1 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter 6 Aggregate Supply: Wages, Prices and Unemployment

2 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.1The AS Curve and the Price Adjustment Mechanism 6.2Inflation and Unemployment 6.3The Wage–Unemployment Relationship: Why are Wages Sticky? 6.4From Phillips Curve to the AS Curve 6.5The Effects of a Monetary Expansion

3 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.6Stagflation, Expected Inflation and the Inflation-Expectations- Augmented Phillips Curve 6.7The Rational Expectations Revolution 6.8Supply Shocks

4 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.1The AS Curve and the Price Adjustment Mechanism 6.2Inflation and Unemployment 6.3The Wage–Unemployment Relationship: Why are Wages Sticky? 6.4From Phillips Curve to the AS Curve 6.5The Effects of a Monetary Expansion

5 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The AS curve is horizontal in the very short run  In the long run the AS curve is vertical  There is a spectrum of upward-sloping intermediate-run AS curves  Equation 6.1 gives the AS curve 6.1 AS and the Price Adjustment Mechanism

6 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Where P t +1 is the price level next period, P t is the price level today, Y* is potential output and is the speed of price adjustment  The equation states that if output is above potential output then prices will rise next period and vice versa  If is large, the AS curve will be steeper and the AS mechanism will return the economy to potential output relatively quickly AS and the Price Adjustment Mechanism

7 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.1The AS Curve and the Price Adjustment Mechanism 6.2Inflation and Unemployment 6.3The Wage–Unemployment Relationship: Why are Wages Sticky? 6.4From Phillips Curve to the AS Curve 6.5The Effects of a Monetary Expansion

8 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The classical model holds that the economy is always at full employment  Any unemployment is purely frictional  Implied is that wages are determined by  Productivity  The impact of money on prices  Unemployment does not affect wages 6.2 Inflation and Unemployment

9 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The classical model has been criticised because  The unemployment rate fluctuates more than is consistent with it all being frictional unemployment (e.g. 8–10%)  There appears to be a systematic relationship between the rate of change of wages and the unemployment rate Inflation and Unemployment

10 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The PC shows an inverse relationship between the rate of unemployment and the rate of increase in money wages  The higher the rate of unemployment, the lower the rate of wage inflation Where g w is the rate of wage inflation and u* is the NRU  When u > u*, wage inflation is falling The Phillips Curve (PC)

11 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz The Phillips Curve (PC)

12 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The PC implies that wages and prices adjust slowly to changes in AD  Hence, in the short run, we are faced with a policy trade-off between  high unemployment and low inflation, or  high inflation and low unemployment The Phillips Curve (PC)

13 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.1The AS Curve and the Price Adjustment Mechanism 6.2Inflation and Unemployment 6.3The Wage–Unemployment Relationship: Why are Wages Sticky? 6.4From Phillips Curve to the AS Curve 6.5The Effects of a Monetary Expansion

14 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Wages are ‘sticky’ when they move slowly over time  Because ‘sticky’ wages are not fully flexible, full employment is not ensured  The PC relationship between the level of employment and the rate of change in wages is  Given by Equations 6.2 to 6.5  Illustrated in Figure Wage–Unemployment Relationship

15 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz The Wage–Unemployment Relationship

16 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  If employment is above the full-employment level, the wage next period increases above this period’s wage N > N* implies W t +1 > W t  If employment is held above N* next period then the increase in wages is shown by an upward shift of the WN curve next period  If N > N* is maintained then W t + 2 > W t +1  This spiral process works in the reverse as well The Wage–Unemployment Relationship

17 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz The Wage–Unemployment Relationship

18 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The extent that wages respond to employment depends on the parameter   If  is large, unemployment has larger effects on the wage and the WN curve is steeper  So changes to AD that alter the unemployment rate this period will have effects on wages in subsequent periods The Wage–Unemployment Relationship

19 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Imperfect information: market clearing  Wages are fully flexible but adjust slowly because information is imperfect  When wages go up because prices increase, workers mistakenly believe real wages have increased and are willing to increase labour supply  This increases output and reduces unemployment until workers realise that real wages have not gone up Wage Stickiness

20 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Coordination problems  As all firms cannot coordinate their prices, any firm that increases its price due to a change in money supply will lose market share  Hence, firms raise prices slowly as the effects of a change in money stock is felt through an increased demand for goods at existing prices Wage Stickiness

21 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Efficiency wages and costs of price change  Efficiency wage theory focuses on wages as a means of motivating labour  Firms may want to pay workers above the market-clearing wage to ensure that employees work harder  This may reduce disguised ‘shirking’ by workers Wage Stickiness

22 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Contracts and long-term relationships  Working conditions and wages are renegotiated periodically, but not frequently, because it is costly to do so  Assume half the labour force renegotiate wages in January and half in June  Assume an increase in the money stock in September  Workers renegotiating wages in January cannot adjust their salary to long-run equilibrium Wage Stickiness

23 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  If they attempted to do so, employers would simply hire June workers as overtime  Thus, there is a danger of unemployment for January workers if the renegotiated wages are too high  Wages only adjust partway to equilibrium  June workers are faced with the same problem when it is time for their renegotiation  Thus, there is a process of staggered wage and price adjustments Wage Stickiness

24 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Insider-outsider models  It is costly for firms to turnover labour due to firing costs, hiring costs and training costs  As a result, insiders have an advantage over outsiders  It may be beneficial for the firm to reach a deal with insiders and pay higher wages even if there are unemployed people who would be willing to work for less  Therefore, unions only look after their workers Wage Stickiness

25 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.1The AS Curve and the Price Adjustment Mechanism 6.2Inflation and Unemployment 6.3The Wage–Unemployment Relationship: Why are Wages Sticky? 6.4From Phillips Curve to the AS Curve 6.5The Effects of a Monetary Expansion

26 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  To derive the AS curve we need to 1.Translate unemployment to output 2.Link the prices firms charge to their costs 3.Use the PC relationship between wages and unemployment 4.Put the three components together to derive an upward-sloping AS curve 6.4 From PC to the AS Curve

27 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Okun’s law shows the relationship between unemployment and output (Equation 6.6)  When  = 0.5 then for every 1% output is above potential output, unemployment will fall by ½% From PC to the AS Curve

28 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Costs and prices  Firms will supply output at a price that at least covers their costs  Firms set price as a mark-up (z) on labour costs of production (W/a) From PC to the AS Curve

29 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Costs and prices  The mark-up costs cover the costs of the other factors of production and the firm’s normal profits  If competition is less than perfect there will be a greater mark-up cost From PC to the AS Curve

30 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Employment and wages and the AS curve  The three components of the AS curve are Okun’s law (6.7), the price–cost relationship (6.5) and the Phillips curve (6.3a)  Substituting 6.7 into 6.3a gives (note incorrect ratios in 6.8): From PC to the AS Curve

31 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Figure 6.3 shows the AS curve implied by equation 6.1 From PC to the AS Curve

32 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz From PC to the AS Curve Setting = gives the earlier equation 6.1:  P t + 1 = P t [ 1 + ( Y - Y *) ]   Y*

33 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz From PC to the AS Curve

34 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  If output is above full-employment level, Y*, then next period the AS curve will shift up to AS’  If Y < Y* then next period the AS will shift down to AS”  The AS curve implies that wages are less than fully flexible  Prices increase with the level of output because increased output implies increased employment (reduced unemployment) and therefore increased labour costs From PC to the AS Curve

35 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.1The AS Curve and the Price Adjustment Mechanism 6.2Inflation and Unemployment 6.3The Wage–Unemployment Relationship: Why are Wages Sticky? 6.4From Phillips Curve to the AS Curve 6.5The Effects of a Monetary Expansion

36 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 6.5 The Effects of a Monetary Expansion

37 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Consider an increase in the nominal money stock  Short-run effects  At each price level real balances are higher, interest rates are lower and hence the demand for output increases  AD shifts to AD’  Firms run down inventories and accordingly hire more labour and increase output to E’  At E’ both prices and output have increased The Effects of a Monetary Expansion

38 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Medium-term adjustment  At E’ prices continue to rise  Workers demand a higher wage to compensate and this shifts the AS curve up to AS’  New equilibrium is at E” where output is lower than that of the first period and prices have risen further The Effects of a Monetary Expansion

39 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Long-term adjustment  As long as output is above the full-employment level, wages are rising  The increase in wages means firms experience cost increases and pass them on, which continues to shift the AS curve up  Output declines back to Y* and prices continue to rise  At E’” prices increase by the same proportion as the nominal money stock The Effects of a Monetary Expansion

40 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Hence, the real money stock (M/P) returns back to its original level, and so do interest rates, AD, output and employment  The increase in the money stock has no real effects (money is neutral as it only raises prices)  The neutrality of money holds in the long run but not in the short run The Effects of a Monetary Expansion

41 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.6Stagflation, Expected Inflation and the Inflation-Expectations- Augmented Phillips Curve 6.7The Rational Expectations Revolution 6.8Supply Shocks

42 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The simple PC neglects anticipated inflation  Decisions are made with regard to real wages, so nominal wages are usually adjusted for any expected inflation  Hence, unemployment depends not on the level of unemployment but on the excess of inflation over what was expected 6.6 Stagflation, Expected Inflation and the Inflation- Expectations-Augmented PC

43 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Incorporating anticipated inflation into our PC equation 6.3 gives Equation 6.10: Inflation-Expectations- Augmented PC

44 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Note two critical properties of the inflation-expectations-augmented PC  That expected inflation is passed on one for one into actual inflation  Unemployment is at the natural rate when actual inflation equals expected inflation  Hence the PC intersects the NRU at the level of expected inflation  For persistent inflation, the short-run PC shifts up Inflation-Expectations- Augmented PC

45 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.6Stagflation, Expected Inflation and the Inflation-Expectations- Augmented Phillips Curve 6.7The Rational Expectations Revolution 6.8Supply Shocks

46 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The PC relationship depends on people being wrong about inflation  Rational expectations assumes that individuals do not make systematic mistakes  Hence, if agents knew that the RBA increased the money supply by 4%  Then agents would expect 4% inflation  Unemployment would remain unchanged  Inflation would rise to 4% 6.7 The Rational Expectations Revolution

47 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  However, if agents did not know the growth of the money supply, then they must guess using all the available information  If actual inflation turns out to be greater than anticipated inflation, AD would increase and unemployment would decrease  As soon as agents are aware of their mistake, they adjust very rapidly as inflationary expectations are set to the correct value, shifting up the AS curve to its long-run position Rational Expectations

48 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Hence, anticipated policy changes have no real effects  Unanticipated policy changes do affect real variables, but only for a short period, as the adjustment process is rapid  Rational expectations are reconsidered in Chapter 20 Rational Expectations

49 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 6.6Stagflation, Expected Inflation and the Inflation-Expectations- Augmented Phillips Curve 6.7The Rational Expectations Revolution 6.8Supply Shocks

50 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Incorporating materials prices into the analysis  Previously, labour costs and the mark-up were the only determinants of output prices  Materials prices also impact upon the prices of final goods  Equation 6.13 shows that for given wages, profit margins and labour productivity, an increase in the real price of materials increases prices and shifts the AS up 6.8 Supply Shocks

51 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Supply Shocks

52 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Supply Shocks

53 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Assume that there is an increase in the price of oil  The AS curve shifts up and the economy moves to point E’  Initially, prices have increased and output decreased  The unemployment at point E’ forces wages and thus the price level down  The economy moves back to point E Supply Shocks

54 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Employment is back to full employment  However, real wages have decreased since nominal prices have returned to their original levels while nominal wages have decreased  Accommodation of supply shocks  The adjustment process is slow, since wages are relatively slow to adjust  The government may accommodate the supply shock by increasing AD Supply Shocks

55 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The economy moves to E*  Price would increase again while nominal wages are unchanged, implying lower real wages  Accommodating policies face the trade-off between the inflationary impact of a shock and its recessionary effects Supply Shocks