14. aggregate supply unemployment and inflation

Aggregate Supply,Aggregate Supply,UnemploymentUnemployment

and Inflationand Inflation

Aggregate Supply, Unemployment and Inflation

Aggregate Supply

AGGREGATE SUPPLY

• Different views on the shape of the AS curve

O

Pric

e le

vel

National output

P

AS

Contrasting views on the aggregate supply curve:(a) Extreme Keynesian

OAD1

Pric

e le

vel

National outputY1

P


AS

YF


O Y1

Pric

e le

vel

National output

AD2

P

AS

YFY2

AD1

O

AS

Pric

e le

vel

National output

Y

Contrasting views on the aggregate supply curve:(b) Extreme Monetarist / New Classical


AS

P1

O

Pric

e le

vel

National output

AD1

Y


AS

O

P1

Pric

e le

vel

National output

AD2

P2

Y

AD1

O

Pric

e le

vel

National output

AS

Contrasting views on the aggregate supply curve:(c) Moderate view


O

AS

Pric

e le

vel

National outputY1

P1

AD1


P2

O

AS

Y1

Pric

e le

vel

National outputY2

P1

AD2

AD1

AGGREGATE SUPPLY


• Short-run aggregate supply

AGGREGATE SUPPLY


• Short-run aggregate supply– the microeconomic foundations

Q1

Short-run response of a profit-maximising firmto a rise in demand

MC

AR1

MR1

£

Q

P1

AR1

MR1

P1

Q1

AR2

MR2

£

Q

MC


MR1

P1

Q1 MR2Q2

P2

£

Q

MC


AR1

AR2

AS short run

The short-run aggregate supply curve

National output

AD1

P1

Y1

AD2

P2

Y2

AD3

P3

Y3

Pric

e le

vel

AGGREGATE SUPPLY



• Long-run aggregate supply

AGGREGATE SUPPLY



• Long-run aggregate supply– the interdependence of firms

AS (long run) AS2 (short run)

AD1

Pric

e le

vel

National output

a

AD2

bc

AS1 (short run)

The long-run AS curve when firms are interdependent

AGGREGATE SUPPLY



• Long-run aggregate supply– the interdependence of firms– investment

Effect of investment on the long-run AS curve

AD1

Pric

e le

vel

National output

a

AS1 (short run)

AS (long run)

AS2 (short run)

AD1

Pric

e le

vel

National output

a

AD2

b

d

AS1 (short run)

Effect of investment on the long-run AS curve

AGGREGATE SUPPLY



• Long-run aggregate supply– the interdependence of firms– investment– expectations

AGGREGATE SUPPLY

• LRAS: monetarist / new classical model– flexible real wage rates

ASL

O

Number of workers

Rea

l wag

e ra

te (W

/ P

)

ADL

We

Qe

N

a b

The aggregate labour market: Monetarist / New Classical analysis

O

Number of workers

Rea

l wag

e ra

te (W

/ P

)

ADL

We

Qe

a b

Assume nowthat AD rises

NASL


O

Number of workers

Rea

l wag

e ra

te (W

/ P

)

ADL

We

Qe

a b

Prices rise.Real wage ratefalls below We

e.g. to W1

W1

NASL


O

Number of workers

Rea

l wag

e ra

te (W

/ P

)

ADL

We

Qe

a b

This gives anexcess demand

for labour of d c.Real wage rate

will rise back to Wec d

W1

NASL


AGGREGATE SUPPLY

• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion

AGGREGATE SUPPLY

• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion– natural level of unemployment

O

Number of workers

Rea

l wag

e ra

te (W

/ P

)

ADL

We

Qe

a b

NASL


AGGREGATE SUPPLY

• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion– natural level of unemployment– implications for shape of LRAS

• LRAS: Keynesian models

AGGREGATE SUPPLY


• LRAS: Keynesian models– wage and price rigidity

N

ADL1

ASL

Keynesian analysis of the aggregate labour market: fall in ADL

O

Number of workers

Rea

l wag

e ra

te (W

/ P

)

We

Qe

a b

ADL2

Q2

Assumption:wage rates are

sticky downwardsc

AGGREGATE SUPPLY


• LRAS: Keynesian models– wage and price rigidity– hysteresis

Keynesian analysis of the aggregate labour market: hysteresis

O

Number of workers

Rea

l wag

e ra

te (W

/ P

)

We

Qe

a b

ADL1ADL2

c

Q2

Assume that thereis now a recovery:

ADL rises back to ADL1.

NASL

O

Number of workers

Rea

l wag

e ra

te (W

/ P

)

We

Qe

a b

ADL1ADL2

c

Q2

There will be amovement up

along ASL2

ASL2

d eWe2

Keynesian analysis of the aggregate labour market: hysteresis

NASL

AGGREGATE SUPPLY


• LRAS: Keynesian models– wage and price rigidity– hysteresis– expectations of output changes

AGGREGATE SUPPLY


• LRAS: Keynesian models– wage and price rigidity– hysteresis– expectations of output changes– long-run money illusion

AGGREGATE SUPPLY

• AS, AD and inflation

– demand-pull inflation

O

National output

Pric

e le

vel

AS

ADAD1

P1 b

AD2

Subsequentsupply response

AS1

P2

P3

aP0

d

c

Demand-pull inflation

O

National output

Pric

e le

vel

AS

AD

P0

AD1

P1

ab

AD2

c

Subsequentdemand response

AS1

d

P2

P3

AD3

P4

e


O

National output

Pric

e le

vel

AS

AD

P0

AD1

P1

ab

AD2

c

AS1

d

P2

P3

AD3

P4

e

Subsequentsupply response

AS2

P5f


O

National output

Pric

e le

vel

AS

AD

P0

AD1

P1

ab

AD2

c

AS1

d

P2

P3

AD3

P4

e

AD4


AS2

fP5

P6

g


AGGREGATE SUPPLY



– cost-push inflation

O

National output

Pric

e le

vel

AS

ADAD1

P1

AS1

P2

P3


AS2

d

P0

ab

c

Cost-push inflation

O

National output

Pric

e le

vel

AS

AD

P0

AD1

P1 ab

c

AS1

d

P2

P3

P4 Subsequentsupply response

AS2

AS3

e

Cost-push inflation

AGGREGATE SUPPLY



– cost-push inflation

– what causes inflation in practice?

Expectations Augmented Phillips

Curve


EXPECTATIONS AUGMENTED PHILLIPS CURVE

• Incorporating expectations into a Phillips equation

• Adaptive expectations

• The accelerationist theory– attempting to reduce unemployment below

the ‘natural’ level

0

4

8

12

16

20

0

P (%).

U (%)6 8I (Pe = 0)

.

b

The accelerationist theory of inflation

a

IV (Pe = 12%).

III (Pe = 8%).

II (Pe = 4%)

P (%).

U (%)6

a

b c

d

8I (Pe = 0)

.

.

e

The accelerationist theory of inflation

f

0

4

8

12

16

20

0






– the long-run Phillips curve

Un

0

4

8

12

16

20

0

P (%).

U (%)6 8

The long-run Phillips curve






– the long-run Phillips curve

– effects of deflationary policies

0

2

4

6

8

10

12

14

16

18

20

22

24

0

P (%).

U (%)8 13

J

X (Pe = 20%).

k

The effects of deflation

0

2

4

6

8

10

12

14

16

18

20

22

24

0

P (%).

U (%)8 13

k

X (Pe = 20%).

XI (Pe = 18%).

XII (Pe = 16%).

l

J

m


0

2

4

6

8

10

12

14

16

18

20

22

24

0

P (%).

U (%)8 13

k

l

m

a

J


• How quickly can inflation be eliminated?– the ‘short, sharp shock’– the slow route

• Explanations of stagflation– clockwise Phillips loops


Year 20

20

0

P (%).

U (%)Un

ab

c

Year 0, 1

Clockwise Phillips loops

Year 5

Year 4

0

20

0

P (%).

U (%)Un

ab

c

d

e f

Year 0, 1

Year 2

Year 3


0

20

0

P (%).

U (%)Un

ab

c

d

e f

h

i

J

Year 0, 1, 10

Year 2, 9

Year 3, 8

Year 4, 7

Year 5, 8


g


• Explanations of stagflation– clockwise Phillips loops– rightward shifts in the long-run Phillips

curve




curve

• Policy implications of the model




curve

• Policy implications of the model– shifting the long-run Phillips curve


0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

75

74

8076

77

79

7173

7278

90

89

97

96

9188

95

82

8384

85

86

93

8792

94

81

Inflation (%)

Unemployment (%)

99

98

Phillips loops in the UK?

0001

02

Rational Expectations and the Phillips Curve


RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Assumptions

– flexible wages and prices

– rational expectations

• Aggregate supply & the Phillips curve: when expectations are correct

– short-run vertical AS curve

O

Pric

e le

vel

National output

AD1

SRAS1 (expected price level = P1)

Q1

AD2

a

P2

Q2

P1

(a) Adaptiveexpectationsb

The effects of an increase in aggregate demand

O

Pric

e le

vel

National output

AD1


P1

Q1

AD2

a

bP2

Q2

SRAS2 (expected price level = P3 )

P3

(a) Adaptiveexpectations

c


O

Pric

e le

vel

National output

AD1


P1

Qn

AD2

a

bP2

Q2


cP3

LRAS

(a) Adaptiveexpectations


O

Pric

e le

vel

National output

AD1


Q1

P1

(b) Rationalexpectations

AD2

a


O

Pric

e le

vel

National output

AD1


Q1

aP1

AD2


P3

c



O

Pric

e le

vel

National output

AD1


aP1

AD2


cP3

Qn

LRAS = SRAS actual




• Assumptions

– flexible wages and prices

– rational expectations

• Aggregate supply & the Phillips curve: when expectations are correct

– short-run vertical AS curve

– short-run vertical Phillips curve

• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market


O

Pric

e le

vel

National output

AD1


P1

Qn

a

Q3

AD2

SRAS2

(expected price level = P2 )

P3

LRAS

P2

How a rise in aggregate demand could cause a rise in national output

AD3

b

O

Pric

e le

vel

National output

AD1

SRAS1

(expected price level = P1)

P1

Qn

a

Q3

AD2

SRAS2

(expected price level = P2 )

P3

LRAS

P2

How a rise in aggregate demand could cause a fall in national output

AD3

c

• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market– the labour market


ASL2 ((W / P )e > W / P )

O

Rea

l wag

e ra

te (W

/ P

)

Number of workers

ADL

Q1

Underpredictionof inflation

Q2

ASL1 ((W / P )e = W / P )

Effects in the labour market of an underprediction of inflation

• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market– the labour market– implications for the Phillips curve

• Policy implications of rational expectations

• Real business cycles– persistent shifts in aggregate supply– turning points


O

Infla

tion

(%)

Unemployment (%)

P e = P

. .P

e > P. .

P e < P

. .

New classical version of short-run Phillips curves



• Real business cycles




• Real business cycles– persistent shifts in aggregate supply




• Real business cycles– persistent shifts in aggregate supply– turning points


Modern Keynesian Views


MODERN KEYNESIAN VIEWS

• Modern developments of the Keynesian model

• Growth in equilibrium unemployment– higher structural unemployment– hysteresis

• The persistence of demand-deficient unemployment– payment of efficiency wages– insider power


• Incorporation of expectations

– expansion of aggregate demand

O

Infla

tion

(%)

Unemployment (%)

U1

P1

.I

II

Z

U2

P2

.c

a

b

Keynesian analysis of reflationary policies




– contraction of aggregate demand

O

Infla

tion

(%)

Unemployment (%)

I

U2

b

U1

a

Keynesian analysis of deflationary policies

L

O

Infla

tion

(%)

Unemployment (%)

U1

Ia b

U2

c

Keynesian analysis of deflationary policies




– contraction of aggregate demand

• Keynesian criticisms ofnon-intervention

Common Ground Among Economists?


COMMON GROUND AMONG ECONOMISTS?

• Short-run effects of changes in aggregate demand

• Long-run effects of changes in aggregate demand

• Role of expectations

• Importance of supply-side factors

14. aggregate supply unemployment and inflation

Education