January 07, 2012

Macroeconomics

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Aggregate Supply Analysis – Classical View

Aggregate Supply

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»Role of Aggregate Demand in determining

the economy’s output

»What does the AD curve signify?

»What is Aggregate Supply and how does the

curve look like?

»Combinations of output and the price level

at which firms are willing, at the given price

level, to supply the given quantity of output

Production Function

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»Technological relation between the rates of

input of productive resources and the

maximum rate of output that can be had

from the inputs, given the technology of

production

»Example?

»What does production function mean in the

microeconomic context?

»Y = f(K, N)

Production Function

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»Output’s relationship to capital stock and

labor employed?

»Recall diminishing returns!

»Assumption for the model: Constant capital

stock and technology

»New production function: Y = f(N)

»The production function graph

»Reason why the slope reduces?

Demand for Labor Function

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»Assumption: Given capital stock, pure

competition

»Demand for labor curve consists of the MP

of labor curve

»The condition of W = P * MPL

»Cost of hiring an additional worker vis-à-vis

the revenue associated with the

employment of the additional laborer

Demand for Labor Function

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»W/P = MPL

»To obtain the demand curve, the

relationship between real wage and the

amount of labor is used

»Slope of the production function

»Downward sloping demand curve for labor:

ND = f(W/P)

»Shifts in demand for labor

Supply of Labor Function

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»Real wages play a key role!

»NS = f(W/P)

»Relationship between real wages and labor

supplied

Summary of labor demand and supply

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»Production is entirely a function of the quantity

of labor: Y = f(N)

»Amount of labor supplied depends only on real

wage and increases with real wage

»Amount of labor demanded also depends only

on real wage rate and decreases with it

»Real wages perfectly flexible (“flex price”)

»Economy is made up of efficiently operating

markets that are very flexible (ND = NS = N)−

Keynesian Aggregate Supply Model

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»Criticism of assumptions made in Classical

model

»Similarity of views on Aggregate Production

Function and demand for labor

»Keynesian Assumptions:

»Nominal wage is exogenous (No rapid

adjustment)

»Labor market is not always in equilibrium

Classical Analysis of Income Determination

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»Say’s Law of Markets: Supply creates its own

demand

»Exchange between parties involves two

transactions of the counteractive nature

»No overproduction of goods

»Possibility of preference of total output

surpassing total demand

»Extension of this theory: Money is not preferred

for money!

Equilibrium in the Classical Model

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»Economy consists of 3 markets: Labor, money

and goods

»Labor Market:

»Y = f(N)

»dY/dN = W/P

»ND = f(W/P)

»NS = f(W/P)

»ND = NS

Equilibrium in the Classical Model

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»Money Market:

»M = KPY

»Goods Market:

»S = f(r)

»I = f(r)

»S = I

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Aggregate Supply Analysis – Keynesian View

Great Depression

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»Classical economists and Say’s law of demand

»Possibility of producing too much of one type of

good and not enough of other type

»Mechanism of wage-price flexibility

»Reasoning: What happens to price when there is

excess supply or excess demand?

»What happens during ‘glut’?

»Keynes viewed AS from a supply side – supply

creates its own demand

Great Depression

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»Spending induces supply

»What happens when individuals and firms spend

lesser or cut back on their budgets? And how

can it be linked to employment?

»Classical economists’ argument on employment

and surplus labor

»Keynesian framework equilibrium does not

happen at the full employment stage. Why or

How?

Equilibrium in the Keynesian Model

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»Economy consists of the same 3 markets in

Keynesian view as well

»Labor Market:

»Y = f(N)

»dY/dN = w/P

»ND = f(w/P)

»W = w

−

−

−

Equilibrium in the Keynesian Model

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»Money Market:

»M = KPY + L(r)

»Goods Market:

»S = f(r)

»I = f(r)

»S = I

»Y = C + I

»Y – C = I; Y – C = S

Wage rigidity

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»Implicit agreement between a business firm and

its key employees

»What happens to a firm that reduces wages?

»As real wages rise the firm lays off workers

»Does inflexible wage mean nominal wages are

also inflexible?

»When will there be an excess supply of labor?

»What happens when price level falls?

»Unemployment arises because of sticky wages

Classical Vs. Keynesian Income Determination

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»3 most important differences in Keynes’

theory

»Wage rigidity Vs. wage-price flexibility

(for situations less than full employment)

»Speculative demand for money

»Income being a far more important

determinant of saving and consumption

than rate of interest (r)

Classical Vs. Keynesian Analysis

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Classical Keynesian

Full Employment exists. Equilibrium at full employment

Full Employment is a special case. Equilibrium at lesser than full employment

Supply creates its own demand Demand creates its own supply

No overproduction Possibility of glut. Supply doesn’t always match demand

No government intervention No ‘laissez faire’.

Wage cut can solve unemployment problem

Wage cuts increases unemployment

Importance of savings and thrift Saving was a private virtue and can’t be forced

Classical Vs. Keynesian Analysis

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Classical Keynesian

Static approach to income/output analysis

Dynamic and a macro approach to output analysis

No faith in fiscal or monetary policies

State intervention through fiscal and monetary policy advocated

Did not take into account business cycles

Considered business cycles in the form of employment

Balanced budget policyDeficit budget during deflation and surplus budget during inflation

Keynesian Chain of causation

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Changes in the quantity of money

Changes in the rate of interest

Changes in Aggregate Demand

Changes in Total Output

Changes in Marginal Costs

Changes in Prices

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Economic Fluctuations and Unemployment

Introduction

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»Efficient operation of an economy is determined

by:

»Real output

»Full employment

»Price Stability

»Can economic expansion lead to recession?

»What happens to the 3 factors mentioned above

in times of recession/depression?

»Fluctuations observed in growth rate of NNPFC

Business Cycles

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»Business Cycle is a swing in total national

output, income and employment (usually lasting

for a period of 2-10 years)

»Marked by widespread expansion or contraction

in many sectors of the economy

»Business peak or boom – Rapid growth of real

GNP

»Contraction or recessionary trough – Businesses

slow, unemployment increases

»Recovery or expansion - ?

Business Cycles

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»4 stages of a business cycle

»Recovery or revival of economic activity

»Prosperity or expansion of activity

»Recession or downturn of activity

»Depression or contraction in activity

»What order do they follow? Does there need to

be an order?

»What is meant by the length of a cycle?

»Do all businesses go through the same cycle?

A few examples

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»What happens to the following variables during

recovery, boom, recession and depression?

»Industrial production

»Profits

»Investment

»Wage rate

»Business failure

»Business expectations

Theories of business cycles

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»Interaction between the multiplier and the

accelerator

»Multiplier theory – Income is determined by

investment

»Accelerator theory – Current investment

depends upon the change in aggregate output

»To maintain constant investment ‘ceiling’ and

‘floor’ are necessary

»Theories concentrating on inventories, public

expenditure

Theories of business cycles

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»Stabilization policies - ?

»How effective are stabilization policies in

developing countries?

»Factors driving ups and downs in a country like

India:

»Performance of agricultural sector

»Behavior of public investments

»Ad hoc policy changes (licensing, subsidies?)

Indicator forecasting

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»Can business cycles be predicted earlier? How?

»What do you understand by leading and lagging

indicators?

»Examples of leading, lagging and coinciding

indicators

»Gives advance warning about turning points in

economic activity

PNG image

Employment Fluctuations

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»What is the importance of employment rates in

an economy?

»Barometer effect

»Keynes – Level of employment is driven by

effective demand

»Unemployment arises because of a deficiency.

What deficiency does this imply?

»Would providing incentives to investors help?

»Involuntary and frictional unemployment

Employment Fluctuations

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»Unemployment:

»(Number of persons unemployed/number in

civilian labor force)*100

»Sign of economic inefficiency

»Frictional unemployment

»Cyclical unemployment

»Structural unemployment

»Link between employment and output

Full Employment

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»Zero unemployment?

»Level of employment that results when the rate

of unemployment is normal

»Thumb rule – 94 – 95% employment

Some statistics:

1. Indian population 2011 – 1.21 bn

2. Unemployment rate for 2011 – 9.4%

3. Unemployment rate for 2010 – 10.7%

Full Employment

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»Natural rate of unemployment is the long run

average of unemployment caused due to

frictional and structural changes

»Major cause of increase in unemployment –

Power to reject job offers

»Actual and Natural rate of unemployment –

Difference?

»What happens to these two during periods of

booms or recessions?

Measurement Problems

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»People excluded though they prefer to work,

people being included who are not active job

seekers

»People seeking employment are not counted as

unemployed

»Part-time workers – Is one hour a week enough?

»People who are not seeking employment are

classified as unemployed

Unemployment Programs

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»Not launched at a large scale

»Result – Reduction in unemployment is marginal

»Problems in implementing employment

guarantee programs:

»Resources

»Choice of appropriate works to be done

»Charity

»Agreement among decision makers is low

Disguised unemployment

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»No standard unit to measure labor productivity

»Too many people involved for a job involving

less number of people

»Relocation of productive resources can add to

saving potential

»Problems in relocating additional human

resources?

»Is there a way to identify sectors of

improvement?

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Price Stability

Inflation

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»An increase in the general level of prices over a

sustained period of time

»Is increase in the price of a particular type of

good called inflation?

»Recall some common measures of inflation

»3 classifications: Creeping, galloping and

hyperinflation

»If WPI is 314.6 in year 1 and 329.8 in year 2,

what would be the inflation?

Economic Impacts of Inflation

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»Effect of Inflation on distribution of income and

wealth?

»What happens to wealth during inflation?

Does it always erode?

»Who gains during inflation?

»Is income of poor indexed to inflation?

»Effect of Inflation on Output and Growth

»Short Run

»Long Run

Inflation in AD-AS Framework

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»Demand-Pull Inflation

»“Too much money chasing too few goods”

»Logic: General rise in price level is because

demand always exceeds the supply at

existing prices

»Real factors: Increase in Government

expenditure with no change in tax receipts

and vice versa

»Monetary factors: Decrease in demand or

increase in supply of money

Inflation in AD-AS Framework

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»Cost-Push Inflation

»Inflation originates from the supply side

»Wage-Push Inflation

»Profit-Push Inflation

»Supply-shock Inflation

Introduction to Phillips Curve

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»Phillips curve establishes a relationship

between rate of wage increase and rate of

unemployment

»What happens to unemployment when wage

rates increase?

»Modified Phillips Curve measures inflation and

unemployment

»Example: If money-wage rates are increasing by

5% and labor productivity is increasing by 2%,

then inflation is?

Introduction to Phillips Curve

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»Justification for downward slope: Organized

labor’s effort to increase wages unmatched with

the increase in labor productivity

»Degree to which organized labor can obtain a

wage increase depends on?

»Phillips curve indicates a trade-off between

inflation and unemployment

»Indicates policy makers flexibility

»“Stagflation” where both increase

simultaneously

Inflation in India

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»Problem of inflation exists right from the first

Five Year Plan

»Observed that whenever inflation has been

high, agricultural production was the cause

»Inflation in India could be attributed to the

excess of money supply and bottlenecks in

supply of goods and services

»Is there one reason explaining the inflation

rates in India?

Factors driving inflation

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»Demand-Pull:

»Government Expenditure

»Hoarding, black-marketing activities

»Population explosion?

»Cost-Push factors:

»Violent fluctuations in output

»Upward revision of administered prices

»Oil shocks and global inflation

Questions???

Have a happy Sunday!