Macro Aggregate Supply Lecture 21 Dr. Jennifer P. Wissink ©2018 Jennifer P. Wissink, all rights reserved. November 6, 2018 1

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SR-AS Shifts If inflation were assumed to be fully anticipated, then wage rates and other input prices would be expected to increase at exactly the same rate as the overall price level in the economy. That would imply that the SR-AS would shift as soon as the AD shifted and the PL changed. That would imply that nothing real in the economy would actually change. Not good news if you want to see discretionary policy work. But many argue that this is simply not the observed case. So... there must be a lag between changes in input prices and changes in output prices, otherwise the SR-AS (the SR price/output response) curve would be vertical. So... we operate with the idea that enough input prices tend to lag behind changes in output prices to make it so we can talk about an upward sloping SR-AS. So... now we need to introduce the (macro) long run aggregate supply curve (LR-AS).

Macro LR-AS So... What is the (macro) long run aggregate supply curve (LR-AS)? Good question! It’s the level of aggregate ouput(income), i.e., Y, that the economy can produce with out generating inflation. Some definitions actually say… without generating accelerating inflation It the level of Y where we are at “full employment” This means resources are used at their normal “full employment” intensity. This level of Y is frequently referred to as Y-potential or Y-full employment. Case/Fair/Oster call Y-potential Yo in lots of their diagrams. This is where employment reaches its “natural” non-inflationary level. Note: This IS NOT Y-capacity where any given macro SR-AS becomes vertical. The macro LR-AS curve will be vertical at Y-potential

(M)AD, SR-AS and LR-AS LR-AS SR-ASN SR-ASO PLN PLO ADN ADO YO YFE

Review: SR-AS versus LR-AS We have distinguished between the short run AS curve (SR-AS) long run AS curve (LR-AS) SR-AS is positively sloped and… tends to start out rather flat/horizontal at low levels of Y. then has a section that’s positively sloped. then tends to get very steep/vertical as we approach Y-capacity (which is different than Ypotential/YFE ). will shift with cost/supply shocks (see chart again, the one with the pics). LR-AS is vertical at YPotential/YFE This is because eventually all prices adjust, including input prices. YPotential/YFE is the level of income/output where there is no inflation. If Y>YFE then you’ll get rising price/wage levels and a shift in the SR-AS back to LR-AS, but now at a higher price level. If Y<YFE then you’ll get falling price/wage levels and a shift in the SR-AS back to LR-AS, but now at a lower price level.

Bad News for Monetary & Fiscal Policy? If LR-AS is vertical, then neither monetary policy nor fiscal policy has any long run effect on aggregate output. In the long run, the multiplier effect of a change in MS, and/or G and/or T on aggregate output, Y, is zero. So: lots of good questions and debate here: How long does it take for SR-AS to shift? Is the LR-AS really vertical? And where exactly is YFE relative to current Y*? Can policy (and what type of policy then?) change where LR-AS is?

Inflation and Deflation Concepts Review Inflation is an increase in the overall price level. Sustained inflation occurs when the overall price level continues to rise over some fairly long period of time. Hyperinflation is a period of very rapid increases in the overall price level. Hyperinflations are rare, but have been used to study the costs and consequences of even moderate inflation. Stagflation occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation). Deflation is a decrease in the overall price level. Prolonged periods of deflation can be just as damaging for the economy as sustained inflation.

TWO New Major Types of Inflation Cost-push, or supply-side, inflation is inflation (stagflation) caused by an increase in costs generating a decrease (a shift leftward) in SR-AS. Demand-pull inflation is inflation initiated by an increase in AD (a shift rightward of AD).

Cost-Push Inflation & Stagflation Leading to Demand Pull Inflation Recall stagflation... occurs when output is falling at the same time that prices are rising. Suppose for example: we’re at Y0 and then... oil prices increase. SR-AS0 shifts left and we get higher prices and less output. So suppose we react and use expansionary monetary and/or fiscal policy. That increases the price level even more!

Another Source of Inflation: Expectations If every firm expects every other firm to raise prices by 10%, every firm will raise prices by about 10%. This is how expectations can get “built into the system.” In terms of the AD/AS diagram, an increase in inflationary expectations shifts the SR-AS curve to the left. Works like a negative cost shock. Called expectational inflation. Turns out to be “self-fulfilling.” Note: Something had to “start” it, like expansionary monetary or fiscal policy.  Expectational inflation can only sustain an ongoing inflation (which typically starts with some increase in AD) Related to an idea of “inertial inflation” when inflation continues on its own inertia when the original reason for it has ceased.

Money Supply and Inflation: 1 of 2 It is often said that, “You can’t have a sustained inflation (or worse yet a hyperinflation) without monetary support.” WHY? HOW’s THAT WORK? Consider an increase in G with the Fed keeping the money supply constant. AD curve shifts right. When MD depends on Y & PL, this leads to an increase in MD and therefore an increase in the interest rate and crowding out of planned investment, so AD shifts back a little leftward. Also once wages and other input prices catch up, SR-AS will shift left, too. This will all stop at a higher price level and back on LR-AS. END OF STORY. Inflation is over....

Money Supply and Inflation: 2 of 2 BUT... If the monetary guys decide to increase the money supply to decrease the interest rate to undo some of the crowding out effect... ...then we kind of start the whole thing over again with another rightward shift in AD. The result is a sustained inflation, perhaps hyperinflation. So if the Fed holds fast on the money supply, the inflation will eventually end on its own. Albeit at a stable HIGHER overall price level.

Back to the “Back-Story” for Macro SR-AS Recall… if inflation is assumed to be fully anticipated, then wage rates and other input prices would increase at exactly the same rate as the overall price level in the economy. That would imply that the SR-AS would shift as soon as the AD shifted and the PL changed. Not good news if you want to see discretionary policy work. But… many argue that this is simply not the observed case. So, we operate with the idea that enough input prices tend to lag behind changes in output prices to make it so we can talk about an upward sloping SR-AS. BUT WHY?? Need to look at labor market Do wages adjust? Or are they sticky?

The Classical View of the Labor Market According to classical economists, the quantity of labor demanded and supplied are brought into equilibrium by rising and falling wage rates. There should be no persistent unemployment above the frictional and structural amount. There should be no lags.

The Classical View of the Labor Market Labor demand illustrates the amount of labor that firms want to employ at each given wage rate. Labor supply illustrates the amount of labor that households want to supply at each given wage rate. The classical view is that the labor market always clears.

The Classical View of the Labor Market Now suppose that output falls and consequently employers demand less labor. If labor demand decreases, the equilibrium wage will fall. Anyone who wants a job at W1 will have one. There is always full employment in this sense.

The Classical View’s Explanation for the Existence of Unemployment So why is there unemployment then? Well...they would argue...maybe it’s not really classical unemployment because.... The unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly. The unemployment rate may sometimes seem high even though the labor market is working well. It’s a measurement problem as people search for higher wages since they are willing to work at higher wages.

The Non-Classical View’s Explanation for the Existence of Unemployment It really is unemployment and one reason for it is sticky wages. Sticky Wages The idea of sticky wages refers to a downward rigidity of wages as an explanation for the existence of unemployment. Inconsistent with the classical view. But, arguably more realistic to many.

Sticky Wages Suppose labor demand falls from D0 to D1. W S0 If wages “stick” at W0 (rather than fall to W1) the result is unemployment equal to L0 – L2. W0 W1 D0 D1 L L2 L1 Lo

Why Sticky Wages? Social, or implicit, contracts: unspoken agreements between workers and firms that firms will not cut wages in bad times, and firms will not cut wages unless all wages in other firms and industries are also cut, so as to maintain relative wage structure. Explicit contracts: employment contracts that stipulate workers’ wages, usually for a period of one to three years. Wages set in this way do not fluctuate quickly with economic conditions. Cost of living adjustments (COLAs): contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised, but usually don’t see COLAs for weak labor markets. If firms have imperfect information, they may simply set wages wrong—wages that do not clear the labor market. Minimum wage laws set a floor for wage rates, and explain at least a fraction of unemployment. The efficiency wage theory: based on the notion that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate.

From Sticky Wages to a Relationship between Inflation and Unemployment Truth of the matter for many... Sticky wages exist. Unemployment happens. So, is there a tradeoff here? If so, between what and what? And for how long? The Original Phillips Curve The Modern Phillips Curve

A Short-Run Relationship Between the Unemployment Rate and the Price Level The relationship between U and PL is negative. As U declines in response to the economy moving closer and closer to capacity output, the overall price level rises more and more. Recall: As depicted by this SR-AS curve, the relationship between Y and the price level (PL) is positive.