Chapter: Aggregate supply, the price level, and the speed of adjustment

Chapter 26 Aggregate supply, the price level, and the speed of adjustment

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

Introducing prices and the labour market

n In discussing equilibrium within the IS-LM model, it has been assumed that – prices are fixed – the supply-side of the economy can be

ignored.

n These assumptions must now be

relaxed.

26.2

The price level and aggregate demand

n The CLASSICAL model of macroeconomics analyses the economy when wages and prices are fully flexible.

n The real money supply is the key variable linking the aggregate demand for goods and the price level.

n The price level is the average price of all the goods produced in the economy.

26.3

The macroeconomic demand schedule

LM0 r

LM1

Income

IS

P P0

P1

MDS

Income

Real money supply is nominal money supply divided by the price level – it influences the position of LM. With price at P0, LM is located at LM0, and given IS, real income is in equilibrium at Y0. At a lower price P1, LM is at LM1, and real income at Y1. The macroeconomic demand schedule (MDS) connects these points ... Y0 Y1

26.4

The macroeconomic demand schedule

LM0 r

LM1

IS1

IS0 Income

P P0

P1 MDS'

Income

MDS

The MDS shows the different combinations of the price level and real income at which planned spending equals actual output once interest rates are set to keep money market equilibrium. Notice that a fall in price may also shift IS by increasing the value of household wealth via the real balance effect. The effect of this is to produce a flatter schedule MDS'.

Y0

Y1

Y2

26.5

The labour market and aggregate supply

– shows the output that firms wish to

n The aggregate supply schedule

supply at each price level.

n Given that output depends on inputs employed, the labour market is the starting point for analysing aggregate supply.

26.6

The labour market

AJ

e g a w

l

a e R

LF

w*

LD

Employment, labour force

LD is the labour demand schedule: it shows how much labour firms demand at each real wage. The schedule LF shows that more people will be in the labour force at higher values of the real wage. AJ shows how many workers have accepted jobs at each real wage.

N* N2

Equilibrium is where AJ = LD, at N*. N2 – N* is the natural rate of unemployment.

26.7

The labour market

e g a w

AJ

l

LF

A B The unemployment that occurs in equilibrium (shown by N2 – N*) is voluntary.

a e R

C w1

w*

LD

If the real wage is above its equilibrium at w1, there is unemployment given by N3 – N1. Of this, BC is voluntary, but AB is involuntary.

N*

N3

N1

N2 Employment, labour force

26.8

The aggregate supply schedule

l

e v e l e c i r P

AS

P

MDS

Output

Yp

In the CLASSICAL model, with no money illusion and flexible money wages, AS is vertical at the level of potential output. Flexibility of wages and prices ensures that real wage adjustment maintains full employment in the labour market.

So overall equilibrium is shown where MDS = AS at the potential output level Yp and price level P.

26.9

Monetary and fiscal policy

l

e v e l e c i r P

AS E' P'

E P0 MDS'

MDS

Output

Yp

Changes in nominal money supply or in fiscal policy shift the MDS, altering the level of aggregate demand at each price. But a shift from MDS to MDS' alters equilibrium from E to E'; price increases from P0 to P' but output remains at Yp.

In the Classical model, a change in nominal money supply leads to an equivalent % change in nominal wages & prices.

Real money supply, interest rates, output, employment and real wages ALL remain unchanged.

26.10

Fiscal policy

n An increase in government expenditure in

this model – bids up prices – so real money supply is lower – interest rates rise – private expenditure on consumption and

– i.e. there is complete crowding out – all that changes is the composition of

investment falls

– the public sector becomes more important.

aggregate demand

26.11

The speed of adjustment

n Adjustment in the Classical world is rapid,

so the economy is always at potential output (full employment).

n If wages and prices are sluggish, then

output may deviate from the potential level.

n A "Keynesian" world of fixed wages and prices may describe the short run period before adjustment is complete.

26.12

Supply-side economics

n The pursuit of policies aimed not at

increasing aggregate demand, but at increasing aggregate supply.

n A way of influencing potential output, seen as critical in the Classical view of the economy.

26.13

Adjustment in the labour market

Medium run (1 year) Short-run (3 months)

WAGES Largely given Beginning to adjust

Long-run (4-6 years) Clearing the labour market

HOURS Demand- determined Normal work week

Hours/ employment mix adjusting EMPLOYMENT Full employment Largely given

26.14

Short-run aggregate supply

n If adjustment is not instantaneous, output

may diverge from Yp in the short run.

n Firms may vary labour input

– via hours of work (overtime or layoffs)

n Wages may be sluggish in falling to restore full employment in response to a fall in aggregate demand

n The short-run aggregate supply schedule shows the prices charged by firms at each output level, given the wages they pay.

26.15

The short-run aggregate supply schedule

Suppose the economy is initially at Yp in full- employment equilibrium at A, with price P0

l

SAS

A

e v e l e c i r P

SAS1 P0

B

In response to a fall in aggregate demand, firms in the short run vary labour input, thus moving along SAS to B.

SAS2

P2

A2

Output

Yp

In time, the firm is able to negotiate lower wages, and the SAS shifts to SAS1 and then to SAS2, until equilibrium is restored at A2.

26.16

A fall in nominal money supply

l

AS

SAS

E

e v e l e c i r P

SAS'

E'

SAS3

P P' P'' P3

E3

MDS Starting from long-run equilibrium at E: a fall in nominal money supply shifts MDS to MDS' Given wage levels, firms adjust to E' in the short run With price at P' but wages unchanged, the real wage rises bringing involuntary unemployment. MDS'

As the labour market (wage) adjusts SAS shifts e.g. to SAS'

Output

Yp

Equilibrium is eventually reached at E3, back at Yp.

26.17

An adverse supply shock: e.g. an increase in the price of oil

SAS'

P

Higher oil prices force firms to charge more for their output, so SAS shifts to SAS'

SAS

equilibrium from E to E'

E'

P' P

E

Higher prices cause a move along MDS, and output falls to Y'

MDS

Output

Y' Yp'

In time, unemployment reduces wages and SAS gradually shifts back to SAS, so Yp is restored.

26.18