The New Classical model and Aggregate Supply

1. The Classical theory of employment2. Labor supply and the expected real wage3. Potential output and the “natural rate” of

unemployment.4. The short-run aggregate supply curve5. Adjustment to long-run equilibrium6. Closing expansionary and contractionary gaps7. Shifts of (long-run) aggregate supply

The New Classical viewMarket, industrialized

economies are self-adjusting and tend automatically to

full-employment

The Classical model3 pillars of the Classical system:

1. Say’s law2. Classical labor market analysis3. 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.

Postulates1. Labor supply (Ns)depends on the expected real

wage)2. Labor demand (Nd ) depends on the actual real

wage.3. Employers can accurately forecast future prices;

suppliers of labor services make forecast errors.

Classical labor market analysis

apep

ap

wW

ee

p

wW

Definitionsis the actual future price level

is the expected future price level

is the actual real wage

is the expected real wage

w is the nominal wage

If ae pp then ae WW

7

Short-run aggregate supply curve

SRAS130

Potential output

Pric

e le

vel

140

120

130

Real GDP (trillions of dollars)

0 14.0

a

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.

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.

Pric

e Le

vel

Real GDP0

ae pp ae pp

Potential GDP

LRAS

The short runIn 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

deae NWWppp

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 gapWhen We > W, output will

expand above the its potential level. This is a

temporary situation, however.

14

Short-run equilibrium when the price level exceeds expectations

Potential output

Pric

e le

vel

140

130

135

AD

SRAS130

b

Real GDP (trillions of dollars)

0 14.0 14.2

a

SRAS140

c

LRAS

Expected price level=130, SRAS130 If actual price level turns out as expected, the quantity supplied = potential output of $14 trillion.Given the AD curve, price level > expected; output exceeds potential (b); expansionary gap.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.

Contractionary gap

deae NWWppp

•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.

16

Short-run equilibrium when the price level is below expectations

Potential output

Pric

e le

vel

130

120

125

AD”

SRAS130

d

Real GDP (trillions of dollars)

0 14.013.8

SRAS120

e

LRAS

a

Actual price level < expected (intersection of AD” with SRAS130); short-run equilibrium: (d). Production below economy’s potential opens a contractionary gap.

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.

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.

18

Long-run aggregate supply curvePr

ice

leve

l

140

120

130

AD”

Real GDP (trillions of dollars)

0 14.0

Potential outputLRAS

ADAD’

b

a

c

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.

19

US output gap measures actual GDP minus potential output as percentage of potential output

1984 1988 1992 1996 2000 2004 2008

20

Effect of a gradual increase in resources on aggregate supply

Pric

e le

vel

LRAS LRAS’

Real GDP (trillions of dollars)

0 14.514.0

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.

21

Effects of a beneficial supply shock on aggregate supply

LRAS LRAS’

Real GDP (trillions of dollars)

0 14.214.0

Pric

e le

vel

130

125

AD”

SRAS130

SRAS125

b

a

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.

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.

22

LRASLRAS”

Real GDP (trillions of dollars)

0 14.013.8

Pric

e le

vel

130

125

AD”

SRAS130

SRAS135

c

a

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.

If the shock is just temporary, the shift of the aggregate supply curves will be temporary.

Effect of an adverse supply shock on aggregate supply