hautes Études Commerciales (HÉC), January 2001

First part

Analyzing the market for goods and services: Aggregate supply We have seen that GDP could grow with the total number of hours worked (L·h) and with the productivity of these hours worked (y). In general, productivity increases with the stock of capital per person-hour (K/Lh) and with technological progress. In the short-run however, the capital stock (the size of the production infrastructures, the installed capacity in machinery and equipment, etc.) is fixed and the state of technology is given. In the short-run, it is difficult to increase productivity.

Analyzing the market for goods and services: Aggregate supply In order to increase production it is thus necessary to increase the total number of hours worked (Lh). There two ways we can do this: Hire new employees within the labor force and increase L Increase the average duration of work (part-time workers who become full-time workers and asking extra hours to full-time workers). However, these extra hours have a cost and this cost is not independent from the level of production.

Deriving the aggregate supply curve Let’s make the following assumptions which are reasonable in the short-run: The size of the labor force is fixed The size of the capital stock is fixed The state of technology is given. Input prices (labor, raw materials, energy, etc.) are fixed. In order to increase production, we must hire more workers and/or increase the average duration of the working week.

Under these assumptions, could we expect an aggregate supply with the following shape ? (equilibrium relationship between the level of aggregate production and the average level of prices)

The successive increases in the level of production (for instance, from Y0 to Y1) bring about an increase in employment. For a given size of the labor force, this increase in employment brings about a reduction in the rate of unemployment. As the rate of unemployment is approaching its lower limit, it becomes more difficult to find skilled workers. The skilled workers are asked to work extra hours and these hours are often paid a higher rate Less skilled workers are hired but their average productivity is lower. These two reasons explain why unit costs should increase with the level of production as the economy approaches the lower limit of the rate of unemployment. The answer is no P Y AS Y0 Y1 The rate of unemployment goes down as the level of aggregate production goes up

Here is an illustration of the link between increases in production and increases in employment (Canada between 1980 et 1999) 8 6 6 4 4 2 2 -2 -2 -4 -4 -6 -6 80 82 84 86 88 90 92 94 96 98 Real GDP (% change) Employment (% change)

The lower limit to the rate of unemployment There are always some people in the labor force who find themselves for a short period of time between two jobs or occupations. They are looking for a new and possibly better position (frictional unemployment). Other people suffer from chronic and long-term unemployment. There are several potential causes to this. Among them: The fact that their particular skills may have become obsolete. Their mobility (between sectors of economic activity and/or between regions) may be low. Whatever the reason, economists call this type of unemployment structural unemployment. The sum of the frictional and the structural rates of unemployment gives us the lower limit to the rate of unemployment. In the literature, this lower limit is known as the natural rate of unemployment (even if there is nothing natural about it)

The aggregate supply curve AS When the economy reaches the lower limit of the rate of unemployment and maximizes the average duration of the working week, it becomes impossible to increase production further. Area where the rate of unemployment approaches its lower limit Area where the rate of unemployment is high Y

The shifts in the aggregate supply curve The entire aggregate supply curve shifts as we relax the following assumptions: The size of the labor force is fixed. The size of the capital stock is fixed. The state of the technology is given. The prices of inputs are fixed. To start with, let us suppose that the labor force (through population growth) and the stock of capital (through investment) both increase at the same rate.

With no gains in productivity, the supply curve shifts to the right at constant cost AS’ A parallel increase in the labor force and the stock of capital (with no gains in productivity) shifts the supply curve to the right. Unit costs remain constant. AS Y

With productivity gains, the supply curve shifts further to the right and units costs are lower. AS with an increase in productivity, more can be produced... AS’ AS’’ at a lower cost... Y

The aggregate supply curve shifts upward when input prices increase Increases in the cost of labor (through higher wages or payroll taxes), in the price of raw materials or in the price of energy bring about an upward shift in the aggregate supply curve AS P Y

But occasionally ... AS P AS ’ Y Brings about a downward shift in the entire aggregate supply curve. A fall in the price of raw materials, energy, wages,etc, Y

Growth and inflation ususally coexist... AS P AS ’ The curve shifts rightward... as well as upward . Y

An important price: the price of crude oil 1990:10 35,92 Gulf War 1985:11 30,81 1999:09 23,88 11,58 1986:07 11,28 1998:12

The growth rate of wages in Canada (wage increases in collective agreements) 2 4 6 8 84 86 88 90 92 94 96 98 Wages growth rate The upward shifts in the AS curve get larger The upward shifts in the AS curve get smaller

When we combine an increase in productivity with an equivalent increase (in %) in wages... The aggregate supply curve shifts to the right only P Y

Wage increases are inflationary only when they exceed productivity gains Productivity gains shift the curve to the right Wage increases exceeding productivity gains raise unit costs Y

The scope for real wage increases When wages and prices increase at the same pace, the purchasing power of wages (W/P defined as the real wage) is constant. When there are productivity gains, real GDP per capita increases and therefore real wages can increase. This is exactly what we have seen with the aggregate supply curve. When wage increases are equal (in %) to productivity gains, there is no inflation (other things equal) and nominal increases in wages are real increases in wages. When wage increases exceed productivity gains, the firms raise their prices to cover their higher unit costs. Inflation brings back real wage increases in line with productivity gains. Of course, we have assumed that firms had a constant mark-up on their unit costs… What would happen if not ?

The concept of potential GDP Strictly speaking, potential GDP corresponds to the vertical portion of the aggregate supply curve. In other words, potential GDP is equal to what the economy can produce in the aggregate when it is using its productive facilities at full capacity and when the rate of unemployment is minimal. As the economy approaches potential GDP, rising costs put pressures on prices. In a situation of general scarcity in the labor market, we might expect that skilled workers will ask for wage increases in order to keep their real wage constant. Inflation would accelerate. This is why a slightly different concept of potential GDP is associated with a rate of unemployment below which inflation would accelerate. More on this later...

End of the first part