Aggregate Supply, Unemployment and Inflation

Aggregate Supply,Aggregate Supply,UnemploymentUnemployment

and Inflationand Inflation

Aggregate Supply, Unemployment and InflationAggregate Supply, Unemployment and Inflation

Aggregate SupplyAggregate Supply

AGGREGATE SUPPLYAGGREGATE SUPPLY

• Different views on the shape of the AS curve

National output

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

National output

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

National output

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

National output

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

National output

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

National output

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

National output

• Short-run aggregate supply

– the microeconomic foundations

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

Q1 MR2Q2

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

AS short run

The short-run aggregate supply curveThe short-run aggregate supply curve

National output

• Long-run aggregate supply

– the interdependence of firms

AS (long run) AS2 (short run)

National output

AS1 (short run)

The long-run AS curve when firms are interdependentThe long-run AS curve when firms are interdependent

– investment

Effect of investment on the long-run AS curveEffect of investment on the long-run AS curve

National output

AS1 (short run)

AS (long run)

AS2 (short run)

National output

AS1 (short run)

Effect of investment on the long-run AS curveEffect of investment on the long-run AS curve

– investment

– expectations

– investment

– expectations

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

Number of workers

The aggregate labour market: Monetarist / New Classical analysisThe aggregate labour market: Monetarist / New Classical analysis

Number of workers

Assume nowthat AD rises

Number of workers

Prices rise.Real wage rate

falls below We

e.g. to W1

Number of workers

This gives anexcess demand

for labour of d c.Real wage rate

will rise back to We

– no money illusion

– natural level of unemployment

Number of workers

– implications for shape of LRAS

• LRAS: Keynesian models

• LRAS: Keynesian models– wage and price rigidity

Keynesian analysis of the aggregate labour market: fall in ADLKeynesian analysis of the aggregate labour market: fall in ADL

Number of workers

Assumption:wage rates are

sticky downwardsc

– hysteresis

Keynesian analysis of the aggregate labour market: hysteresisKeynesian analysis of the aggregate labour market: hysteresis

Number of workers

ADL1ADL2

Assume that thereis now a recovery:

ADL rises back to ADL1.

Number of workers

ADL1ADL2

There will be amovement up

along ASL2

d eWe2

Keynesian analysis of the aggregate labour market: hysteresisKeynesian analysis of the aggregate labour market: hysteresis

– hysteresis

– expectations of output changes

– hysteresis

– long-run money illusion

– hysteresis

– long-run money illusion

• AS, AD and inflation

– demand-pull inflation

National output

Subsequentsupply response

Demand-pull inflationDemand-pull inflation

National output

Subsequentdemand response

National output

Subsequentsupply response

National output

– cost-push inflation

National output

Cost-push inflationCost-push inflation

National output

P4 Subsequentsupply response

Cost-push inflationCost-push inflation

– what causes inflation in practice?

Expectations Augmented Phillips

EXPECTATIONS AUGMENTED PHILLIPS CURVEEXPECTATIONS AUGMENTED PHILLIPS CURVE

• Incorporating expectations into a Phillips equation

• Adaptive expectations

• The accelerationist theory

– attempting to reduce unemployment below the ‘natural’ level

P (%).

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

The accelerationist theory of inflationThe accelerationist theory of inflation

IV (Pe = 12%).

III (Pe = 8%).

II (Pe = 4%)

P (%).

U (%)6

8I (Pe = 0)

The accelerationist theory of inflationThe accelerationist theory of inflation

– the long-run Phillips curve

P (%).

U (%)6 8

The long-run Phillips curveThe long-run Phillips curve

– effects of deflationary policies

P (%).

U (%)8 13

X (Pe = 20%).

The effects of deflationThe effects of deflation

P (%).

U (%)8 13

X (Pe = 20%).

XI (Pe = 18%).

XII (Pe = 16%).

P (%).

U (%)8 13

• How quickly can inflation be eliminated?

– the ‘short, sharp shock’

– the slow route

• Explanations of stagflation

– clockwise Phillips loops

– the slow route

Year 20

P (%).

U (%)Un

Year 0, 1

Clockwise Phillips loopsClockwise Phillips loops

Year 5

Year 4

P (%).

U (%)Un

Year 0, 1

Year 2

Year 3

P (%).

U (%)Un

Year 0, 1, 10

Year 2, 9

Year 3, 8

Year 4, 7

Year 5, 8

– the slow route

– rightward shifts in the long-run Phillips curve

– the slow route

• Policy implications of the model

– the slow route

– shifting the long-run Phillips curve

– the slow route

– shifting the long-run Phillips curve

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

Inflation (%)

Unemployment (%)

Phillips loops in the UK?Phillips loops in the UK?

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

Inflation (%)

Unemployment (%)

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

Inflation (%)

Unemployment (%)

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

Inflation (%)

Unemployment (%)

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

Inflation (%)

Unemployment (%)

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

Inflation (%)

Unemployment (%)

Rational Expectations and the Phillips CurveRational Expectations and the Phillips Curve

RATIONAL EXPECTATIONS AND THE PHILLIPS CURVERATIONAL 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

• Assumptions

National output

(expected price level = P1)

(a) Adaptiveexpectationsb

The effects of an increase in aggregate demandThe effects of an increase in aggregate demand

National output

(expected price level = P3 )

(a) Adaptiveexpectations

National output

(a) Adaptiveexpectations

National output

(b) Rationalexpectations

National output

LRAS = SRAS actual

• Assumptions

– short-run vertical Phillips curve

• Assumptions

– short-run vertical Phillips curve

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

– the goods market

National output

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

National output

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

– the labour market

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

Number of workers

Underpredictionof inflation

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

Effects in the labour market of an underprediction of inflationEffects in the labour market of an underprediction of inflation

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

– implications for the Phillips curve

• Policy implications of rational expectations

• Real business cycles– persistent shifts in aggregate supply

– turning points

Unemployment (%)

P e = P

e > P. .

P e < P

New classical version of short-run Phillips curvesNew classical version of short-run Phillips curves

• Real business cycles

– turning points

Modern Keynesian Views

MODERN KEYNESIAN VIEWSMODERN 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

• 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

Unemployment (%)

Keynesian analysis of reflationary policiesKeynesian analysis of reflationary policies

– contraction of aggregate demand

Unemployment (%)

Keynesian analysis of deflationary policiesKeynesian analysis of deflationary policies

Unemployment (%)

Keynesian analysis of deflationary policiesKeynesian analysis of deflationary policies

• Keynesian criticisms ofnon-intervention

Common Ground Among Economists?

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

• Short-run effects of changes in aggregate demand

• Long-run effects of changes in aggregate demand

• Role of expectations

• Importance of supply-side factors

Aggregate Supply, Unemployment and Inflation

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