Aggregate Demand (AD) & Aggregate Supply (AS) 1. Neoclassical A.S. curve 2. Modified Keynesian A.S. 3. Expectations-augmented A.S. 4. Rational expectations A.S. Appendices -- Other AS relationships: 5. wage-indexation; 6. real business cycles (RBC) Lecture 20: Aggregate Supply -- Price level P, Inflation π, & Wages W ITF220 - Prof.J.Frankel

Aggregate Demand curve slopes down ITF220 - Prof.J.Frankel P ↑ => LM shifts left (“real balance effect”) => Y ↓ => M1 / P ↓ y p AD Why?

A monetary expansion shifts AD to the right. ITF220 - Prof.J.Frankel By how much? y p AD AD ´ By the answer to IS-LM. By how much? Or it shifts AD up. In proportion to Δ M1. { Equilibrium outcome (Y vs. P) depends on AS. ● ● ● ●

The notion of Aggregate Supply If demand rises too rapidly, it shows up in the price level, not output. In practice, the path of potential output is often measured by the point beyond which inflation begins to accelerate; and the natural rate of unemployment ū is measured as the rate below which inflation begins to accelerate. ITF220 - Prof.J.Frankel

US output fell sharply below potential in Brad deLong, Jan

Inflation fell in the global recession. World Economic Outlook, p.6

Can readily be derived from aggregation of supply decisions by individual firms which maximize profits and operate in competitive goods & labor markets. ITF220 - Prof.J.Frankel

Employment determines output, via the production function. And the real wage determines employment, via the demand for labor. If M arginal P roduct of labor > W/P If M P of labor < W/P Sum labor demand across all firms. Then set equal to supply of labor. Determines w. => hire more N => cut N ● ● ITF220 - Prof.J.Frankel

AD´ AS´ ● ● ( w P/W ) σ, In the all-purpose supply function, ITF220 - Prof.J.Frankel

MONETARY EXPANSION RAISES AD IN THE SR  A rise in the current level of M shifts LM curve out, because M/P , in the SR.  Alternatively, a rise in expected future growth rate of M shifts IS out, because  e  => r  => A . Either way, IS-LM shifts right => AD shifts right: Result is higher Y and higher P. ●

SR: Point B in Figure MR: Point C. LR: Point D. and in long run P e adjusts to P. σ =1. Implications: Demand expansion goes partly into P, partly into Y in the short run; entirely into P in the long run ITF220 - Prof.J.Frankel

26.4 Initially – Point A. Then monetary expansion. MR -- Point C: P e adjusts partway => W does too. LR -- Point D: P e, and so W, have fully adjusted. SR -- Point B: before W has had time to adjust. ● ● ● ● ITF220 - Prof.J.Frankel

Bob Lucas Implications: An unpredictable demand expansion goes partly into P, party into Y in the short run; but predictable demand expansions have no effect on Y, even in the short run.  Committing monetary policy to a nominal anchor Would reduce inflation at little cost in terms of output. ITF220 - Prof.J.Frankel

Mexican sexenio From 1976 through 1994, inflation would shoot up the peso would devalue, and/or every 6 th year (presidential election years). ITF220 - Prof.J.Frankel Example of rational expectations:

ITF220 - Prof.J.Frankel If monetary policy cannot have a systematic effect on output anyway, the central bank might as well give up, and attain the only goal it can: price stability. But only if it “ties its hands” will its commitment not to inflate be credible.

ITF220 - Prof.J.Frankel Alternative Nominal Anchors Money supply targets (e.g., monetarism in 1980s.) Pegged price of gold (e.g., classical gold standard) Price level target (e.g., Inflation Targeting) Fixed exchange rate (e.g., currency board)

Appendix I: More AS relationships 5. Indexed wages – Application: real wage rigidity in Europe, vs. US. 6. Real Business Cycle theory ITF220 - Prof.J.Frankel Appendix II: Measures of output gap

ITF220 - Prof.J.Frankel Explicit wage indexation: Examples in 1970s-80s -- US: Cost of Living Adjustment clauses Italy: scala mobile Argentina: complete indexation of everything Implicit real wage rigidity: Example -- thought to characterize Europe.

If actual real wage > warranted real wage w, Y < permanently. Growth in demand will not show up in increased employment. E.g., comparison of US vs. Europe: – In the 1970s the upward trend of warranted w slowed sharply <= productivity slowdown <= oil shocks. – In the US, employment continued to rise, but real w did not; – in Europe, real continued to rise, but employment did not. ITF220 - Prof.J.Frankel

In the 1970s, the upward trend of warranted w slowed sharply, employment rose in US,while real wage contracts rose in Europe. ITF220 - Prof.J.Frankel

The Netherlands may have found a “middle way.” ITF220 - Prof.J.Frankel One view: Europeans prefer job security; Americans prefer job growth.

“Labor market rigidities” in Europe go beyond sticky real wages; They include also, e.g., laws against laying off workers, which discourage hiring. ITF220 - Prof.J.Frankel

6. Real business cycle (RBC) theory Y = N =. According to this theory, all fluctuations are due to real (supply) factors: – technology shocks & – shifts in preferences for work vs. leisure. – Not monetary policy. ITF220 - Prof.J.Frankel

Three measures of excess supply tend to move together. Source: IMF, World Economic Outlook.. Appendix II: Measures of output gap

Output gap in eurozone periphery Source: IMF Economic Outlook, Sept (note: data for 2012 are predictions) Greece & Ireland overheated by 2007: Y >> and crashed in : Y << Like Italy, Spain & Portugal in ITF220 - Prof.J.Frankel

Inflation turned negative in , along with the output gap, and again in ITF220 - Prof.J.Frankel