Lecture 20: Aggregate Supply - Harvard University · PDF fileThe notion of Aggregate Supply...
Transcript of Lecture 20: Aggregate Supply - Harvard University · PDF fileThe notion of Aggregate Supply...
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Aggregate Demand (AD)
& Aggregate Supply (AS)
1. Ultra-Keynesian A.S. case 2. Neoclassical A.S. case 3. Intermediate A.S. curve
4. Expectations-augmented A.S. curve 5. Rational-expectations A.S. 6. Real Business Cycle models (RBC)
Appendices -- 7. Labor market rigidities.
Lecture 20: Aggregate Supply -- Price level P, Inflation π, & Wages W
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Aggregate Demand curve slopes down.
ITF220 - Prof.J.Frankel
Say P ↑
=> LM shifts left
(“real balance effect”)
=> Y ↓
=> M1 / P ↓
y
p
AD
Why? (e.g., because W↑)
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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.
●
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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 𝒀 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
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US output fell sharply below potential in 2008-09.
Brad deLong, Jan. 2014 http://delong.typepad.com/delong_long_form/2014/01/the-relative-efficacy-of-fiscal-and-monetary-policy-at-the-zero-lower-bound-where-are-the-goalposts-anyway-the-honest-bro.html
𝒀
𝒀
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Inflation fell in the 2008-09 global recession. WORLD ECONOMIC OUTLOOK (WEO)
Uneven Growth: Short- and Long-Term Factors
April 2015 IMF
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Can readily be derived from aggregation of supply decisions by individual firms that maximize profits and
operate in competitive goods & labor markets.
ITF220 - Prof.J.Frankel
All-purpose supply function: 𝑌/𝑌 = (ω 𝑃/𝑊)σ
𝑌 ≡ potential output
W ≡ nominal wage
W/P ≡ real wage
ω ≡ “warranted real wage”
σ ≡ elasticity of aggregate supply .
Then ω ≡ MP of Labor at full employment. (See graphs in Appendix I.)
ALTERNATIVE SUPPLY RELATIONSHIPS
where:
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API-120 - Prof. J. Frankel, Harvard University
Two polar extreme cases
1) Ultra-Keynesian case:
AS flat, at 𝑃 => AD expansion goes entirely into Y.
y
p
y
p
AD'
AD'
AS
AS 2) Classical case
AS vertical at 𝑌 => AD expansion goes entirely into P.
Realistic in Very Short Run.
Only AS shocks move Y , e.g., productivity shocks.
Realistic in Long Run.
𝑦
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AGGREGATE SUPPLY (continued)
𝑌𝑌 = ω 𝑃
𝑊 σ
● 3) Intermediate case:
W = 𝑊 => AS has some slope, even in the SR.
SR supply relationship:
Implication: Demand expansion goes partly into P, partly into Y.
y
p
AD'
AS
●
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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.
●
AS long run
AS short run
AD initial
AD expanded
p
pe
y
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AGGREGATE SUPPLY (continued)
Milton Friedman
𝑌𝑌 = ω 𝑃
𝑊 σ
𝑌𝑌 = 𝑃 𝑃𝑒 σ
or in logs, y - 𝑦 = σ (π − π𝑒) where π ≡ p – p-1
and πe ≡ pe – p-1 .
W is set in line with Pe, which adjusts over time.
Yearly wage contract 𝑊 = ω 𝑃𝑒.
SR supply relationship:
● 4) Friedman-Phelps supply curve:
But over time πe adjusts to actual π, so Y = 𝑌 . In LR, AS is vertical.
SR: Point B in Figure 26.4. MR: Point C. LR: Point D.
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26.4
Initially – Point A. Then monetary expansion.
MR -- Point C: Pe adjusts partway => W does too.
LR -- Point D: Pe, and so W, have fully adjusted.
SR -- Point B: before W has had time to adjust.
● ●
●
●
ITF220 - Prof.J.Frankel
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OVERVIEW OF AGGREGATE SUPPLY (continued)
Robert Lucas
● 5) Lucas supply relationship
𝑌𝑌 = 𝑃 𝑃𝑒 σ
or in logs, y - 𝑦 = σ (π − π𝑒)
= σ ε,
Rational expectations => ε is unforecastable.
where ε is the forecast error.
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.
Committing monetary policy to a nominal anchor would reduce inflation at little cost in terms of output.
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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.
Odysseus tied to
the mast
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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)
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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
Y
N
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Appendix II: Another AS relationship
• 7. Indexed wages
– Application: real wage rigidity in Europe, vs. US.
ITF220 - Prof.J.Frankel
Appendix III: Measures of output gap
Appendix I: Derivation of general AS relationship
Appendix IV: An example of rational expectations
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Employment determines output, via the production function.
And the real wage determines employment, via the demand for labor.
If a firm’s Marginal Product 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
●
Appendix I
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An alternative approach:
ITF220 - Prof.J.Frankel
allows firms to be imperfectly competitive, with a profit mark-up over cost, but still has Y↑ => P ↑ via firms’ demand for labor & marginal cost.
The New Keynesian Phillips curve
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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.
Appendix II: Labor market rigidities
7.
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If actual real wage > warranted real wage ω,
• Y < permanently .
• Growth in demand will not show up in increased employment. – because it is “classical unemployment,”
not Keynesian unemployment.
• 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.
Y
ITF220 - Prof.J.Frankel
w
w
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In the 1970s & 80s, the upward trend of warranted w slowed sharply, employment rose in US, while real wage contracts rose in Europe.
ITF220 - Prof.J.Frankel
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The Netherlands may have found a “middle way.” ITF220 - Prof.J.Frankel
One view: Europeans prefer job security; Americans prefer job growth.
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ITF220 - Prof.J.Frankel
source: Giuseppe Bertola (2001)
“Labor market rigidities” in Europe go beyond sticky real wages;
They include also, e.g., laws against laying off workers, which discourage hiring.
One view of the divergence Between Germany & Greece: Labor market reforms enacted by Gerhard Schröder 2003-05 improved labor market efficiency.
Employment Protection Legislation often does not raise overall employment.
If anything, the reverse.
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ITF220 - Prof.J.Frankel
Three measures of excess supply tend to move together.
Source: IMF,
World Economic Outlook.
.
Appendix III: Measures of output gap
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Inflation turned negative in 1930-33, along with the output gap,
and again in 1938-39
ITF220 - Prof.J.Frankel
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Jobs vary with GDP though usually less-than-proportionately , in practice.
”G20 labour markets: outlook, key challenges and policy responses,” Sept. 2014, ILO, OECD, World Bank Group,
Report prepared for the G20 Labour and Employment Ministerial Meeting, Melbourne, Australia,
Data: OECD Quarterly National
Accounts Database; OECD Labour
Force Statistics Database, Eurostat,
Annual national accounts for the
European countries, ILO, ILOSTAT
Database and results from national
labour force surveys for Argentina and
India.
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Mexican sexenio
From 1976 through 1994,
inflation would shoot up
the peso would devalue,
and/or
every 6th year (presidential election years). ITF220 - Prof.J.Frankel
Appendix IV An example of rational
expectations: