Post on 17-Dec-2015
What are we modelling?Focus on explaining fluctuations
in real GDP, Y, and the GDP Deflator, P.
Framework reminiscent of the supply and demand model.
Two Aspects of Potential OutputPotential Output is unrelated to
the price level but is determined by capital infrastructure, efficiency of labor markets, population, technological know-how. ◦Output increases above potential
only if unemployment falls below natural level;
◦if unemployment rises above natural level, output will be below potential.
Potential output and labor market. Potential output can be viewed
as a level consistent with equilibrium in labor market.
When output is above potential output, low unemployment and the search for workers will push up wages.
When output is below potential, high unemployment and the surplus of workers will push down wages.
P
Y
Potential Output
Upward Pressure on Wages
Downward Pressure on Wages
YP
Unemployment below natural rate
Unemployment above natural rate
Sticky Wages & SRASMoney wages paid to workers
adjust dynamically over time through negotiation.
At a given wage, a rise in the price level reduces the cost of labor relative to value of goods produced making hiring labor to produce goods more attractive.
At a given wage rate, higher prices induce higher production → in the short run, supply is positively associated with output.
1. Shift in Potential OutputAdvance in Technology Frontier,
PP& E, or expansion in potential labor force (population, demographics).
Shifts SRAS w/ potential output. 2. Shifts in SRASWhen dollar cost of labor (or prices of
energy) shift, changes in costs are passed on into prices.
Wages and other cost shifters shift SRAS at a given level potential output.
Expenditure: C + I + G + NX
Wealth Effect – Real value of monetary assets rises as prices fall. This adds to wealth of households stimulating consumption.
Competitiveness Effect – Holding exchange rate constant, a lower price level makes domestic exports more attractive and foreign imports less stimulating net exports.
Prices and Spending
Prices and LiquidityDepending on monetary policy,
there may be a negative relationship between prices and the liquidity that central banks make available.
More on that later.
EquilibriumEquilibrium in the competitive market
occurs when the price is set at a level (P*) such that the amount that consumers want to buy is equal to the amount that sellers want to sell (Y*). Excess Supply If P were above equilibrium,
sellers would want to sell more goods than buyers would want to buy. Competition between sellers would force prices down.
Excess Demand If P were below equilibrium, customers would want to buy more goods than people would want to sell. Competition between buyers would force prices up.
Self Correction ProcessBusiness cycles have a natural
end. The equilibrium output may be greater than or less than potential output, however, in that case surplus or shortage of workers in labor markets will be putting downward or upward pressure on wages.
Pressure on wage costs will shift the supply curve until equilibrium output is equal to potential output.
Cyclical FluctuationsPeriod-by-period, different
important events will impact the economy. We will think of these events as primarily driving the demand side of the economy (shifting the AD curve) or primarily driving the supply side (shifting the supply side).
The strength of these will determine the correspondence between movements in output and inflation.
P
Y
AS
Output below potential. Downward pressure on wages. Cost of production falls and AS shifts down
AD1
YP
AD2
Y**
P***
1
2
AS2
Wages fall
3
As costs fall, competitive prices fall, there is a movement along the AD curve.
P
Y
AS4
Wages will keep falling until the surplus of labor is absorbed – when prices fall enough that demand reaches potential output
AD1
YP
AD2
Y**
P**
4
AS2
Wages fall
3
What shifts the AD curve?
Shift outward in AD Shift inward in AD
Increasing Optimism Increasing Pessimism
Increasing Value of Assets Falling Value of Assets
Increasing Foreign GDP Decreasing Foreign GDP
Expansionary Monetary Policy
Contractionary Monetary Policy
Expansionary Fiscal Policy Contractionary Fiscal Policy
Consumer Confidence and…
http://business.asiaone.com/Business/News/Story/A1Story20091229-188708.html
http://hk.nielsen.com/news/20091103.shtml
..and Business Confidence…
BNP Parabis Research
..and changes in Asset Prices..http://urbanpolicy.berkeley.edu/pdf/CQSAdvMacro2005Web.pdf
AS-AD and Expected inflation
Potential GDP generally increases at a consistent rate.
On average, aggregate quantity of liquid assets tends to increase faster than potential GDP.
Workers wages will tend to rise to match increases in the cost of living.
AD does not always rise evenly with GDP.
P
Y
ASt
Dynamic AS-AD Model: Trend Path
ADt
Yt*
YtP YP
t+1
ADt+1
ASt+
1
Y*t+1
Pt*
P*t+1
Demand expansion matches supply expansion
Average Inflation
P
Y
ASt
Dynamic AS-AD Model: Inflation Acceleration
ADt
Yt*
YtP YP
t+1
ADt+1
ASt+
1
Y*t+1
Pt*
P*t+1
Gap
Demand expands faster than expected
Expected Inflation
Positive Output Gap
Inflation rises more than usual
P
Y
ASt
Dynamic AS-AD Model: Recession, Inflation Deceleration
ADt
Yt*
YtP YP
t+1
ADt+1
ASt+
1
Y*t+1
Pt*P*t+1
Expected Inflation
Gap
Demand expands slower than expected
Negative Output Gap
Inflation rises less than usual
Inflation Acceleration: πt – πt-1
UK 1992-2008
-4
-3
-2
-1
0
1
2
-4 -3 -2 -1 0 1 2 3
Output Gap
Infl
atio
n A
ccel
erat
on
P
Y
AS
Supply side shocks cause output and prices to move in opposite directions: Stagflation
AD1
P*
Y*
AS2
Y**
P**
1
2
Commodity Prices increase..
In 2007, rising commodity & energy prices lead to global inflation
Bank of England Report