The New Classical model and Aggregate Supply The Classical theory of employment Labor supply and the expected real wage Potential output and the “natural rate” of unemployment. The short-run aggregate supply curve Adjustment to long-run equilibrium Closing expansionary and contractionary gaps Shifts of (long-run) aggregate supply

The New Classical view Market, industrialized economies are self-adjusting and tend automatically to full-employment

The Classical model 3 pillars of the Classical system: Say’s law Classical labor market analysis The quantity theory of money

Say’s Law “Supply creates its own demand.” A general glut of goods and services cannot appear as result of deficiency of aggregate spending power—because, in the process of producing goods and services firms will distribute income sufficient to allow for the purchase of all goods and services produced during the same period.

Classical labor market analysis Postulates Labor supply (Ns)depends on the expected real wage) Labor demand (Nd ) depends on the actual real wage. Employers can accurately forecast future prices; suppliers of labor services make forecast errors.

Definitions If then is the actual future price level is the expected future price level is the nominal wage is the actual real wage is the expected real wage If then

Short-run aggregate supply curve Potential output The SRAS curve is based on a given expected price level, in this case, 130. Point a shows that if the actual price level equals the expected price level of 130, producers supply potential output. If the actual price level is below 130, firms supply less than potential. Output levels that fall short of the economy’s potential are shaded red; output levels that exceed the economy’s potential are shaded blue. Price level 140 120 130 SRAS130 a Real GDP (trillions of dollars) 14.0

Potential GDP and the Natural Rate of unemployment Potential Output (GDP) is the economy’s sustainable maximum output given the supply of resources, technology, and the rules of the game; the output level where there are no surprises about the price level. The Natural Rate of Unemployment is the unemployment rate when the economy produces its potential output. It is the “full-employment unemployment rate and consists of seasonal, structural, frictional—but NOT cyclical—unemployment.

LRAS Price Level Potential GDP Real GDP

The short run In macroeconomics, a period during which some resource prices, especially those for labor, are fixed. Alternative definition: The short run is the period during which the expectations of labor do not fully adjust to changes in the price level.

Effects of a reduced real wage (W) in the short run We will hire more workers and produce more output if the real wage (W) falls

Nominal contracts Labor contracts (implicit and explicit) are written in money terms and typically are NOT indexed to inflation. Contracts are reset periodically –often only once per year. If the price level over the term of the contract is higher than expected by workers (suppliers of labor services), the actual real wage will be less than expected real wage. In this situation, firms are able to hire the same number of workers at a lower real wage. Firms will react by hiring more workers and expanding output (because it is profitable to do so).

Expansionary gap When We > W, output will expand above the its potential level. This is a temporary situation, however.

Short-run equilibrium when the price level exceeds expectations Expected price level=130, SRAS130 If actual price level turns out as expected, the quantity supplied = potential output of $14 trillion. Potential output Price level 140 130 135 LRAS SRAS140 Given the AD curve, price level > expected; output exceeds potential (b); expansionary gap. AD SRAS130 c In the long-run, price-level expectations and nominal wages will be revised upward. Costs will rise and the SRAS curve shifts leftward to SRAS140. Eventually, the economy will move to long-run equilibrium (c), thus closing the expansionary gap. b a Real GDP (trillions of dollars) 14.0 14.2

Contractionary gap Under these conditions, firms will scale back on output and offer less employment. This situation may persist in nominal wages fail to adjust downward when the price level falls.

Short-run equilibrium when the price level is below expectations Actual price level < expected (intersection of AD” with SRAS130); short-run equilibrium: (d). Production below economy’s potential opens a contractionary gap. Potential output Price level 130 120 125 SRAS130 LRAS SRAS120 If prices and wages are flexible enough in the long run, nominal wages will be renegotiate lower. As resource costs fall, the short-run aggregate supply curve eventually shifts rightward to SRAS120 and the economy moves to long-run equilibrium at (e), with output increasing to the potential level of $14.0 trillion. AD” a d e Real GDP (trillions of dollars) 14.0 13.8

Downward rigidity of the nominal wage (w) Experience shows that workers will resist cuts in money wages. Employers fear employees will be demoralized if their money pay is cut, so they may prefer to lay off workers instead.

Long-run aggregate supply curve Potential output LRAS In the long run, when the actual price level equals the expected price level, the economy produces its potential. In the long-run, $14.0 trillion in real GDP will be supplied regardless of the actual price level. As long as wages and prices are flexible, the economy’s potential GDP is consistent with any price level. Thus, shifts of the aggregate demand curve will, in the long-run, not affect potential output. The long-run aggregate supply curve, LRAS, is a vertical line at potential GDP. Price level 140 120 130 AD’ AD AD” b a c Real GDP (trillions of dollars) 14.0

US output gap measures actual GDP minus potential output as percentage of potential output 1984 1988 1992 1996 2000 2004 2008

Effect of a gradual increase in resources on aggregate supply LRAS LRAS’ Price level A gradual increase in the supply of resources increases the potential GDP – in this case, from $14.0 trillion to $14.5 trillion. The long-run aggregate supply curve shifts to the right. Real GDP (trillions of dollars) 14.5 14.0

Effects of a beneficial supply shock on aggregate supply LRAS LRAS’ SRAS130 Given the AD curve, a beneficial supply shock that has a lasting effect, such as a breakthrough in technology, will permanently shift both the short-run aggregate supply curve and the long-run aggregate supply curve, or potential output. A beneficial supply shock lowers the price level and increases output, as reflected by the change in equilibrium from a to b. Price level 130 125 SRAS125 AD” a b Real GDP (trillions of dollars) 14.2 14.0 A temporary beneficial supply shock (an unusually favorable growing season), will shift the AS curves only temporarily. If the next growing season returns to normal, the AS curves will return to their original equilibrium position at a.

Effect of an adverse supply shock on aggregate supply LRAS” LRAS SRAS135 Price level 130 125 Given the AD curve, an adverse supply shock, such as an increased threat of terrorism, shifts the short-run and long-run aggregate supply curves to the left, increasing the price level and reducing real GDP, a movement called stagflation. This change is shown by the move in equilibrium from a to c. SRAS130 AD” c a Real GDP (trillions of dollars) 14.0 13.8 If the shock is just temporary, the shift of the aggregate supply curves will be temporary.