Aggregate Demand (AD) & Aggregate Supply (AS) 1.Ultra-Keynesian A.S. case 2.Neoclassical A.S. case 3.Intermediate A.S. curve 4.Expectations-augmented A.S. curve 5.Rational-expectations A.S. 6.Real Business Cycle models (RBC) Appendices Labor market rigidities. Lecture 20: Aggregate Supply -- Price level P, Inflation π, & Wages W

Aggregate Demand curve slopes down. ITF220 - Prof.J.Frankel Say P ↑ => LM shifts left (“real balance effect”) => Y ↓ => M1 / P ↓ y p AD Why? (e.g., because W↑)

A monetary expansion shifts AD to the right. ITF220 - Prof.J.Frankel By how much? y p AD AD′ By the answer to IS-LM. By how much? Or it shifts AD up. In proportion to Δ M1. { ● ● ● Equilibrium outcome (Y vs. P) depends on AS. ●

The notion of Aggregate Supply ITF220 - Prof.J.Frankel

US output fell sharply below potential in Brad deLong, Jan

Inflation fell in the global recession. WORLD ECONOMIC OUTLOOK (WEO) Uneven Growth: Short- and Long-Term Factors April 2015 IMF

Can readily be derived from aggregation of supply decisions by individual firms that maximize profits and operate in competitive goods & labor markets. ITF220 - Prof.J.Frankel Then ω ≡ MP of L abor at full employment. (See graphs in Appendix I.) ALTERNATIVE SUPPLY RELATIONSHIPS where:

API Prof. J. Frankel, Harvard University Two polar extreme cases y p y p AD' AS Realistic in Very Short Run. Only AS shocks move Y, e.g., productivity shocks. Realistic in Long Run.

AGGREGATE SUPPLY (continued) SR supply relationship: Implication: Demand expansion goes partly into P, partly into Y. y p AD' AS ●

ITF220 - Prof.J.Frankel Monetary expansion raises AD in the SR.  A rise in the current level of M shifts LM curve out, because M/P , in the SR.  Alternatively, a rise in expected future growth rate of M shifts IS out, because  e  => r  => A . Either way, IS-LM shifts right => AD shifts right: Result is higher Y and higher P. ● AS long run AS short run AD initial AD expanded p p pepe pepe y y

AGGREGATE SUPPLY (continued) Milton Friedman where π ≡ p – p -1 and π e ≡ p e – p -1. W is set in line with P e, which adjusts over time. SR supply relationship: ● 4) Friedman-Phelps supply curve: SR: Point B in Figure MR: Point C. LR: Point D.

26.4 Initially – Point A. Then monetary expansion. MR -- Point C: P e adjusts partway => W does too. LR -- Point D: P e, and so W, have fully adjusted. SR -- Point B: before W has had time to adjust. ● ● ● ● ITF220 - Prof.J.Frankel

OVERVIEW OF AGGREGATE SUPPLY (continued) Robert Lucas ● 5) Lucas supply relationship Implications: An unpredictable demand expansion goes partly into P, party into Y in the short run; but predictable demand expansions have no effect on Y.  Committing monetary policy to a nominal anchor would reduce inflation at little cost in terms of output.

ITF220 - Prof.J.Frankel If monetary policy cannot have a systematic effect on output anyway, the central bank might as well give up, and attain the only goal it can: price stability. But only if it“ties its hands” will its commitment not to inflate be credible. Odysseus tied to the mast

ITF220 - Prof.J.Frankel Alternative Nominal Anchors Money supply targets (e.g., monetarism in 1980s.) Pegged price of gold (e.g., classical gold standard) Price level target (e.g., Inflation Targeting) Fixed exchange rate (e.g., currency board)

6. Real business cycle (RBC) theory Y = N =. According to this theory, all fluctuations are due to real (supply) factors: – technology shocks & – shifts in preferences for work vs. leisure. – Not monetary policy. ITF220 - Prof.J.Frankel

Appendix II: Another AS relationship 7. Indexed wages – Application: real wage rigidity in Europe, vs. US. ITF220 - Prof.J.Frankel Appendix III: Measures of output gap Appendix I: Derivation of general AS relationship Appendix IV: An example of rational expectations

Employment determines output, via the production function. And the real wage determines employment, via the demand for labor. If a firm’s M arginal P roduct of L abor > W/P If M P of Labor < W/P Sum labor demand across all firms. Then set equal to supply of labor. Determines w. => hire more N. => cut N. ● ITF220 - Prof.J.Frankel ● Appendix I

An alternative approach: ITF220 - Prof.J.Frankel allows firms to be imperfectly competitive, with a profit mark-up over cost, but still has Y↑ => P ↑ via firms’ demand for labor & marginal cost. The New Keynesian Phillips curve

ITF220 - Prof.J.Frankel Explicit wage indexation: Examples in 1970s-80s -- US: Cost of Living Adjustment clauses Italy: scala mobile Argentina: complete indexation of everything Implicit real wage rigidity: Example -- thought to characterize Europe. Appendix II: Labor market rigidities 7.

If actual real wage > warranted real wage ω, Y < permanently. Growth in demand will not show up in increased employment. – because it is “classical unemployment,” not Keynesian unemployment. E.g., comparison of US vs. Europe: – In the 1970s the upward trend of warranted w slowed sharply <= productivity slowdown <= oil shocks. – In the US, employment continued to rise, but real w did not; – in Europe, real continued to rise, but employment did not. ITF220 - Prof.J.Frankel

In the 1970s & 80s, the upward trend of warranted w slowed sharply, employment rose in US,while real wage contracts rose in Europe. ITF220 - Prof.J.Frankel

The Netherlands may have found a “middle way.” ITF220 - Prof.J.Frankel One view: Europeans prefer job security; Americans prefer job growth.

ITF220 - Prof.J.Frankel source: Giuseppe Bertola (2001) “Labor market rigidities” in Europe go beyond sticky real wages; They include also, e.g., laws against laying off workers, which discourage hiring. One view of the divergence Between Germany & Greece: Labor market reforms enacted by Gerhard Schröder improved labor market efficiency. Employment Protection Legislation often does not raise overall employment. If anything, the reverse.

ITF220 - Prof.J.Frankel Three measures of excess supply tend to move together. Source: IMF, World Economic Outlook.. Appendix III: Measures of output gap

Inflation turned negative in , along with the output gap, and again in ITF220 - Prof.J.Frankel

Jobs vary with GDP though usually less-than-proportionately, in practice. ”G20 labour markets: outlook, key challenges and policy responses,” Sept. 2014, ILO, OECD, World Bank Group, Report prepared for the G20 Labour and Employment Ministerial Meeting, Melbourne, Australia, Data: OECD Quarterly National Accounts Database; OECD Labour Force Statistics Database, Eurostat, Annual national accounts for the European countries, ILO, ILOSTAT Database and results from national labour force surveys for Argentina and India.

Mexican sexenio From 1976 through 1994, inflation would shoot up the peso would devalue, and/or every 6 th year (presidential election years). ITF220 - Prof.J.Frankel Appendix IV An example of rational expectations: