Supply and Inflation IMQF course in International Finance Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson

Outline How changes in monetary policy are reflected in both output and prices? - Aggregate supply relationship Frictionless neoclassical supply relationship Modified keynesian supply relationship Friedman-phelps supply relationship Lucas-sargent-barro supply relationship (New Classical Macroeconomics)

Aggregate Supply Relationship If prices rise (e.g. oil shock), real money supply decreases (LM=M/P curve shifting to the left) – decrease in demand reduces output The inverse relationship between P and Y is downward sloping AD curve Monetary expansion – shifting AD to the right Only if 10% increase in money supply triggers 10% rise in prices, will the LM curve be unchanged, i.e. would Y be unchanged

Aggregate Supply Relationship Five aggregate supply relationships exist: Frictionless neoclassical Keynesian Friedman-Phelps (expectations augmented) Lucas-Sargent-Barro (New Classical) Indexed wages The basic model Exponent sigma is the elasticity of supply with respect to price level, given the wage rate W, i.e. the increase in output that firm chooses to supply when the price level goes up by 1%

Aggregate Supply Relationship Competitive firms choose employment so as to maximize profits Output Y=f(N), where N is the number of workers employed Firms decide on the number of workers to be employed based on the real wages (W/P) – sloped downwards When firms receive higher prices, relative to the cost of their variable input, the incentive provided by higher profits encourages them to produce more

Aggregate Supply Relationship FRICTIONLESS NEOCLASSICAL SUPPLY RELATIONSHIP In the absence of frictions either in prices or wages, labor is fully employed and output is at the potential level – aggregate supply is inelastic Real wages adjust frictionlessly to equal marginal product of labor – labor force is fully employed (at the natural rate of employment) – output is at the full level capacity If W/P>w – excess supply of labor – wage rate declines – rise in demand for labor If W/P<w – excess demand of labor – wage rate rises – pushing down demand for labor Wage rate adjusts so as to provide equilibrium at the labor market Any increase in aggregate demand goes entirely into prices and wages, rather than output or employment (monetary expansion by 10%, raises W and P by 10%) Changes in Y over time attributed to changes in potential output, not to changes in demand Potential output is a function of capital stock, labor force and human capital, productivity and firms’ efficiency

Aggregate Supply Relationship MODIFIED KEYNESIAN SUPPLY RELATIONSHIP Keynesian view assumes wage and price rigidity – firms set prices and supply output demanded at that price (adequate in short run) – aggregate supply curve is horizontal In mid run, aggregate supply curve can have some upward slope: prices are flexible, while wages are predetermined e.g. set by means of collective bargaining contract, which lasts for more than a year or by means of implicit contracts

Aggregate Supply Relationship MODIFIED KEYNESIAN SUPPLY RELATIONSHIP Starting point A (full employment) Monetary expansion goes partily into prices and partly into output (point B) Adverse supply shock (e.g. fall in productivity, bad harvests, etc.) shifts the AS curve to the left To avoid inflation (at cost of fall in output) government can restrict demand (e.g. Switzerland 1974) – point C To avoid recession (at cost of inflation) government can go for expansionary demand policy (e.g. Sweden and US, 1974) -- point D After the collective contract expires, wages go up, shifting the AS curve up

Aggregate Supply Relationship FRIEDMAN-PHELPS SUPPLY RELATIONSHIP 1) Adding inflation expectations to the supply relationship Wage rate to reflect expected inflation during the life of the contract Short run AS curve passes through the reference unit ( ), point A if inflation corresponds to the expected inflation, wages will clear the market (fully employment, no output gap) if sudden monetary expansion shifts prices, output will rise, as real wages will decline (below the marginal produtivity), point B 2) Expected inflation adjusts to actual inflation, with the passage of time Reference point is rising, as the expected prices adjust to the price level observed most recently

Aggregate Supply Relationship LUCAS-SARGENT-BARRO SUPPLY RELATIONSHIP (New Classical Macroeconomics) Only unanticipated rise in prices can lift the output beyond the potential level However, as inflation expectations are adaptive, i.e. rational, output cannot exceed potential level for many consecutive periods If people could perfectly foresight inflation, expected inflation would equal actual inflation, thus output being equal to potential Rational expectations: variable in question (P) can differ from expected value by a random error term: Error is uncorrelated with any information available at the time expectations were formed, so in average it shall equal zero Government may want to raise demand before elections or in case of recession. But, if it does so systemically, it will be reflected into the expected inflation, which means that such policy will have no impact on output, as actual inflation equals expected inflation