EC202A Macroeconomics

1. EC202A Macroeconomics The AS-AD model Reading material that you may find useful: Abel, Bernanke and McNabb, Chapters 11 and 13 Abel, Bernanke, 5th ed, Chapters 10 and 12. Dornbusch, Fisher and Startz, Chapters 5-6 (9th ed)

2. Objective of the lecture • Unemployment and inflation are the most important macroeconomic problems for almost any country in the world. Politicians try to win consensus by promising low inflation and high growth. • Moreover, unemployment and inflation are linked empirically by the Phillips curve, a fact that is missed by the IS-LM model, because of the assumption of fixed prices. Therefore, we need another framework.

3. Objective of the lecture • While keeping some of the foundations built in the previous lectures, we will now take the analysis further by relaxing the assumption of fixed prices, and we will develop the AD-AS model, as a basic macroeconomic tool for determining output, employment and the price level.

4. Outline • The labour market ; • The aggregate supply curve and price adjustments ; • The AS-AD model ; • The Phillips curve ; • The expectations-augmented Phillips curve .

5. The labour market • The full employment level of output is the level of output that is produced in an economy when there is full employment, that is, labour demand is equal to labour supply: LS Given the production function and the current stock of capital K, the full employment level of output is a function of NF: YF = f(NF) Also: N = f-1(Y) Real wages LD NF Labour, N

6. The labour market • If the current level of output is persistently different from YFand the labour supply or demand haven’t changed, then there is disequilibrium in the labour market, which must be explained in some way (i.e. imperfect information, coordination problems, efficiency wages,…) We call the unemployment rate that exists when output is at full employment level YF the natural rate. The natural rate exceeds zero because of frictions in the labour market (i.e. shifting between jobs) and lags in matching demand with supply for labour. LS Real wages LD NF Labour, N

7. The Classical Flexible-Price model • The assumption that wages and prices are flexible was commonly made by classical economists • Thus, this assumption is often called the classical assumption: • it guarantees that all markets clear • it guarantees full employment • it guarantees that actual output is equal to potential output

8. The Classical Flexible-Price model • In the Classical Flexible-Price model: • The Savings = Investment equilibrium determines the real interest rate: S = Y - C = I(r) • The levels of potential output and real wages are determined in the labour market: LS(w) = MPN • The aggregate price level is determined by the quantity theory of money: M ∙velocity = P ∙Y

9. The aggregate supply curve and price adjustments • We call the relationship between the aggregate level of output and the price level in the economy the Aggregate Supply Curve or AS: The short-run AS curve reflects an assumption that in the short-run the price level is fixed and firms are willing to supply any amount of output at that price level. Long runAS P Short run AS But in the long run prices adjust so that output is at full employment level YF. Y YF

10. The aggregate supply curve and price adjustments • The horizontal short-run AS curve is exactly equivalent to the assumption of fixed prices in the IS-LM-BP model, which served us well to answer a certain kind of questions. But if we want to analyse the link between unemployment and prices, this assumption becomes too simplistic. In practice, wages and prices are slow to adjust, therefore the aggregate supply is upward sloping in the short run. LRAS P SRAS Y YF

11. The aggregate supply curve and price adjustments • The theory of aggregate supply is one of the least settled areas in macroeconomics. There is a general consensus that prices adjust slowly to changes in output demanded, but there are a number of different theories used to explain this phenomenon. • Here we review 3 theories (not mutually exclusive): • Misperception, or imperfect information ; • Coordination problems ; • Efficiency wages.

12. The aggregate supply curve and price adjustments • Misperception, or imperfect information: • Producers have imperfect information about the general price level. As a result, producers forecast the price level using their imperfect information. They don't know whether a price change is due to a change in the overall price level or a market-specific demand, but they have an expectation of the general price level. • When a producer sees that the price of his own product has increased above the expected general price level, he assumes that the relative price of his product has increased, so he will increase production to earn more money.

13. The aggregate supply curve and price adjustments • Misperception, or imperfect information: • In other words, producers misinterpret changes in the general price level as changes in relative prices. This leads to a short-run aggregate supply curve that isn’t vertical. If P > PE, producers are fooled into thinking that the relative prices of their own goods have risen, and they increase their output. LRAS P SRAS PE If P < PE, producers believe that the relative prices of their goods have fallen, and they reduce their output. Y YF

14. The aggregate supply curve and price adjustments • Different firms within an economy cannot coordinate price or wage changes in response to policy changes. If any one firm increases its price but no one else does, then the single firm that raised its price will loose business. • Coordination problems : LRAS • If Y > YF, producers may react in 2 ways: • changing prices so as to restore full employment in the labour market (at output level YF) ; • Or, decide to accommodate demand. P SRAS Y YF

15. The aggregate supply curve and price adjustments • Unsure about the behaviour of competitors, individual firms change their prices or wages only reluctantly, preferring to accommodate demand rather than changing prices. • Therefore, if demand • increases prices do not rise • enough to bring the economy • back to YF. This leads again • to a short-run aggregate • supply curve that • isn’t vertical. • Coordination problems : LRAS P SRAS Y YF

16. The aggregate supply curve and price adjustments • Employers pay above market-clearing wages to motivate their workers to work harder, and are reluctant to change wages because of the perceived cost (efficiency loss) involved. • On the other hand, firms are inclined to pay higher wages also because they can pass this cost onto consumers, in the form of higher prices. This happens because each firm enjoys some degree of monopoly power in her own market. • Efficiency wages:

17. The aggregate supply curve and price adjustments • In addition, there are long-term relations between firms and workers, that is, wages are usually set in nominal terms and wage contracts are renegotiated only periodically. As prices change over time, real wages fluctuate over the length of the wage contract. • Efficiency wages:

18. The aggregate supply curve and price adjustments • As a result of the existence of efficiency wages, at any point in time real wages need not be at the level needed to clear the labour market, therefore actual output need not be equal to YF. • Efficiency wages: LRAS The process of adjusting wages and prices continues until the economy eventually gets back to full employment, and the level of output will go back to YF, but during this process output adjusts only slowly to the changes. P SRAS YF Y

19. The AS-AD model • The aggregate demand curve AD shows the relationship between the quantity of goods demanded and the price level when the goods market and the money market are in equilibrium. So the AD curve represents the price levels and output levels at which the IS and LM curves intersect. LM (P=P2) r LM (P=P1) IS Y P P2 P1 AD Y

20. The AS-AD model • The AD curve slopes downward because a higher price level is associated with lower real money supply, shifting the LM curve up, raising r, and decreasing Y. • Any factor that causes the intersection of the IS and LM curves to shift causes the AD curve to shift. • For example, an increase in government expenditure shifts the IS to the right, so it shifts the AD curve to the right as well. LM r IS2 IS1 Y P AD2 AD1 Y

21. The AS-AD model • Equilibrium in the AD-AS model: • Short-run equilibrium: AD intersects SRAS • Long-run equilibrium: AD intersects LRAS LRAS P If the economy isn’t in general equilibrium, economic forces work to restore equilibrium both in AD-AS diagram and IS-LM diagram. SRAS AD YF Y

22. The Phillips curve • Many people think there is a trade-off between inflation and unemployment. The idea is that, to reduce unemployment, the economy must tolerate high inflation, or alternatively that, to reduce unemployment, more inflation must be accepted. • The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain. • Statistical studies also found a similar negative relationship for other countries and time periods. • Since then, economists have looked at the relationship between unemployment and inflation.

23. The Phillips curve • The Phillips curve shows an empirical inverse relationship between the unemployment rate and increases in the nominal wage rate. • This relationship can be expanded into a relationship between inflation and unemployment, which implies that the Phillips curve and the AS-curve can be viewed as two alternative ways to study price adjustments

24. The Phillips curve Example: The Phillips curve and the U.S. economy during the 1960s

25. The Phillips curve • In the 1950s and 1960s the prevailing view was that the economy had a negative relationship between the two variables. This suggested that policymakers could choose the combination of unemployment and inflation they most desired: • = – h(u – u)Phillips curve • However, in the following decades the negative relationship failed to hold. The 1970s were a particularly bad period, with both high inflation and high unemployment, inconsistent with the Phillips curve.

26. The Phillips curve Example: Inflation and unemployment in the United States, 1970–2002

27. The Phillips curve This experience raised at least 3 important questions: Why was the original Phillips curve frequently observed historically (Britain before 1958 and the US and Europe in the 1960s) ? Why did it seem to vanish after 1970 ? Does the Phillips curve actually provide a menu of unemployment and inflation rates from which politicians can choose? economic theory provided an answer to these questions, even before the actual breakdown of the Phillips curve!

28. The expectations-augmented Phillips curve • During the second half of the 1960s, Friedman and Phelps questioned the logic of the Phillips curve. They argued that there should not be a stable negative relationship between inflation and unemployment. Instead, a negative relationship should exist between unanticipated inflation (the difference between actual and expected inflation) and cyclical unemployment (the difference between actual and natural unemployment rates).

29. The expectations-augmented Phillips curve • How does this work in the AD-AS model? • First case: anticipated increase in money supply LRAS P • AD shifts up and SRAS shifts up, with no misperceptions because the increase in the money supply is fully anticipated ; • Result: P rises, Y unchanged ; • Inflation rises with no change in unemployment . SRAS2 SRAS1 AD2 AD1 YF Y

30. The expectations-augmented Phillips curve • Second case: unanticipated increase in money supply LRAS P • Money supply rises unexpectedly, so AD1 shifts to AD2 ; • Result: Y rises as misperception occur ; • Long run: misperception goes away as producers cannot be fooled indefinitely . P rises, Y declines to full-employment level. SRAS2 SRAS1 AD2 AD1 YF Y

31. The expectations-augmented Phillips curve • Thus, when the public correctly predicts aggregate demand growth and inflation, unanticipated inflation is zero, actual employment equals the natural rate, and cyclical unemployment is zero. If aggregate demand goes up unexpectedly, the economy faces a period of positive unanticipated inflation and negative cyclical unemployment. –e : unanticipated inflation (u – u) :cyclical unemployment h : a positive number The relationship between unanticipated inflation and cyclical unemployment implied by this analysis is: –e= – h(u – u)

32. The expectations-augmented Phillips curve • The preceding equation expresses the idea that unanticipated inflation will be positive (negative) when cyclical unemployment is negative (positive). • We can re-write it as: • = e – h(u – u) Expectations-augmented Phillips curve

33. EC202A Macroeconomics The Phillips curve and the aggregate supply Reading material that you may find useful: Abel, Bernanke and McNabb, Chapter 13. Abel, Bernanke, 5th ed, Chapter 12 Dornbusch, Fisher and Startz, Chapter 6 (9th ed).

34. Objective of the lecture • The Phillips curve is one of the most controversial relationships in macroeconomics, whose existence has been questioned several times. • Does the original Phillips curve relationship apply to all historical cases?

35. The Original Phillips Curve for the United Kingdom

37. Inflation and unemployment in the UK 1978-2000

38. Objective of the lecture • In this lecture we will see how economic theory can explain these apparently illogical patterns in the data. We will focus on the role of expectations and credibility.

39. Outline: • The Phillips curve and the aggregate supply; • Shifts in the AS curve ; • Macroeconomic policy ; • Credibility ; • The shifting Phillips curve in practice • Supply shocks .

40. The Phillips curve and the aggregate supply • The original Phillips curve showed an empirical inverse relationship between the unemployment rate and increases in the nominal wage rate. • This relationship can be expanded into a relationship between inflation and unemployment, which implies that the Phillips curve and the AS-curve can be viewed as two alternative ways to study price adjustments.

41. The Phillips curve and the aggregate supply Write the simple Phillips curve as: gW = – h ∙(u – u) Where: gW : changein the nominal wage rate u : actual unemployment rate u : natural unemployment rate (u – u) : cyclical unemployment h: responsiveness of wages to unemployment when u = u, gW = 0

42. The Phillips curve and the aggregate supply • When u = u, the labour market is in equilibrium. Thus, the estimated Phillips curve provides a measure of the natural rate of unemployment in a country. For example, by looking at the previous graph, we can see that the natural rate for Britain in the period 1861-1913 was about 5%. • However, the simple Phillips curve fell apart in the 1960s. Friedman and Phelps showed that this happened because the original Phillips curve lacked an important element: inflation expectations.

43. The Phillips curve and the aggregate supply • When workers and firms bargain over wages, they are concerned with the real value of wages, so they take into account expected inflation. For example, a wage increase of 3% with expected inflation of 0 is quite a different thing from the same wage increase with e= 10%. • Now we need 2 more steps to go from the Phillips curve to the AS curve. Thus, according to Friedman and Phelps: gW –e= – h ∙(u – u)

44. The Phillips curve and the aggregate supply Step 1: Specify the relationship between wage growth and prices • Assumption: firms set prices according to a mark-up rule P = (1+m) ∙W Where: m = mark-up ; P= price ; W= wage . As a result: gW =

45. The Phillips curve and the aggregate supply Step 2: Specify the relationship between unemployment and output • According to Okun’s law: (Y–YF )/ YF = –ω ∙ (u – u) Where: Y = output ; YF= full-employment or potential output ; ω ≈ 2.5

46. The Phillips curve and the aggregate supply • gW –e= – h ∙(u – u) • gW = • (Y–YF )/ YF = –ω ∙ (u – u) • –e=h/ω∙ (Y–YF )/ YF • = (Pt– Pt-1 )/ Pt-1 • e= (PEt– Pt-1 )/ Pt-1 • (Pt– Pt-1 )/ Pt-1–(PEt– Pt-1 )/ Pt-1= • =h/ω∙ (Y–YF )/ YF

47. The Phillips curve and the aggregate supply • Therefore, the AS curve : • Pt–PEt= Pt-1∙ h/ω∙ (Y–YF )/ YF • Pt = PEt+ Pt-1∙ h/ω∙ (Y–YF )/ YF Simplification: Pt-1 = 1 a = (h/ω)/ YF Pt = PEt+ a ∙ (Y–YF ) Short-runAS curve

48. The Phillips curve and the aggregate supply • The slope of the SRASdepends on a, its position depends on PEt. Pt = PEt+ a ∙ (Y–YF ) Pt SRAS PE Y YF • 3 cases are possible: • If a = 0, then the SRASis horizontal. • If a = infinity, then the SRASis vertical. • If a > 0, then the SRASis upward-sloping.

49. The Phillips curve and the aggregate supply But if the SRASwere horizontal, prices would be fixed, which is unrealistic. Pt SRAS YF Y Pt SRAS But if the SRASwere vertical, then Y=YFalways. This can be true only if, whenever Y≠YF, firms increase their prices until Y=YFagain. YF Y

50. The Phillips curve and the aggregate supply We know that, whenever Y≠YF, u ≠u , so the labour market is not in equilibrium. Firms maximise profits only when Y=YF and u =u . W LS LD LF L If demand for output is higher than YF, firms can quell the demand by increasing prices. If demand for output is lower than YF, firms can increase their sales by decreasing prices.