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

2. 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)

3. 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

4. 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%

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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