Fluctuations and growth: the aggregate supply - aggregate demand model École des Hautes Études Commerciales (HÉC), November 2001

Analyzing the market for goods and services: Aggregate supply We have seen that GDP could grow with the total number of hours worked (L·h) and with the productivity of these hours worked (y). In general, productivity increases with the stock of capital per person-hour (K/Lh) and with technological progress. In the short-run however, the capital stock (the size of the production infrastructures, the installed capacity in machinery and equipment, etc.) is fixed and the state of technology is given. In the short-run, it is difficult to increase productivity.

Analyzing the market for goods and services: Aggregate supply In order to increase production it is thus necessary to increase the total number of hours worked (Lh). There two ways we can do this: Hire new employees within the labor force and increase L Increase the average duration of work (part-time workers who become full-time workers and asking extra hours to full-time workers). However, these extra hours have a cost and this cost is not independent from the level of production.

Deriving the aggregate supply curve Let’s make the following assumptions which are reasonable in the short-run: The size of the labor force is fixed The size of the capital stock is fixed The state of technology is given. Input prices (labor, raw materials, energy, etc.) are fixed. In order to increase production, we must hire more workers and/or increase the average duration of the working week.

Under these assumptions, could we expect an aggregate supply with the following shape ? (equilibrium relationship between the level of aggregate production and the average level of prices)

The successive increases in the level of production (for instance, from Y0 to Y1) bring about an increase in employment. For a given size of the labor force, this increase in employment brings about a reduction in the rate of unemployment. As the rate of unemployment is approaching its lower limit, it becomes more difficult to find skilled workers. The skilled workers are asked to work extra hours and these hours are often paid a higher rate Less skilled workers are hired but their average productivity is lower. These two reasons explain why unit costs should increase with the level of production as the economy approaches the lower limit of the rate of unemployment. The answer is no P Y AS Y0 Y1 The rate of unemployment goes down as the level of aggregate production goes up

Here is an illustration of the link between increases in production and increases in employment (Canada between 1980 et 1999) 8 6 6 4 4 2 2 -2 -2 -4 -4 -6 -6 80 82 84 86 88 90 92 94 96 98 Real GDP (% change) Employment (% change)

The lower limit to the rate of unemployment There are always some people in the labor force who find themselves for a short period of time between two jobs or occupations. They are looking for a new and possibly better position (frictional unemployment). Other people suffer from chronic and long-term unemployment. There are several potential causes to this. Among them: The fact that their particular skills may have become obsolete. Their mobility (between sectors of economic activity and/or between regions) may be low. Whatever the reason, economists call this type of unemployment structural unemployment. The sum of the frictional and the structural rates of unemployment gives us the lower limit to the rate of unemployment. In the literature, this lower limit is known as the natural rate of unemployment (even if there is nothing natural about it)

The aggregate supply curve AS When the economy reaches the lower limit of the rate of unemployment and maximizes the average duration of the working week, it becomes impossible to increase production further. Area where the rate of unemployment approaches its lower limit Area where the rate of unemployment is high Y

The shifts in the aggregate supply curve The entire aggregate supply curve shifts as we relax the following assumptions: The size of the labor force is fixed. The size of the capital stock is fixed. The state of the technology is given. The prices of inputs are fixed. To start with, let us suppose that the labor force (through population growth) and the stock of capital (through investment) both increase at the same rate.

With no gains in productivity, the supply curve shifts to the right at constant cost AS’ A parallel increase in the labor force and the stock of capital (with no gains in productivity) shifts the supply curve to the right. Unit costs remain constant. AS Y

With productivity gains, the supply curve shifts further to the right and units costs are lower. AS with an increase in productivity, more can be produced... AS’ AS’’ at a lower cost... Y

The aggregate supply curve shifts upward when input prices increase Increases in the cost of labor (through higher wages or payroll taxes), in the price of raw materials or in the price of energy bring about an upward shift in the aggregate supply curve AS P Y

But occasionally ... AS P AS ’ Y Brings about a downward shift in the entire aggregate supply curve. A fall in the price of raw materials, energy, wages,etc, Y

Growth and inflation usually coexist... AS P AS ’ The curve shifts rightward... as well as upward . Y

An important price: the price of crude oil 1990:10 35,92 Gulf War 1985:11 30,81 1999:09 23,88 11,58 1986:07 11,28 1998:12

The growth rate of wages in Canada (wage increases in collective agreements) 2 4 6 8 84 86 88 90 92 94 96 98 Wages growth rate The upward shifts in the AS curve get larger The upward shifts in the AS curve get smaller

When we combine an increase in productivity with an equivalent increase (in %) in wages... The aggregate supply curve shifts to the right only P Y

Wage increases are inflationary only when they exceed productivity gains Productivity gains shift the curve to the right Wage increases exceeding productivity gains raise unit costs Y

The scope for real wage increases When wages and prices increase at the same pace, the purchasing power of wages (W/P defined as the real wage) is constant. When there are productivity gains, real GDP per capita increases and therefore real wages can increase. This is exactly what we have seen with the aggregate supply curve. When wage increases are equal (in %) to productivity gains, there is no inflation (other things equal) and nominal increases in wages are real increases in wages. When wage increases exceed productivity gains, the firms raise their prices to cover their higher unit costs. Inflation brings back real wage increases in line with productivity gains. Of course, we have assumed that firms had a constant mark-up on their unit costs… What would happen if not ?

The concept of potential GDP Strictly speaking, potential GDP corresponds to the vertical portion of the aggregate supply curve. In other words, potential GDP is equal to what the economy can produce in the aggregate when it is using its productive facilities at full capacity and when the rate of unemployment is minimal. As the economy approaches potential GDP, rising costs put pressures on prices. In a situation of general scarcity in the labor market, we might expect that skilled workers will ask for wage increases in order to keep their real wage constant. Inflation would accelerate. This is why a slightly different concept of potential GDP is associated with a rate of unemployment below which inflation would accelerate. More on this later...

The influence of aggregate demand Of course, firms will choose to increase production only if there is a market for this production. Aggregate demand is as important as aggregate supply to understand how the level of prices and the level of production are simultaneously determined. The aggregate demand for the domestic firms production is, as we have seen, the sum of domestic absorption and net exports:AD = DA + NX The question is what variables determine DA and NX ?

Domestic absorption: C + I + G C+I+G = DA represents the aggregate expenditure of the domestic residents (households, firms and governments). Their spending is intimately connected with their disposable incomes: (wages + net investment income + transfers - income taxes) for the households. (retained earnings + net investment income + transfers - corporate income taxes) for the firms. (taxes + net investment income - government transfers for the governments. The sum of the three sectors’ disposable incomes should be equal (if well measured) to gross national disposable income (GNDI). We are interested in real demand for production since it is real GDP that we ultimately want to determine. Domestic absorption in real terms should depend on real GNDI.

Domestic absorption: C + I + G We thus write: DA (in real terms) = f ( GNDI / P ) Of course, domestic absorption depends upon other variables which we will later study. However, at this level of aggregation, we can already analyze two important shocks that might affect the macroeconomic equilibrium of the economy. Let’s first derive the aggregate demand curve in the P and Y space. What happens if the average level of prices (P) goes up ? The purchasing power of gross national disposable income goes down and this exerts downward pressures on real domestic absorption.

The aggregate demand curve AD P AD P0 P1 An increase in P, say from P0 to P1 AD1 AD0 reduces (GNDI/P) and exerts downward pressures on aggregate demand (from AD0 to AD1)

Domestic absorption: C + I + G Now, any event other than a change in P that would affect (GNDI / P) would also affect aggregate demand. In this case, instead of inducing a change in demand along a given aggregate demand curve, this would shift the entire curve. Let’s consider a few possible examples: In nominal terms, GNDI depends on the value of net exports NX and on the value of net factor payments NFP. The value of net exports depends on the terms of trade (the price of exports in terms of imports : TOT = PX/PM ). The value of net factor payments depend on the interest rates we pay on the foreign debt (i*). We can write: GNDI = f ( TOT , i* ) and consider the following shocks.

P AD0 ( TOT0 ) AD1 (TOT1 < TOT0 ) AD When the terms of trade deteriorate, the aggregate demand curve shifts to the left as real domestic absorption falls.

P AD0 ( i*0 ) AD1 (i*1 > i*0 ) AD When interest rates on our foreign debt go up, the aggregate demand curve shifts to the left as real domestic absorption falls.

Domestic absorption: the other determinants When we go into the details of the three components of domestic absorption we find that other important variables need be considered. Domestic investment (I) certainly depends on the level of domestic real interest rates (r) and on the availability of credit. Domestic consumption (C) may also depend on the level of domestic real interest rates (r) and the availability of credit. Government consumption (G) may also depend on the same variables but the key determinant will be the government’s fiscal policy. The government’s fiscal policy can also affect C and I by reducing or increasing taxes. Consumption and Investment may depend not only on private disposable income but also on the real capital gains that the households and firms realize on their assets. Finally, consumption and investment may change as expectations of future events, positive or negative, change the propensity to spend now versus the future (Keynes’ “animal spirits”)

Domestic absorption: summing up Summing up, we can write: DA = f ( TOT, i* , r, credit availability, fiscal policy, capital gains, “animal spirits” ) Discussion in class and examples on the blackboard

Net exports: X-M Domestic absorption is not the only source of demand for domestic production. The second source is net exports. X - M in real terms depends upon many things but we will formalize the problem somehow. First, an increase in real domestic absorption DA real generates imports. At the same time however, an increase in our trade partners domestic absorption DA* real increases our exports. We can thus write: (X - M ) real terms = f ( DA*real / DA real ) For example, when our trading partners are increasing their domestic absorption faster than we do, our net exports tend to increase and so does our aggregate demand, other things equal.

Net exports: X-M But this is only part of the story. As far as there is some substitutability between foreign and domestic goods, the propensity to spend on foreign goods instead of domestic goods should depend upon the relative price of foreign goods in terms of domestic goods. If we designate the price of foreign exchange by the letter E (the “nominal exchange rate”), the relative price of foreign goods in terms of domestic goods (a variable sometimes called the “real exchange rate”) is equal to EP*/P and we thus write: (X - M ) real terms = f ( DA*real / DA real , EP*/P) An increase in EP*/P (sometimes called a real devaluation) should bring about an increase in net exports and aggregate demand, other things equal. We are ready to sum up:

Summing up the determinants of aggregate demand AD = f ( TOT, i* , r, credit availability, fiscal policy, capital gains, “animal spirits”, DA*real / DA real , EP*/P ) Discussion in class (slope versus shifts) and examples on the blackboard

The moving equilibrium between aggregate demand and aggregate supply... AD = AS = Y AS0 AD0 Y0 P0

determines both real growth and inflation... AS1 AD1 P AS0 AD0 Y1 P1 Y0 P0

Growth and inflation The aggregate demand and aggregate supply curves are not stationary. They are subject to a trend and are affected by a multitude of temporary shocks. These fluctuations explain the variations in the growth rate of real GDP and in the rate of inflation.

The rising trend in real GDP The rising trend in real GDP cannot be explained by the rise in aggregate demand only. With a static aggregate supply curve, a continual rise in aggregate demand would eventually bring the economy to the limit of its productive capacity (potential GDP).

The growth in AD P AD = AS = Y Y0 P0 AS0 AD2 P1 AD1 AD0 Y1

The trend in real GDP As we have seen before, the rising trend in real GDP is due to: the rising trend in productivity; the rising trend in the labor force, in employment and in the capital stock. These factors shift the aggregate supply curve to the right.

When employment and the capital stock grow at the same speed AS1 P AS0 P1 AD0 AD = AS = Y Y1

When productivity increases (increases in K/Lh and innovation) AD0 Y0 P0 P1 AD = AS = Y Y1

The shifts in the aggregate supply curve These shifts in the aggregate supply curve can explain the rising trend in real GDP but not the rising trend in the aggregate level of of prices (inflation). For the aggregate level of prices to rise along with real GDP, the aggregate demand curve must also shift to the right.

The simultanous shifts in AD and AS Y1 P1 P Y0 P0 AS0 AD0

What explains the rightward trend in the aggregate demand curve ? In the short run, several factors may contribute to shift the aggregate demand curve to the right. In the long run however, only a continual expansion in the means of payments linked to credit can support a continual increase in aggregate demand. We shall come back to this when discussing monetary policy.

The trends in real GDP growth and inflation AS0 AD0 Y0 P0 AS1 AD and AS are both subject to a positive long run trend. These trends are explained by the regular increases in the labor force, in te capital stock, in productivity and in wages (AS) and by the normal expansion of the means of payments linked to credit (AD). AD1 P1 Y1

Short-run fluctuations The shifts in aggregate supply and aggregate demand are not the same every quarter. In the short-run, several shocks may hit the economy through their influence on the AD and/or the AS curves. Let ’s consider a few examples.

A positive demand shock A positive demand shock (e.g. a fall in the real interest rate, a reduction in tax rates, an improvement in the terms of trade, etc,) would shift the aggregate demand curve to the right beyond its normal trend. Inflation and real GDP growth both increase. P AS0 AD0 Y0 P0 AS1 AD1 P1 Y1

A negative demand shock A negative AD shock (e.g. a fall in the growth rate of absorption in the European Union, a rise in the real interest rate, etc,) would slow the pace of AD expansion with respect to its normal trend. Inflation and the growth rate of real GDP are both reduced. P AS0 AD0 Y0 P0 AS1 AD1 P1 Y1

Conclusion AD shocks (positive or negative) induce variations in the growth rate of real GDP and in the rate of inflation which go in the same direction.

A positive aggregate supply shock with constant productivity A positive AS shock (e.g. a fall in payroll tax rates) reduces unit costs which induces a downward shift in the aggregate supply curve. Growth is higher and inflation is lower. P AS0 AD0 Y0 P0 AS1 AD1 P1 Y1

When productivity rises faster AD0 Y0 P0 AS1 An increase in the productivity growth rate (with respect to its normal trend) shifts the AS curve further to the right and downward. Real GDP growth accelerates while inflation decelerates. AD1 P1 Y1

A negative supply shock with constant productivity A negative AS shock (e.g. a rise in the price of oil) increases unit costs and shifts the aggregate supply curve upward. Inflation is higher and growth is lower. P AS0 AD0 Y0 P0 AS1 AD1 P1 Y1

Conclusion AS shocks (positive or negative) bring variations in the growth rate of GDP and inflation which go in opposite directions.

Inflation in the neighborhood of full employment: the acceleration hypothesis When aggregate demand shifts to the right in the rising costs section of the aggregate supply curve (when the unemployment rate is close to its lower limit), price increases are higher. If nominal wages stayed unchanged, higher prices would mean lower real wages. As the unemployment rate approaches its lower limit, we should expect skilled workers to ask for increases in their nominal wages so as to protect the purchasing power of their wage.

The inflation acceleration hypothesis When the rate of unemployment approaches its lower limit, inflation tends to accelerate because wags tend to increase more rapidly to catch up with rising prices.. P AS0 AD0 Y0 P0 AS1 AD1 P1 Y1

The inflation acceleration hypothesis Because unit costs rise more rapidly, inflation accelerates. When the rate of unemployment is close to its lower limit, an acceleration in the growth of aggregate demand would accelerate inflation only. Central banks and financial markets are well aware of that...

Discussion in class: Using the aggregate supply - aggregate demand model to discuss recent trends and current policy issues in North America

Fluctuations and growth: the aggregate supply - aggregate demand model École des Hautes Études Commerciales (HÉC), November 2001