Aggregate Supply,

1
Aggregate Supply, Unemployment and Inflation
2
Aggregate Supply, Unemployment and Inflation

• Aggregate Supply

3
AGGREGATE SUPPLY

• Different views on the shape of the AS curve

4
Contrasting views on the aggregate supply
curve(a) Extreme Keynesian
Price level
P
O
National output
5
Contrasting views on the aggregate supply
curve(a) Extreme Keynesian
AS
Price level
P
AD1
O
National output
6
Contrasting views on the aggregate supply
curve(a) Extreme Keynesian
AS
Price level
P
AD2
AD1
O
YF
Y1
National output
7
Contrasting views on the aggregate supply
curve(b) Extreme Monetarist / New Classical
Price level
O
Y
National output
8
Contrasting views on the aggregate supply
curve(b) Extreme Monetarist / New Classical
AS
Price level
AD1
O
Y
National output
9
Contrasting views on the aggregate supply
curve(b) Extreme Monetarist / New Classical
AS
Price level
P2
P1
AD2
AD1
O
Y
National output
10
Contrasting views on the aggregate supply
curve(c) Moderate view
Price level
O
National output
11
Contrasting views on the aggregate supply
curve(c) Moderate view
AS
Price level
AD1
O
National output
12
Contrasting views on the aggregate supply
curve(c) Moderate view
AS
Price level
P1
AD2
AD1
O
Y1
National output
13
AGGREGATE SUPPLY

• Different views on the shape of the AS curve
• Short-run aggregate supply

14
AGGREGATE SUPPLY

• Different views on the shape of the AS curve
• Short-run aggregate supply
• the microeconomic foundations

15
Short-run response of a profit-maximising firmto
a rise in demand

MC
AR1
Q
MR1
16
Short-run response of a profit-maximising firmto
a rise in demand

MC
P1
AR2
AR1
Q1
Q
MR1
17
Short-run response of a profit-maximising firmto
a rise in demand

MC
P2
P1
AR2
AR1
MR2
Q1
Q
MR1
18
The short-run aggregate supply curve
Price level
National output
19
AGGREGATE SUPPLY

• Different views on the shape of the AS curve
• Short-run aggregate supply
• the microeconomic foundations
• Long-run aggregate supply

20
AGGREGATE SUPPLY

• Different views on the shape of the AS curve
• Short-run aggregate supply
• the microeconomic foundations
• Long-run aggregate supply
• the interdependence of firms

21
The long-run AS curve when firms are
interdependent
AS1 (short run)
Price level
AD1
National output
22
AGGREGATE SUPPLY

• Different views on the shape of the AS curve
• Short-run aggregate supply
• the microeconomic foundations
• Long-run aggregate supply
• the interdependence of firms
• investment

23
Effect of investment on the long-run AS curve
AS1 (short run)
Price level
AD1
National output
24
Effect of investment on the long-run AS curve
AS1 (short run)
Price level
a
AD2
AD1
National output
25
AGGREGATE SUPPLY

• Different views on the shape of the AS curve
• Short-run aggregate supply
• the microeconomic foundations
• Long-run aggregate supply
• the interdependence of firms
• investment
• expectations

26
AGGREGATE SUPPLY

• LRAS monetarist / new classical model
• flexible real wage rates

27
The aggregate labour market Monetarist / New
Classical analysis
Real wage rate (W / P)
O
Number of workers
28
The aggregate labour market Monetarist / New
Classical analysis
ASL
N
Assume now that AD rises
Real wage rate (W / P)
a
b
We
ADL
O
Qe
Number of workers
29
The aggregate labour market Monetarist / New
Classical analysis
ASL
N
Real wage rate (W / P)
a
b
We
ADL
O
Qe
Number of workers
30
The aggregate labour market Monetarist / New
Classical analysis
ASL
N
Real wage rate (W / P)
a
b
We
W1
ADL
O
Qe
Number of workers
31
AGGREGATE SUPPLY

• LRAS monetarist / new classical model
• flexible real wage rates
• no money illusion

32
AGGREGATE SUPPLY

• LRAS monetarist / new classical model
• flexible real wage rates
• no money illusion
• natural level of unemployment

33
The aggregate labour market Monetarist / New
Classical analysis
ASL
N
Real wage rate (W / P)
a
We
ADL
O
Qe
Number of workers
34
AGGREGATE SUPPLY

• LRAS monetarist / new classical model
• flexible real wage rates
• no money illusion
• natural level of unemployment
• implications for shape of LRAS
• LRAS Keynesian models

35
AGGREGATE SUPPLY

• LRAS monetarist / new classical model
• flexible real wage rates
• no money illusion
• natural level of unemployment
• implications for shape of LRAS
• LRAS Keynesian models
• wage and price rigidity

36
Keynesian analysis of the aggregate labour
market fall in ADL
Real wage rate (W / P)
We
O
Number of workers
37
AGGREGATE SUPPLY

• LRAS monetarist / new classical model
• flexible real wage rates
• no money illusion
• natural level of unemployment
• implications for shape of LRAS
• LRAS Keynesian models
• wage and price rigidity
• hysteresis

38
Keynesian analysis of the aggregate labour
market hysteresis
ASL
N
Real wage rate (W / P)
a
c
b
We
ADL1
ADL2
O
Qe
Q2
Number of workers
39
Keynesian analysis of the aggregate labour
market hysteresis
ASL
N
We2
Real wage rate (W / P)
a
c
b
We
ADL1
ADL2
O
Qe
Q2
Number of workers
40
AGGREGATE SUPPLY

• LRAS monetarist / new classical model
• flexible real wage rates
• no money illusion
• natural level of unemployment
• implications for shape of LRAS
• LRAS Keynesian models
• wage and price rigidity
• hysteresis
• expectations of output changes

41
AGGREGATE SUPPLY

• LRAS monetarist / new classical model
• flexible real wage rates
• no money illusion
• natural level of unemployment
• implications for shape of LRAS
• LRAS Keynesian models
• wage and price rigidity
• hysteresis
• expectations of output changes
• long-run money illusion

42
AGGREGATE SUPPLY

• AS, AD and inflation
• demand-pull inflation

43
Demand-pull inflation
Price level
O
National output
44
Demand-pull inflation
Subsequent demand response
AS
AS1
d
P3
Price level
c
P2
b
P1
a
P0
AD2
AD1
AD
O
National output
45
Demand-pull inflation
AS
AS1
e
P4
Subsequent supply response
d
P3
Price level
c
P2
b
P1
a
P0
AD3
AD2
AD1
AD
O
National output
46
Demand-pull inflation
AS2
AS
AS1
f
P5
e
Subsequent demand response
P4
d
P3
Price level
c
P2
b
P1
a
P0
AD3
AD2
AD1
AD
O
National output
47
AGGREGATE SUPPLY

• AS, AD and inflation
• demand-pull inflation
• cost-push inflation

48
Cost-push inflation
Price level
O
National output
49
Cost-push inflation
AS2
AS1
AS
Subsequent supply response
d
P3
c
Price level
P2
b
P1
a
P0
AD1
AD
O
National output
50
AGGREGATE SUPPLY

• AS, AD and inflation
• demand-pull inflation
• cost-push inflation
• what causes inflation in practice?

51
Aggregate Supply, Unemployment and Inflation

• Expectations Augmented Phillips Curve

52
EXPECTATIONS AUGMENTED PHILLIPS CURVE

• Incorporating expectations into a Phillips
  equation
• Adaptive expectations
• The accelerationist theory
• attempting to reduce unemployment below the
  natural level

53
The accelerationist theory of inflation
.
P ()
U ()
6
8
54
The accelerationist theory of inflation
.
P ()
b
.
a
.
U ()
6
8
I (Pe 0)
55
EXPECTATIONS AUGMENTED PHILLIPS CURVE

• Incorporating expectations into a Phillips
  equation
• Adaptive expectations
• The accelerationist theory
• attempting to reduce unemployment below the
  natural level
• the long-run Phillips curve

56
The long-run Phillips curve
.
P ()
U ()
6
8
Un
57
EXPECTATIONS AUGMENTED PHILLIPS CURVE

• Incorporating expectations into a Phillips
  equation
• Adaptive expectations
• The accelerationist theory
• attempting to reduce unemployment below the
  natural level
• the long-run Phillips curve
• effects of deflationary policies

58
The effects of deflation
.
P ()
.
X (Pe 20)
U ()
8
13
59
The effects of deflation
.
P ()
J
k
.
X (Pe 20)
.
XI (Pe 18)
U ()
8
13
60
The effects of deflation
.
P ()
J
k
l
m
a
U ()
8
13
61
EXPECTATIONS AUGMENTED PHILLIPS CURVE

• How quickly can inflation be eliminated?
• the short, sharp shock
• the slow route
• Explanations of stagflation
• clockwise Phillips loops

62
Clockwise Phillips loops
.
P ()
U ()
Un
Year 0, 1
63
Clockwise Phillips loops
.
P ()
c
Year 3
b
a
Year 2
U ()
Un
Year 0, 1
64
Clockwise Phillips loops
.
P ()
f
e
d
Year 5, 8
c
Year 4, 7
Year 3, 8
b
a
Year 2, 9
U ()
Un
Year 0, 1, 10
65
EXPECTATIONS AUGMENTED PHILLIPS CURVE

• How quickly can inflation be eliminated?
• the short, sharp shock
• the slow route
• Explanations of stagflation
• clockwise Phillips loops
• rightward shifts in the long-run Phillips curve

66
EXPECTATIONS AUGMENTED PHILLIPS CURVE

• How quickly can inflation be eliminated?
• the short, sharp shock
• the slow route
• Explanations of stagflation
• clockwise Phillips loops
• rightward shifts in the long-run Phillips curve
• Policy implications of the model

67
EXPECTATIONS AUGMENTED PHILLIPS CURVE

• How quickly can inflation be eliminated?
• the short, sharp shock
• the slow route
• Explanations of stagflation
• clockwise Phillips loops
• rightward shifts in the long-run Phillips curve
• Policy implications of the model
• shifting the long-run Phillips curve

68
Inflation ()
Phillips loops in the UK?
75
80
76
74
77
79
81
90
71
73
82
78
89
72
91
85
84
88
83
87
98
95
97
86
00
92
94
01
96
93
99
02
Unemployment ()
69
Inflation ()
Phillips loops in the UK?
75
80
76
74
77
79
81
90
71
73
82
78
89
72
91
85
84
88
83
87
98
95
97
86
00
92
94
01
96
93
99
02
Unemployment ()
70
Inflation ()
Phillips loops in the UK?
75
80
76
74
77
79
81
90
71
73
82
78
89
72
91
85
84
88
83
87
98
95
97
86
00
92
94
01
96
93
99
02
Unemployment ()
71
Inflation ()
Phillips loops in the UK?
75
80
76
74
77
79
81
90
71
73
82
78
89
72
91
85
84
88
83
87
98
95
97
86
00
92
94
01
96
93
99
02
Unemployment ()
72
Inflation ()
Phillips loops in the UK?
75
80
76
74
77
79
81
90
71
73
82
78
89
72
91
85
84
88
83
87
98
95
97
86
00
92
94
01
96
93
99
02
Unemployment ()
73
Inflation ()
Phillips loops in the UK?
75
80
76
74
77
79
81
90
71
73
82
78
89
72
91
85
84
88
83
87
98
95
97
86
00
92
94
01
96
93
99
02
Unemployment ()
74
Aggregate Supply, Unemployment and Inflation

• Rational Expectations and the Phillips Curve

75
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Assumptions
• flexible wages and prices
• rational expectations
• Aggregate supply the Phillips curve when
  expectations are correct
• short-run vertical AS curve

76
The effects of an increase in aggregate demand
SRAS1 (expected price level P1)
Price level
(a) Adaptive expectations
P2
P1
a
AD1
O
Q2
Q1
National output
77
The effects of an increase in aggregate demand
SRAS2 (expected price level P3
)
SRAS1 (expected price level P1)
P3
Price level
(a) Adaptive expectations
P2
b
P1
a
AD2
AD1
O
Q2
Q1
National output
78
The effects of an increase in aggregate demand
LRAS
SRAS2 (expected price level P3
)
SRAS1 (expected price level P1)
c
P3
Price level
(a) Adaptive expectations
P2
b
P1
a
AD2
AD1
O
Q2
Qn
National output
79
The effects of an increase in aggregate demand
SRAS1 (expected price level P1)
Price level
(b) Rational expectations
P1
a
AD1
O
Q1
National output
80
The effects of an increase in aggregate demand
SRAS2 (expected price level P3
)
SRAS1 (expected price level P1)
Price level
(b) Rational expectations
P1
a
AD2
AD1
O
Q1
National output
81
The effects of an increase in aggregate demand
LRAS SRAS actual
SRAS2 (expected price level P3
)
SRAS1 (expected price level P1)
c
P3
Price level
(b) Rational expectations
P1
a
AD2
AD1
O
Qn
National output
82
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Assumptions
• flexible wages and prices
• rational expectations
• Aggregate supply the Phillips curve when
  expectations are correct
• short-run vertical AS curve
• short-run vertical Phillips curve

83
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Aggregate supply the Phillips curve when
  expectations are incorrect
• the goods market

84
How a rise in aggregate demand could cause a rise
in national output
LRAS
SRAS1 (expected price
level P1)
Price level
P1
a
AD1
O
Qn
National output
85
How a rise in aggregate demand could cause a fall
in national output
LRAS
SRAS1 (expected price
level P1)
Price level
P1
a
AD1
O
Qn
National output
86
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Aggregate supply the Phillips curve when
  expectations are incorrect
• the goods market
• the labour market

87
Effects in the labour market of an
underprediction of inflation
ASL1 ((W / P )e W / P )
Real wage rate (W / P)
ADL
O
Q1
Q2
Number of workers
88
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Aggregate supply the Phillips curve when
  expectations are incorrect
• the goods market
• the labour market
• implications for the Phillips curve
• Policy implications of rational expectations
• Real business cycles
• persistent shifts in aggregate supply
• turning points

89
New classical version of short-run Phillips curves
Inflation ()
O
Unemployment ()
90
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Aggregate supply the Phillips curve when
  expectations are incorrect
• the goods market
• the labour market
• implications for the Phillips curve
• Policy implications of rational expectations

91
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Aggregate supply the Phillips curve when
  expectations are incorrect
• the goods market
• the labour market
• implications for the Phillips curve
• Policy implications of rational expectations
• Real business cycles

92
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Aggregate supply the Phillips curve when
  expectations are incorrect
• the goods market
• the labour market
• implications for the Phillips curve
• Policy implications of rational expectations
• Real business cycles
• persistent shifts in aggregate supply

93
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE

• Aggregate supply the Phillips curve when
  expectations are incorrect
• the goods market
• the labour market
• implications for the Phillips curve
• Policy implications of rational expectations
• Real business cycles
• persistent shifts in aggregate supply
• turning points

94
Aggregate Supply, Unemployment and Inflation

• Modern Keynesian Views

95
MODERN KEYNESIAN VIEWS

• Modern developments of the Keynesian model
• Growth in equilibrium unemployment
• higher structural unemployment
• hysteresis
• The persistence of demand-deficient unemployment
• payment of efficiency wages
• insider power

96
MODERN KEYNESIAN VIEWS

• Incorporation of expectations
• expansion of aggregate demand

97
Keynesian analysis of reflationary policies
Inflation ()
O
Unemployment ()
98
MODERN KEYNESIAN VIEWS

• Incorporation of expectations
• expansion of aggregate demand
• contraction of aggregate demand

99
Keynesian analysis of deflationary policies
Inflation ()
O
Unemployment ()
100
Keynesian analysis of deflationary policies
Inflation ()
a
b
I
c
O
U1
U2
Unemployment ()
101
MODERN KEYNESIAN VIEWS

• Incorporation of expectations
• expansion of aggregate demand
• contraction of aggregate demand
• Keynesian criticisms ofnon-intervention

102
Aggregate Supply, Unemployment and Inflation

• Common Ground Among Economists?

103
COMMON GROUND AMONG ECONOMISTS?

• Short-run effects of changes in aggregate demand
• Long-run effects of changes in aggregate demand
• Role of expectations
• Importance of supply-side factors