1. Chapter 21 Aggregate supply, prices and adjustment to shocks
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2. The classical model of macroeconomics
The classical model of macroeconomics is the polar opposite of the extreme Keynesian model.
It analyses the economy when wages and prices are fully flexible.
In this model, the economy is always at its potential level.
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3. The classical model of macroeconomics (2)
Excess demand or supply are rapidly eliminated by wage or price changes so that potential output is quickly restored.
Monetary and fiscal policy affect prices but have no impact on output.
In the short run, before wages and prices have adjusted, the Keynesian position is relevant, whilst the classical model is relevant to the long run.
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4. A simple monetary policy rule
This shows how monetary policy works when interest rates are set in pursuit of an inflation target. r i
Real Interest Rate
When inflation is above (below) the target Π*, real interest rates are set higher (lower) than normal.
Along the schedule ii a given monetary policy is being pursued. i Π*
Inflation
If the inflation rate is Π* , the corresponding real interest rate will be i*
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5. A simple monetary policy rule (2)
The central bank is interested in the real interest rate, which affects aggregate demand,
But the central bank does not directly control the price of output or the inflation rate.
Hence, to achieve the ii schedule, the central bank first forecasts inflation, then sets a nominal interest rate r to achieve the real interest rate i ( = r – ) that it desires.
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6. The aggregate demand schedule
Output
Inflation AD
The aggregate demand schedule (AD) shows that higher inflation reduces aggregate demand by inducing the central bank to raise real interest rates.
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7. The aggregate demand schedule (2)
The slope of the schedule is determined by:
the reaction of interest rate decisions to inflation
and the responsiveness of aggregate demand to interest rate changes
Consequently:
It will be flat when
interest rate decisions respond a lot to inflation,
and aggregate demand is highly responsive to interest rate changes.
It will be steep when
interest rate decisions do not respond much to inflation,
and aggregate demand responds little to interest rate changes.
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8. Aggregate supply and potential output
Potential output depends upon:
the level of technology
the quantities of available inputs (labour, capital, land energy)
the efficiency with which resources and technology are used
In the short run we can treat potential output as given.
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9. The classical aggregate supply schedule
The classical model has an aggregate supply curve which is vertical at potential output.
This means that equilibrium output can be reached at different levels of inflation.
In the classical model, people do not suffer from money illusion.
Consequently, only changes in real variables influence other real variables.
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10. The classical aggregate supply schedule (2)
This schedule shows the output firms wish to supply at each inflation rate. AS
Inflation
When wages and prices are
flexible, output is always at its
potential level (Y*).
Potential output is the economy’s long-run equilibrium output. Y*
Output
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11. The classical aggregate supply schedule (3)
Better technology will shift AS to the right and hence increase potential output.
Increased employment will also shift AS to the right and increase potential output,
as will the use of more capital.
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Equilibrium AS A
Overall equilibrium is
shown, where AD = AS
at the potential output
level Y* and inflation level *. AD * 
Inflation
At A, the goods, money and labour markets are all in equilibrium. Y*
Output
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13. Equilibrium: A supply shockD
AS1
A beneficial supply shock raises
potential output by shifting AS0 to
AS1and lowers inflation to 2* at D. 
2*
Y1*
AS0 
This will lead to an increased amount of money being demanded: to achieve money market equilibrium at this interest rate, the bank must supply more money.
AD1 C
If the central bank pursues a target of 0* when the economy is at potential output, it must respond by reducing its target real interest rate.
Inflation
0*  A
AD0
Y0*
Output
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14. Equilibrium inflation: a demand shock
Beginning at A, an increase in
aggregate demand brought by an increase in investment say, would shift AD0 to AD1 moving us to a new equilibrium B. At B, potential output is the same but  is higher at 1* B
1*
AS0
Inflation
0*  A
The central bank will raise interest rates to shift AD1 back to AD0 . Thus restoring equilibrium at A.
AD0
Y0*
Output
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15. The speed of adjustment
Adjustment in the Classical world is rapid, so the economy is always at potential output (full employment).
If wages and prices are sluggish, then output may deviate from the potential level.
A Keynesian world of fixed wages and prices may describe the short run period before adjustment is complete.
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16. Supply-side economics
The pursuit of policies aimed not at increasing aggregate demand, but at increasing aggregate supply.
A way of influencing potential output, seen as critical in the classical view of the economy.
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17. Adjustment in the labour market
Short-run
First few months
Medium-run
2 years
Long-run
4-6 years
Clearing
the labour
market
Largely
given
Beginning
to adjust
WAGES
Flexible
Flexible
Normal
work week
HOURS
Largely
given
Beginning
to adjust
Full
employment
EMPLOYMENT
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18. Short-run aggregate supply
If adjustment is not instantaneous, output may diverge from its potential level in the short run.
Firms may vary labour input
via hours of work (overtime or layoffs).
Wages may be sluggish in failing to restore full employment in response to a fall in aggregate demand.
The short-run aggregate supply schedule (SAS) shows how desired output varies with inflation, for a given inherited growth of nominal wages.
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19. The short-run aggregate supply scheduleB
Firms raise prices when wage costs rise. Each SAS function reflects a different rate of inherited nominal wage growth.
SAS
Inflation A
 0
SAS1
SAS2
For any given rate, higher inflation moves firms up a given short-run supply schedule. A2
 2
A persisting boom or slump gradually bids nominal wage growth up or down shifting short run supply schedules. Y Y*
Output
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20. The adjustment process
When SAS and AD are combined, changes in AD lead mainly to a change in output in the short run.
Over time, deviations from full employment gradually change wage growth and short- run aggregate supply.
The economy, therefore, gradually works its way back to potential output.
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21. A lower inflation target
Starting from long-run
equilibrium at E: AS
AD'
the inflation target is cut
from * to 3*: the raising of
interest rates to achieve this
shifts AD to AD'.
SAS
Inflation E * E' 1
Given wage levels, firms
adjust to E' in the short run.
SAS'
As the labour market (wage)
adjusts, SAS shifts e.g. to SAS’. 2 E2
3*
SAS3
With inflation at ' but wages unchanged, the real wage rises, bringing involuntary unemployment. E3 AD Y*
Output
Equilibrium is eventually reached at E3, back at Y*.
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22. A temporary supply shock e.g. an increase in the price of oil
SAS'
Higher oil prices force firms to raise prices, so SAS shifts to SAS’.
SAS
 ' E'
Equilibrium moves from E to E’. Y'
Higher inflation reduces aggregate demand as the central bank raises real interest rates
Inflation
 * E AD
Lower output and employment at E' gradually reduce inflation and nominal wage growth, shifting SAS' back to SAS so Y* is restored. Y*
Output
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Output Gaps
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24. Tradeoffs in monetary objectives
Inflation targeting works well when all shocks are demand shocks.
When shocks are supply shocks, stabilizing inflation may lead to highly variable output.
Conversely, a policy of stabilizing output may lead to highly variable inflation.
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25. Tradeoffs in monetary objectives (2)
One way round this is to steer a middle course by using a Taylor Rule, i.e. a rule that takes into account deviations of both inflation and output from their long-run levels.
Another is to allow flexible inflation targeting
because the inflation target is a medium-run one, this allows some discretion for reducing variability in output
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The Taylor Rule
Formally, the Taylor rule implies that real interest i obeys
i – i* = a(π- π*) +b (Y-Y*)
In the long run, the real interest rate is i*, inflation is π*, and real output is Y*.
Inflation above target, or output above target, is a signal to raise interest rates and vice versa.
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