Essentials of Economics

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Essentials of Economics

• Business 502

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Concepts of Aggregate Supply
The Aggregate Demand curve we have derived is
really not a demand curve in the same sense as
microeconomic demand, but is analogous. Can we
derive something that would be an analogy to the
supply curve, and aggregate supply? Ideas on
this have evolved over the 20th Century.
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Apologia

• What follows is my best approximation to a
  nonpartisan but orthodox aggregate supply theory.
  
• I disagree with it on several points.
• My partisan and unorthodox ideas are not the
  subject matter of the course.
• I will try not to waste your time with tedious
  expressions of my skepticism.

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Aggregate Supply

• The relationship between real GDP (relative to
  potential output) and the price level (relative
  to its previously-expected value) is the
  short-run aggregate supply curve

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Translating
In a given year, we start out with a specific
price level and expected inflation rate, and we
get
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Aggregate Supply

• When real GDP is greater than potential output,
  inflation is likely to be higher than previously
  anticipated
• inflation will probably accelerate
• When real GDP is lower than potential output,
  inflation is likely to be lower than previously
  anticipated
• the inflation rate will probably fall (may even
  end up with deflation)

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Short-Run Aggregate Supply

• High levels of real GDP are associated with high
  inflation and a high price level for many reasons
• when demand for products is stronger than
  anticipated, firms raise their prices
• when aggregate demand is higher than potential
  output, some industries may reach the limits of
  capacity

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Potential Output
The classical view was that the amount
businessmen will want to sell does not depend on
the price level at all. In a diagram with the
price level, "Aggregate Supply" would be shown by
a vertical line, since production depends on the
relationship between prices (especially between
output prices and labor) and not on the price
level. This "long run" production is the
potential output of the economy.
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Potential Output -- and a Paradox
This would mean that the aggregate supply
(potential output) is represented in a RGDP/price
level diagram by a vertical line, like this
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1950s Vintage
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1960s Vintage
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Current Vintage
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NAIRU

• NAIRU or Natural Rate of Unemployment
• Non-Accelerating Inflation Rate of Unemployment
• The rate of unemployment at which inflation
  neither speeds up nor slows down.
• Potential Output
• Potential output is the NAIRGDP, that is, the
  output corresponding to the non-accelerating
  inflation rate of unemployment.

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Where is the Short Run Aggregate Supply Curve?
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Surprise Principle

• This is a particular instance of what I have
  called the surprise principle.
• The surprise principle says that people may
  respond differently to the same events, depending
  whether the events are expected or come as a
  surprise.
• Other applications may be to consumption,
  investment, and currency exchange movements.

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Aggregate Supply and Aggregate Demand

• Where the aggregate supply and aggregate demand
  curves cross is the current level of real GDP and
  the current inflation rate

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Expectations

• Surprises are relative to expectations. There are
  three hypotheses about expectations.
• Rational Expectations
• Agents use all available information and are
  right on the average.
• Adaptive Expectations
• Agents base their expectations on a fairly simple
  projection from recent experience.
• Static Expectations
• Expectations are given and do not change
  predictably.

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Surprise Makes a Difference

• According to New Classical economists, increased
  production would seem profitable when inflation
  comes as a surprise because
• Businessmen have incomplete information, and
  believe that the price increase is a relative
  price increase -- increasing their margin over
  costs -- when it is not.
• Contracts based on the old price level have some
  time to run, and while they are in force, it
  really is more profitable to increase production.
  
• If businessmen have adaptive expectations, then
  it takes some time for them to adjust their
  expectations even if they have complete
  information.

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More Surprise

• Macroeconomic Long Run
• The macroeconomic long run is a period long
  enough so that businessmen are not surprised by
  inflation.
• Macroeconomic Short Run
• The macroeconomic short run is a period short
  enough so that businessmen believe it is
  profitable to increase output when the price
  level is higher than they had expected, because
  they are taken by surprise.

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Inflationary Expectations
If people expect an increase in the price level,
the SAS curve will shift leftward to exactly the
expected price level.
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Disinflation
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The Three Faces of Aggregate Supply

• Aggregate supply relates the price level to the
  level of real GDP
• Aggregate supply can also relate the inflation
  rate to the growth of real GDP
• The Phillips curve relates aggregate supply to
  the unemployment rate

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A Foundation of Aggregate Supply

• The Phillips Curve
• An inverse relationship between inflation and
  unemployment

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Phillips Curve

• Prof. Phillips first observed it as a statistical
  relationship in the 1950s, a period of
  relatively low, steady inflation.
• Almost everybody agrees it is NOT a straight-line
  relationship -- not that simple.
• But some are skeptical about the whole idea .

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Many Economists argue that

• Labor costs rise less rapidly than prices when
  unemployment is high, so that inflation slows
  down.
• Low enough unemployment will cause costs to rise
  faster than prices, with the result that
  inflation speeds up.
• There is an unemployment rate that just balances
  those tendencies

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Supply and Demand (More or Less)
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U. S. Inflation and Unemployment 1948-2003
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1998-2003 and 1987-92
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Nevertheless,

• Even though there is no very stable relationship
  between unemployment and inflation, most
  economists believe that inflation will speed up
  when unemployment is low and slow down when it is
  high.

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Expectations Augmented Phillips Curve
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Equilibrium

• The economys equilibrium inflation and
  unemployment rates depend on
• the natural rate of unemployment
• the expected rate of inflation
• supply shocks
• aggregate demand
• demand shocks

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Milton Friedman

• 1912-2006
• Nobel 1976
• Among many other contributions, Friedman was one
  of the first to point out how inflationary
  expectations would shift the Phillips Curve.

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George Akerlof

• 1940-
• Nobel 2001
• One of many critics of the expectations-augmented
  Phillips curve, he expressed his reservations in
  his Nobel lecture.

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Phillips Curve Resartus 1

• Probably the single most important macroeconomic
  relationship is the Phillips Curve.
• Economists should not have accepted the natural
  rate hypothesis so readily.
• At very low unemployment rates, the Friedman/
  Phelps prediction of accelerating inflation seems
  quite possibly reasonable and empirically
  relevant.
• Unemployment in the U.S. for the whole of the
  1930s was indisputably in excess of the natural
  rate. According to the natural rate hypothesis,
  price deflation should have accelerated for the
  whole decade. That did not happen. Prices fell
  for a time, but deflation stopped after 1932

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Phillips Curve Resartus 2

• Akerlof sees a long-run relation between
  inflation and unemployment when unemployment is
  high and inflation is low because
• Cuts in nominal wages create problems
• At relatively low inflation rates relative wage
  cuts become nominal wage cuts
• Some relative wage cuts are needed with changing
  circumstances
• Note that rapid productivity growth will cushion
  this
• And because ignoring inflation is near-rational
  when inflation is low.

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The Natural Rate of Unemployment

• Unemployment cannot be reduced below its natural
  rate without accelerating inflation
• If the natural rate of unemployment is high,
  expansionary fiscal and monetary policy are
  largely ineffective as tools to reduce
  unemployment
• Most estimates of the current natural rate in the
  U.S. lie between 4.5 and 5.0 percent

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Fluctuations in Unemployment and the Natural Rate
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The Natural Rate of Unemployment

• Four sets of factors influence the natural rate
  of unemployment
• demography
• the relative age and educational distribution of
  the labor force
• institutions
• labor unions, worker mobility, taxes
• productivity growth
• wage growth
• past levels of unemployment

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Expected Inflation

• The natural rate of unemployment and expected
  inflation together determine the position of the
  Phillips curve
• higher expected inflation moves the Phillips
  curve upward

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Expected Inflation

• There are three basic scenarios for how inflation
  expectations are formed
• static expectations
• prevail when people ignore the fact that
  inflation can change
• adaptive expectations
• prevail when people assume the future will be
  like the recent past
• rational expectations
• prevail when people use all the information they
  have as best they can

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The Phillips Curve under Static Expectations

• If inflation expectations are static, expected
  inflation never changes
• the trade-off between inflation and unemployment
  will not change from year to year
• If inflation has been low and stable, businesses
  will probably hold static inflation expectations

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Static Expectations of Inflation
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Static Expectations of Inflation in the 1960s

• In the 1960s, the Phillips curve did not shift up
  or down in response to changes in expected
  inflation
• when unemployment was above 5.5, inflation was
  below 1.5
• when unemployment was below 4, inflation was
  above 4
• The economy moved along a stable Phillips curve

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Static Expectations and the Phillips Curve,
1960-1968
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The Phillips Curve under Adaptive Expectations

• If the inflation rate varies too much for workers
  and businesses to ignore it and if last years
  inflation rate is a good guide to inflation this
  year, individuals are likely to hold adaptive
  expectations
• inflation will be forecasted by assuming that
  this year will be like last year
• forecast will be good only if inflation changes
  slowly

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Accelerating Inflation
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Adaptive Expectations and the Volcker Disinflation

• At the end of the 1970s, expected inflation gave
  the U.S. an unfavorable short-run Phillips curve
  trade-off
• Between 1979 and the mid-1980s, Fed chairman Paul
  Volcker reduced inflation from 9 to 3 percent per
  year
• The fall in inflation triggered a fall in
  expected inflation
• the Phillips curve shifted down

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The Phillips Curve before and after the Volcker
Disinflation
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The Phillips Curve under Rational Expectations

• If the economy is changing rapidly enough that
  adaptive expectations lead to large errors,
  individuals will switch to rational expectations
• People form their forecasts of future inflation
  not by looking backward but by looking forward
• they look at what current and expected government
  policies tell us about what inflation will be

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The Phillips Curve under Rational Expectations

• The Phillips curve will shift as rapidly as
  changes in economic policy that affect aggregate
  demand
• Anticipated changes in economic policy turn out
  to have no effect on the level of production or
  employment

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Government Policy to Stimulate the Economy

• Suppose that the unemployment rate is equal to
  its natural rate and inflation is equal to
  expected inflation
• The government takes steps to stimulate the
  economy by cutting taxes and raising government
  spending to reduce the unemployment rate below
  the natural rate

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Government Policy to Stimulate the Economy

• If the policy comes as a surprise, the economy
  moves up and to the left along the Phillips curve
  in response to the change in government policy
• Unemployment will be lower, production will be
  higher, and the rate of inflation will be higher

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Government Policy to Stimulate the Economy

• If the policy is anticipated, individuals will
  take the policy into account when they form their
  expectations of inflation
• The Phillips curve will shift up
• There will be no effect on unemployment or output
• The rate of inflation will rise

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Government Policy Announcements are Incredible
-- Why?

• Governments have announced that "they really mean
  it this time" so often that people have good
  reason not to believe them.
• The monetary authorities cannot make their plans
  credible, even when they "really mean it, this
  time," because people know that the temptation to
  accommodate inflation is so great.
• Peoples expectations are not rational but
  adaptive.

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From the Short Runto the Long Run

• In the case of an anticipated shift in economic
  policy under rational expectations, the long run
  is now

• If expectations are rational and changes in
  policy foreseen, expected inflation will be equal
  to actual inflation and unemployment will be at
  its natural rate

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From the Short Runto the Long Run

• If expectations are adaptive, the economy will
  approach the long run gradually
• an expansionary shock will lower unemployment,
  increase real GDP, and lead to an increase in the
  inflation rate
• individuals will raise their expectations of
  inflation in the next periods
• as time passes, the gaps between actual
  unemployment and its natural rate and actual and
  expected inflation will shrink to zero

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From the Short Runto the Long Run

• Under static expectations, the long run never
  arrives
• the gap between expected and actual inflation can
  grow arbitrarily large as different shocks hit
  the economy
• if the gap between actual and expected inflation
  becomes large, individuals will not remain so
  foolish as to retain static expectations

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Summary

• Many modern economists subscribe to a theory of
  aggregate supply microfounded on a model of
  labor markets.
• In this theory, surprises play the key role in
  generating responses to aggregate demand
  policy.
• This can be derived from hypotheses of rational
  or adaptive expectations.
• This seems to fit some historical periods well,
  but others less well.