Lecture 20: Aggregate Supply – Bring in price level P, inflation π, & wage W. Aggregate Demand (AD) & Aggregate Supply (AS) Ultra-Keynesian A.S. case Neoclassical A.S. case Intermediate A.S. curve Expectations-augmented A.S. curve Rational-expectations A.S. Real Business Cycle models (RBC) Appendices -- 7. Labor market rigidities.

Aggregate Demand curve slopes down. Why? Say P ↑ y p AD (e.g., because wage W↑) => (M1 / P )↓ (“real balance effect”) => LM shifts left => Y ↓ BGP-620 - Prof.J.Frankel

A monetary expansion shifts AD to the right. By how much? y p AD Or it shifts AD up. By the answer to IS-LM. { ● By how much? Equilibrium outcome (Y vs. P) depends on AS. ● In proportion to Δ M1. ● ● AD′ BGP-620 - Prof.J.Frankel

The notion of Aggregate Supply If demand rises too rapidly, it shows up in the price level, not output. In practice, the path of potential output 𝒀 is often measured by the point beyond which inflation begins to accelerate; and the natural rate of unemployment ū is measured as the rate below which inflation begins to accelerate. BGP-620 - Prof.J.Frankel

US output fell sharply below potential in 2008-09. 𝒀 𝒀 BGP-620 - Prof.J.Frankel Brad deLong, Jan. 2014 http://delong.typepad.com/delong_long_form/2014/01/the-relative-efficacy-of-fiscal-and-monetary-policy-at-the-zero-lower-bound-where-are-the-goalposts-anyway-the-honest-bro.html

Inflation also fell in the 2008-09 global recession. WORLD ECONOMIC OUTLOOK (WEO) Uneven Growth: Short- and Long-Term Factors April 2015 IMF BGP-620 - Prof.J.Frankel

ALTERNATE SUPPLY RELATIONSHIPS All-purpose supply function: 𝑌/ 𝑌 = (ω 𝑃/𝑊)σ 𝑌 ≡ potential output W ≡ nominal wage W/P ≡ real wage ω ≡ “warranted real wage” σ ≡ elasticity of aggregate supply . where: Can readily be derived from aggregation of supply decisions by individual firms that maximize profits and operate in competitive goods & labor markets. Then ω ≡ Marginal Product of Labor at full employment. (See graphs in Appendix I.)

Two polar extreme cases 1) Ultra-Keynesian case: AS flat, at 𝑃 => AD expansion goes entirely into Y. AD' y p AS Realistic in Very Short Run. 2) Classical case AS vertical at 𝑌 => AD expansion goes entirely into P. AS y p AD' Then only AS shocks move Y = 𝑌 , e.g., productivity shocks. (RBC models.) Realistic in Long Run. 𝑦

AGGREGATE SUPPLY (continued) 3) Intermediate case: W = 𝑊 , e.g., due to one-year labor contract. => AS has some slope, even in the SR. 𝑌 𝑌 = ω 𝑃 𝑊 σ SR supply relationship: y p AS AD

Monetary expansion raises AD in the SR. A rise in the current level of M1 shifts LM curve out, because (M/P) , in the SR. => AD shifts out, goes partly into higher Y partly higher P. AS long run p AS short run ● pe AD expanded AD initial y

• • • • • Intermediate case: AS has some slope in the SR; 𝑦 So a monetary expansion initially goes into both P and Y. E.g., Y > 𝑌. Next, over time, P responds to excess demand until Y is back at 𝑌 . • What if the economy is found to be in excess supply: Y < 𝑌 ? e.g., in the aftermath of a fall in 𝐴 ? Eventually P will respond by falling enough to restore Y = 𝑌 . But that might be a long painful recession. The government could expand demand to speed it up. p • AS short run • • AD initial • y 𝑦 API-120 - Prof. J. Frankel

AGGREGATE SUPPLY (continued) 𝑌 𝑌 = ω 𝑃 𝑊 σ SR supply relationship: 4) Friedman-Phelps supply curve: W is set in line with Pe, expected P, which adjusts over time. Yearly wage contract 𝑊 = ω 𝑃 𝑒 . 𝑌 𝑌 = 𝑃 𝑃 𝑒 σ Milton Friedman or in logs, yt - 𝑦 = σ (πt− πt 𝑒 ) where πt ≡ pt – pt-1 and πte ≡ pte – pt-1 . But over time πe adjusts to actual π, so Y = 𝑌 . In LR, AS is vertical. SR: Point B in Figure 26.4. MR: Point C. LR: Point D.

Effects of an increase in the level of M1 over time. Initially – Point A. Then a monetary expansion. MR -- Point C: Pe begins to adjust => W does too. AS↑. LR -- W, Pe, & P continue to adjust until, in LR, Y is back to 𝒀 at point D. => Money is neutral in LR. • D 𝑌 𝑌 = 𝑃 𝑃 𝑒 σ p SR -- Point B: before W has had time to adjust. ● • AS short run C −𝑝2 𝑒 -- • B −𝑝1 𝑒 -- AD´ A AD initial y 𝑦

OVERVIEW OF AGGREGATE SUPPLY (continued) 5) Lucas supply relationship 𝑌 𝑌 = 𝑃 𝑃 𝑒 σ or in logs, y - 𝑦 = σ (π− π 𝑒 ) Robert Lucas = σ ε, where ε is the forecast error. Rational expectations => ε is unforecastable. 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.

Odysseus tied to the mast 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 BGP-620 - Prof.J.Frankel

Alternative Nominal Anchors Money supply targets (e.g., monetarism in 1980s.) Pegged price of gold (e.g., classical gold standard) CPI target (e.g., Inflation Targeting) Fixed exchange rate (e.g., currency board) BGP-620 - Prof.J.Frankel

6. Real business cycle (RBC) theory According to this theory (e.g., Kydland & Prescott, 1982), all fluctuations are due to real supply factors: technology shocks & shifts in preferences for work vs. leisure. Not monetary policy. BGP-620 - Prof.J.Frankel

Appendix V: A 7th AS relationship: Appendix I: Increase in expected inflation Appendix II: Derivation of the general AS relationship Appendix III: Y and π in the Great Depression Appendix IV: An example of rational expectations Mexican sexenio Appendix V: A 7th AS relationship: Indexed wages Application: real wage rigidity in Europe, vs. US. BGP-620 - Prof.J.Frankel

Appendix I: What about an increase in expected rate of growth of M1, as opposed to the level? Example: in Jan. 2013, Bank of Japan raised  target to 2 %. An increase in the expected future rate of growth of M1 shifts IS out, because  e  => r  => A  . Either way, r  , IS-LM shifts right => AD shifts right. AS long run p AS short run • pe AD expanded AD initial 𝑦 y

● ● If M P of Labor => hire more N. => cut N. Appendix II: The general AS relationship, derived If a firm’s Marginal Product of Labor > W/P If M P of Labor < W/P => hire more N. => cut N. ● Employment determines output, via the production function. Sum labor demand across all firms. Then set equal to supply of labor. And the real wage determines employment, via the demand for labor: ● When W/P = ω, then N= 𝑁 and Y= 𝑌 . Determines ω.

Jobs vary with GDP though usually less-than-proportionately , in practice. 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. ”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, BGP-620 - Prof.J.Frankel

Output gaps and unemployment rates have improved since the height of the GFC, but remain high in some Mediterranean countries. IMF WEO, Oct.2016, fig. 1.10.

An alternative approach: The New Keynesian Phillips curve 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. BGP-620 - Prof.J.Frankel

Appendix III: The Great Depression Inflation turned negative in 1930-33, along with the output gap, and again in 1938-39 BGP-620 - Prof.J.Frankel

An example of rational expectations: Appendix IV An example of rational expectations: Mexican sexenio From 1976 through 1994, inflation would shoot up and/or the peso would devalue, every 6th year (presidential election years). BGP-620 - Prof.J.Frankel

Appendix V: Labor market rigidities 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. 7. BGP-620 - Prof.J.Frankel

If actual real wage W/P is stuck at ω > warranted real wage ω, then Y < 𝑌 permanently . In this case, 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: After 1973, the upward trend of warranted ω slowed sharply <= productivity slowdown (<= oil shocks?). In the US, employment continued to rise, but W/P did not; in Europe, W/P continued to rise, but employment did not. BGP-620 - Prof.J.Frankel

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

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

“Labor market rigidities” in Europe go beyond Employment Protection Legislation often does not raise overall employment. If anything, the reverse. “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 2003-05 improved labor market efficiency. source: Giuseppe Bertola (2001)