Aggregate Supply

1
Aggregate Supply
2
Labor Supply and Demand
The aggregate supply curve is built upon a theory
of supply and demand in the labor market. In the
figure, labor supply and labor demand give us an
equilibrium real wage (W/P)eq. This, as we can
see, is a full-employment model.
3
Empirical Inconsistencies
Two empirical facts seem to be inconsistent with
the model above. (1) The observed stickiness of
nominal wages. Virtually all labor contracts are
written in nominal terms. (2) The persistence of
unemployment above full-employment. Remember in
1933, the unemployment rate peaked at 25.
4
Types of Unemployment

• We need to define three distinct concepts of
  unemployment
• Frictional unemployment - is the unemployment
  that exists as a result of individuals shifting
  between jobs and looking for new jobs. Even at
  "full" employment, the measured unemployment rate
  is not zero.
• The natural rate of unemployment - the rate of
  unemployment for which inflation does not start
  to increase. This is also called the
  non-accelerating inflationary rate of
  unemployment (NAIRU)
• Structural unemployment - mismatch between jobs
  and skills.

5
OECD Unemployment Rates
The unemployment rate in the U.S. is generally
lower than in Europe, but the opposite was true
in the 1970s. Even after a decade of stagnation,
the US unemployment is higher than in Japan.
These related to cultural differences and labor
market frictions.
Recent data can be found at the OECD website.
6
The Phillips Curve
A theory advanced to explain fact one is known as
the Phillips curve. It posits an inverse
relationship between the rate of unemployment and
the rate of increase in money wages. The higher
the rate of unemployment, the lower the rate of
wage deflation,
where W is money wages and gw is the rate of wage
inflation. Letting u represent the NAIRU, we can
write a simple Phillips curve as
7
The Nominal Wage and Employment
Noting that gw is the percentage change in wages
For wages to rise above their previous level,
unemployment must fall below the non-inflationary
rate. Let us define the unemployment rate as
where LF is the total labor force and N is the
number employed
We have now expressed the money wage as a
function of employment.
8
Sticky Wages
e is the sensitivity parameter relating how
responsive wages are to changes in the level of
employment. If e is large, then the WN schedule
is steep. In the limit, with e0, we have a
vertical aggregate labor supply function.
Over time, this function will shift up or down in
persistent situations of under or
over-employment. Example Let N50, N40, e2,
Wt-15, and LF60. Solving we get W20/3. Solving
again, we would get W80/9 gt 20/3, so the N
intersection would shift up.
9
Deriving AS 1/2
A production function relates units of output to
inputs. We assume a very simple one,
where a measures labor productivity. This will
enable us to finally get an expression in P and
Y. We will assume that firms set prices by
marking them up over labor costs.
Substituting into a previous equation
10
Deriving AS 2/2
Noting that
We obtain
Finally, we can replace the N's by inverting the
production function NY/a,
Letting ?e/YF , we have
11
Numerical Example

• Let us first set the values of the exogenous
  variables
• The production relation Y3N (a3)
• The natural rate N80
• The labor force LF100
• Sensitivity of wages to unemployment e0.5
• The mark-up factor z0.5
• The past level of money wages, Wt-1 50.

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Solution 1/2
Substitute first into the labor supply function
Note that NY/a
13
Solution 2/2
Mutliply by (1z) to replace W with P
14
The Classical Adjustment Mechanism
The question we are interested in answering here
is whether or not the economy is self-regulating.
Will the economy get back to Y, when there is
unemployment. The means by which the economy
restores itself to full-employment is called the
classical adjustment mechanism. This mechanism,
as we'll see, consists of falling wages in
situations of unemployment.
When Y lt Y, then wages are falling, and prices
are falling. The AS will continue to shift until
it crosses the AD function at Y. Why doesn't the
AD shift? The AD will only shift with policy
changes in M or changes in autonomous demands.
Remember that we derived the AD by shifting P
with M constant. That is the situation we have
here.
15
In The Long Run

• We'll return very shortly to two ideas
• When does the classical adjustment mechanism
  fail.
• Might the classical adjustment mechanism be so
  slow as to be nearly inoperative. Keynes in the
  long-run ,we are all dead. Essentially, we are
  asking when does the economy need policy
  intervention to ensure or speed its return to Y

16
Full AD/AS Example
Aggregate demand
Aggregate supply
17
Solution IS/LM/AD
YCIG1000.9(Y-50)85-2i501900.9Y-2i
IS
LM/P0.25i0.3Y-70/P
LM
Y1900-20(1.2Y-280/P)1900-24Y5600/P25Y1900560
0/P
AD
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Solution AS
Substitute into the wage equation Y's for N,
using the production function, Y4N240,
YF4LF300,
Then use the markup factor to get prices
19
Solution Output
Plug in from the AS for P in the AD,
To solve for Y, we must first get rid of the
fraction,
Now let's transform this into a quadratic equation
20
Solution General Eq.
We can now apply the quadratic formula with
a0.0625, b-17.75, c-1934. Plugging in these
values,
We obtain
Now substitute back into the AS to find prices
21
Persistent Unemployment
Note that our economy is in bad shape.
Yeq84.07ltY240. How will this economy adjust to
get back closer to full employment. Return to the
old AS.
We know that the new aggregate supply will shift
out and pass through Y at P in the next period
If were were to resolve for output after the AS
has shifted, we would find
Y76224/16.650.046Y86.85
Solving for prices, we would also find
P116.650.04686.8520.65
22
Keynesian Unemployment
If there is Keynesian unemployment, one of two
things must be true. Either interest rates are
unresponsive or investment is unresponsive to the
interest rate. At the first equilibrium, we can
find the interest rate from the LM equation
i1.284.07-280/27.7590.79
After the AS shifts, we find
i'1.286.85-280/20.6590.66
While this economy is not in a liquidity trap,
interest rates are not very elastic with respect
to prices, and there is very little output
response. This is a case of Keynesian
unemployment, where falling prices have very
little impact on aggregate demand. In the
extreme, AD can be vertical, and there will be no
response of output at all.
23
Classical Unemployment
In some other economies, AD may be very
responsive to falling prices, but wages and
prices are sticky and are slow to fall. At the
extreme, we may be in an economy where wages fail
to adjust at all. Consider an example economy,
identical to our numerical example, except that
e0.10. The new AS will be
The new equilibrium output is 82.30 and the price
level is 35.53.(You should verify this
yourself!!!). If we resolve for next period's AS,
Notice that the intercept has shifted only 3
points compared to 6 in the previous example.
24
Supply Shocks
Exogenous changes in inputs to the production
process are known as supply shocks.
25
Modeling Supply Shocks
Let us now add raw materials to our pricing
equation
where ? denotes the material requirement per unit
of output and Pm are materials prices. Define pm
Pm/P, divide through by P to get
This tells us that, ceteris paribus, an increase
in the real price of raw materials will increase
prices by raising input costs.
26
OPEC Shocks
We can analyze the two OPEC (Organization of
Petroleum Exporting Countries) shocks of 1973 and
1979-80 in our model. The first shock quadrupled
the price of oil between 1971 and 1974. The
second shock doubled the price. Both episodes
were followed by recessions in which prices
actually rose. This is consistent with our model
when the AS shifts to the left. How would
classical adjustment respond to a supply shock?
Policy makers, at the time of the two shocks,
(including Alan Greenspan, then Gerald Ford's
chairman of the Council of Economic Advisers),
responded solely to the inflation, shifting back
the AD.
27
Oil Prices
From January 1982 to December 1986, the price of
a barrel of West Texas Intermediate Crude fell
from 35.86 to 14.51, a decline of 60. In 1998,
real petroleum prices were well below their 1947
levels. Since 2002, the path has been up. Why?
28
Supply Side Economics?
Why can't we control the economy from the supply
side? Look at the principal variables involved
W, a, z, ?, Pm. These are largely out of the
government's control, and surely are slow to
change.