Review of Aggregate Supply & Aggregate Demand

Learning Objectives 1.Understand the role of expectations in economic fluctuations 2.Understand how Fiscal and Monetary policy can work to stabilize the economy 3.Understand how an economy can adjust to shocks by itself

Overview of AS-AD Simple model of Aggregate Supply and Aggregate Demand Same idea as supply and demand AD slopes down: –As price rises AD falls –summarizes the whole of the IS-LM-BP model AS slopes up: –As price rises AS increases –Expectations are important

P Y AS AD

Example: Fiscal Policy If G increases then AD shifts to right At any P, AD will be higher because G is higher P and Y rise Why P rise? –Need to pay higher w to get higher output P Y AD o AS AD 1 A B

Aggregate Supply Q: What underlies the Aggregate Supply Curve? A: Labour market Why? – to increase production –hire more people –Pay higher wages More of other inputs also –Focus on labour market

Labour Market Firms have a demand for labour Decreases as wage rises Increases as Price of output rises –Curve shifts to the right –At any wage firm will want more workers W L DoDo D1D1

Workers supply labour Form expectation about cost of living –Price expectation (P e ) Higher wage will induce more work(ers) Increased (P e ) –Curve shifts up –Higher wage for any level of work W L

Labour market Equilibrium Put two curves together Lab Mkt eqm –Firms and workers plans agree –Wage and employment Also agree on price –P=P e –Rational expectations Implies agree on real wages W L D(P) S(P e )

Derive the Aggregate Supply Curve We can use the labour market to derive the AS curve in short run and in the long run First the short run: –Assume that expectations do not change –P e = P –S L will not move

Suppose start at A which represents lab mkt eqm –P level rises –D L increases –New eqm at B Employment increases Wage increases –Goods market Output increases –Upward sloping supply curve Note that AS depends on expectations

W L Y P A D L (P 0 ) A D L (P 1 ) B B AS(P e ) S L (P e )

Note that all this implies something weird about workers –The work more, for less! W has increased, but P has increased by more –Real wages have declined –See diagram Supply of labour was conditional on prices being at a certain level –P e = P –But this no longer true

With P>P e we have Demand w increase to restore living standards –they adjust expectations upwards –Supply curve shifts up –Shifts up so that increase in W is same as increase in P New equilibrium is a point C –Real wage same at C as at A –Employment same at C as at A

W L Y P A D L (P 0 ) A D L (P 1 ) B B AS(P e ) S L (P e ) C AS(P e ) S L (P e ) C

As expectations change there is a new AS curve Eqm at C has same output as A –Reflects the fact that employment is the same Net effect is that output and employment remain the same P and W go up by the same amount

Summary of AS We have a distinction between short run and long run The Short run is for fixed expectations –AS(P e ) –SRAS –Quite flat: Explains why ISLM works as approx LR is how long it takes for real wages to adjust –Expectations adjust –Workers to act on exp –ISLM wont work in LR In LR Y is unaffected by P

Y*Y* LRAS Y AS(P e ) P

What determines Y * ? –Natural rate –Incentives –Technology –“growth” –Not anything that just affects price

Policy in AS-AD Model Suppose there is an increase in G AD shifts right –For all P, there is higher AD, because govt component has risen –Could derive this from IS-LM –Same for MP For fixed expectations i.e. SR –Move along AS –New (temp) eqm at B –Y increases –P increases (but not by much)

P rising implies real wage falling –P>P e P e will adjust upwards –W increase –SRAS shifts up Keep going until output returns to “natural level” How long does transition take? –Theory: depends. Instantaneous? –Empirics: about 2 years – see diagram

Y*Y* LRAS Y AS(P e ) P AD 0 AD 1 C B A

Be clear on the reasons why there is no long run effect –In order to get more output need to pay more people higher wages –Higher wages imply firms need to charge higher prices –Higher prices negate the higher wages as far as workers are concerned –We go back to original values of real variables –Only affect nominal variables Policy is ineffective!

We can only get an increase in Y in long run i.e. increase in Y * –If induce people to work more –Need increase in real wage –Technology –Efficiency –Lower taxes? Reganomics Supply side economics Voodoo economics

Reagan Style Tax Cut Cut personal taxes –Idea is that this will improve incentives –People will work more –Shift the LRAS to the right –Increase Y * and reduce P –Note that SRAS shifts also as expectations adjust to the new lower level But cutting taxes will shift the AD curve to right –SR boom –LR return to Y * with higher P Which happened? –Both –Demand effect larger

Y*Y* LRAS Y AS(P e ) P AD 0 AS(P e ) A B

Dealing With Shocks The AS-AD diagram shows how an economy will automatically adjust to a shock Re-adjust to be in terms of inflation Start from LR eqm –Y=Y * –  e =  Suppose there is a fall in AD –Eqm moves from A to B –Y<Y * This can only be a temporary eqm

At B,  e –Real wages are higher than expected Prices fall, but by more than nominal wages See labour market diagram –Workers are expensive –Explains the decline in output –Over time workers will Reduce price expectations Reduce wage demands SRAS shifts down Process continues until LR eqm is restored at C –Real wage returns to original level –Y=Y * –  e =  but at new lower level

 Y Y*Y* LRAS AD 0 AD 1 SRAS(  e ) A B C

So the economy will automatically work itself out of recession Mechanism depends on wage adjustment –Mirror image of previous discussions –Workers respond to lower prices by demanding lower wages –Reasonable? Yes real wages return to normal No long term decline in real wages –Realistic? No! see data Nominal wages are rigid Have to wait for productivity –Have lower wage increases than otherwise

All this takes time –3+ years Alternative is for Government to expand AD –Shift AD back –Return to long run equilibrium A Rationale for stabilization policy –After WTC, cut interest rates –Enough? Or too much? Debate over which is best –Policy: “long and variable lags” –Automatic: “long run we are all dead” –Calls for “flexibility” after EMU

Disinflation We can use the model to analyse the issue of deflation –i.e. how do we lower inflation without causing (much) unemployment (lower output) This is the flip-side of what we just looked at –What happens when we try to reduce unemployment We already know part of the answer –LR there is no trade-off No LR increase in unemployment (or loss of output) –SR there is a trade off Reducing inflation will mean higher U (lower Y) –Expectations play a role

 Y Y*Y* LRAS AD 0 AD 1 SRAS(  e ) B A C

Suppose we are at A –Unemployment equals its natural rate (6%) –Inflation is 12% –Too high want to reduce it Reduce AD (increase interest rates) –Unemployment rises: 8% > 6% –Move down the SRAS to B –Actual inflation falls B cannot be LR eqm (why?) –Actual Inflation (9%) is lower than expected (12%) –Real wages higher than expected –Expectations adjust down – –New SRAS

New SR eqm at C –Still not a LR equilibrium –Inflation will keep falling for as long as U is kept above the natural rate When the gov. is satisfied with the level of inflation, –allow unemployment to return to the natural rate –Inflation stable

Disinflation achieved at a cost –Y<Y * for several years –Sacrifice ratio The increase in unemployment (above the natural rate) needed to reduce inflation by one percentage point in one year. My example: 0.66 Example Volker disinflation –Inflation fell by 6.7% over 4 years ( ) –Unemployment was 9.5%, 9,5%, 7.4% and 7.1% –Natural rate was 6% –Sacrifice ratio 1.4

Painless Disinflation Previous example assumed expectations adjust gradually In reality expectations could adjust a lot quicker Think of extreme case –Expectations adjust fully and immediately –Full immediate fall in inflation without any increase in unemployment –Sacrifice ration of zero

What is required for this? –Policy must be announced –Policy must be credible Willing to cause pain Intermediate case is more realistic –More credible policy maker faces a lower sacrifice ratio

What Have We Learned? 1.Expectations affect how fast an economy adjusts to shocks 2.Fiscal and Monetary policy can work to stabilize the economy but they are not without problems. 3.An economy can adjust to shocks by itself if left alone but the process could be slow and painful