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


O

Pric

e le

vel

National output

P

AS

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


O

AD1

Pric

e le

vel

National output

Y1

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 output

Y1

P1

AD1



P2

O

AS

Y1

Pric

e le

vel

National output

Y2

P1

AD2

AD1



• 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 curveThe short-run aggregate supply curve

National output

AD1

P1

Y1

AD2

P2

Y2

AD3

P3

Y3

Pri

ce le

vel





• Long-run aggregate supply










– the interdependence of firms






AS (long run) AS2 (short run)

AD1

Pri

ce le

vel

National output

a

AD2

bc

AS1 (short run)

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







– investment






– investment

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

AD1

Pri

ce le

vel

National output

a

AS1 (short run)

AS (long run)

AS2 (short run)

AD1

Pri

ce le

vel

National output

a

AD2

b

d

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


ASL

O

Number of workers

Re

al w

ag

e ra

te (

W /

P)

ADL

We

Qe

N

a b

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

O

Number of workers

Re

al w

ag

e ra

te (

W /

P)

ADL

We

Qe

a b

Assume nowthat AD rises

NASL


O

Number of workers

Re

al w

ag

e ra

te (

W /

P)

ADL

We

Qe

a b

Prices rise.Real wage rate

falls below We

e.g. to W1

W1

NASL


O

Number of workers

Re

al w

ag

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 We

c dW1

NASL




– no money illusion






– natural level of unemployment




O

Number of workers

Re

al w

ag

e ra

te (

W /

P)

ADL

We

Qe

a b

NASL






– implications for shape of LRAS

• LRAS: Keynesian models





• LRAS: Keynesian models






• LRAS: Keynesian models– wage and price rigidity






N

ADL1

ASL

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

O

Number of workers

Re

al w

ag

e ra

te (

W /

P)

We

Qe

a b

ADL2

Q2

Assumption:wage rates are

sticky downwardsc







– hysteresis






– hysteresis

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

O

Number of workers

Re

al w

ag

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

Re

al w

ag

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: hysteresisKeynesian analysis of the aggregate labour market: hysteresis

NASL







– hysteresis

– expectations of output changes






– hysteresis








– hysteresis


– long-run money illusion






– hysteresis


– long-run money illusion


• AS, AD and inflation

– demand-pull inflation



O

National output

Pri

ce le

vel

AS

ADAD1

P1b

AD2

Subsequentsupply response

AS1

P2

P3

aP0

d

c

Demand-pull inflationDemand-pull inflation

O

National output

Pri

ce le

vel

AS

AD

P0

AD1

P1

a

b

AD2

c

Subsequentdemand response

AS1

d

P2

P3

AD3

P4

e


O

National output

Pri

ce le

vel

AS

AD

P0

AD1

P1

a

b

AD2

c

AS1

d

P2

P3

AD3

P4

e

Subsequentsupply response

AS2

P5f


O

National output

Pri

ce le

vel

AS

AD

P0

AD1

P1

a

b

AD2

c

AS1

d

P2

P3

AD3

P4

e

AD4


AS2

fP5

P6

g





– cost-push inflation




O

National output

Pri

ce le

vel

AS

ADAD1

P1

AS1

P2

P3


AS2

d

P0

ab

c

Cost-push inflationCost-push inflation

O

National output

Pri

ce le

vel

AS

AD

P0

AD1

P1 ab

c

AS1

d

P2

P3

P4 Subsequentsupply response

AS2

AS3

e

Cost-push inflationCost-push inflation





– what causes inflation in practice?




– what causes inflation in practice?

Expectations Augmented Phillips

Curve

Expectations Augmented Phillips

Curve


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





0

4

8

12

16

20

0

P (%).

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

.

b

The accelerationist theory of inflationThe 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 inflationThe 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 curveThe long-run Phillips curve







– effects of deflationary policies






– 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 deflationThe 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



– the slow route




Year 20

20

0

P (%).

U (%)Un

ab

c

Year 0, 1

Clockwise Phillips loopsClockwise Phillips loops

Year 5

Year 4

0

20

0

P (%).

U (%)Un

ab

c

d

ef

Year 0, 1

Year 2

Year 3


0

20

0

P (%).

U (%)Un

ab

c

d

ef

h

i

J

Year 0, 1, 10

Year 2, 9

Year 3, 8

Year 4, 7

Year 5, 8


g



– the slow route



– rightward shifts in the long-run Phillips curve



– the slow route







– the slow route




• Policy implications of the model



– the slow route








– the slow route





– shifting the long-run Phillips curve



– the slow route





– 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?Phillips loops in the UK?

0001

02

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





O

Pri

ce 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 demandThe effects of an increase in aggregate demand

O

Pri

ce le

vel

National output

AD1

SRAS1


P1

Q1

AD2

a

bP2

Q2

SRAS2

(expected price level = P3 )

P3

(a) Adaptiveexpectations

c


O

Pri

ce le

vel

National output

AD1

SRAS1


P1

Qn

AD2

a

bP2

Q2

SRAS2


cP3

LRAS

(a) Adaptiveexpectations


O

Pri

ce le

vel

National output

AD1

SRAS1


Q1

P1

(b) Rationalexpectations

AD2

a


O

Pri

ce le

vel

National output

AD1

SRAS1


Q1

aP1

AD2

SRAS2


P3

c



O

Pri

ce le

vel

National output

AD1

SRAS1


aP1

AD2

SRAS2


cP3

Qn

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




O

Pri

ce le

vel

National output

AD1

SRAS1


P1

Qn

a

Q3

AD2

SRAS2


P3

LRAS

P2

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

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

AD3

b

O

Pri

ce le

vel

National output

AD1

SRAS1


P1

Qn

a

Q3

AD2

SRAS2


P3

LRAS

P2

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

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

AD3

c



– the labour market





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

O

Re

al w

ag

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 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






– turning points


O

Infla

tion

(%)

Unemployment (%)

P e = P

. .P

e > P. .

P e < P

. .

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





• Real business cycles





• Real business cycles







– turning points






– turning points


Modern Keynesian Views

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



O

Infla

tion

(%)

Unemployment (%)

U1

P1

.

I

II

Z

U2

P2

.c

a

b

Keynesian analysis of reflationary policiesKeynesian analysis of reflationary policies




– contraction of aggregate demand




O

Infla

tion

(%)

Unemployment (%)

I

U2

b

U1

a

Keynesian analysis of deflationary policiesKeynesian analysis of deflationary policies

L

O

Infla

tion

(%)

Unemployment (%)

U1

Ia

b

U2

c

Keynesian analysis of deflationary policiesKeynesian analysis of deflationary policies





• Keynesian criticisms ofnon-intervention




• Keynesian criticisms ofnon-intervention

Common Ground Among Economists?

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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