1. Lecture 20: Aggregate Supply --
Price level P, Inflation π, & Wages W
Aggregate Demand (AD) & Aggregate Supply (AS)
Ultra-Keynesian A.S.
Neoclassical A.S.
Intermediate A.S. curve
Expectations-augmented A.S.
Rational expectations A.S.
Real Business Cycles (RBC)
Appendices Labor market rigidities.
ITF220 - Prof.J.Frankel

2. Aggregate Demand curve slopes down.
Why? y p AD
P ↑
=> M1 / P ↓
(“real balance effect”)
=> LM shifts left
=> Y ↓
ITF220 - Prof.J.Frankel

3. 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′ 𝑦
ITF220 - Prof.J.Frankel

4. 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.
ITF220 - Prof.J.Frankel

5. US output fell sharply below potential in 2008-09.𝒀 𝒀
Brad deLong, Jan

6. Inflation fell in the 2008-09 global recession.
WORLD ECONOMIC OUTLOOK (WEO)
Uneven Growth: Short- and Long-Term Factors
April 2015
IMF

7. ALTERNATIVE 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 ≡ MP of Labor at full employment (See graphs in Appendix I.)
ITF220 - Prof.J.Frankel

8. API-120 - Prof. J. Frankel, Harvard University
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'
Realistic in Long Run.
Only AS shocks move Y , e.g., productivity shocks.
API Prof. J. Frankel, Harvard University

9. AGGREGATE SUPPLY (continued)
● 3) Intermediate case: W = 𝑊 => AS has some slope, even in the SR.
𝑌 𝑌 = ω 𝑃 𝑊 σ
SR supply relationship: y p AS ●
AD'
Implication: Demand expansion goes partly into P, partly into Y.

10. Monetary expansion raises AD in the SR.
A rise in the current level of M shifts LM curve out, because M/P , in the SR.
Alternatively, a rise in expected future growth rate of M shifts IS out, because  e  => r  => A  .
Either way, IS-LM shifts right => AD shifts right:
Result is higher Y and higher P. ●
ITF220 - Prof.J.Frankel

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

12. ● ● ● ● Initially – Point A. Then monetary expansion.
26.4
Initially – Point A. Then monetary expansion.
MR -- Point C: Pe adjusts partway => W does too.
LR -- Point D: Pe, and so W, have fully adjusted.
SR -- Point B: before W has had time to adjust. ● ● ● ●
ITF220 - Prof.J.Frankel

13. 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.

14. 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).
ITF220 - Prof.J.Frankel

15. 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
ITF220 - Prof.J.Frankel

16. Alternative Nominal Anchors
Money supply targets (e.g., monetarism in 1980s.)
Pegged price of gold (e.g., classical gold standard)
Price level target (e.g., Inflation Targeting)
Fixed exchange rate (e.g., currency board)
ITF220 - Prof.J.Frankel

17. 6. Real business cycle (RBC) theory
According to this theory, all fluctuations are due to real (supply) factors:
technology shocks &
shifts in preferences for work vs. leisure.
Not monetary policy.
ITF220 - Prof.J.Frankel

18. Appendix II: Another AS relationship
Appendix I: Derivation of general AS relationship
Appendix II: Another AS relationship
7. Indexed wages
Application: real wage rigidity in Europe, vs. US.
Appendix III: Measures of output gap
ITF220 - Prof.J.Frankel

19. Appendix I ● ● If M P of Labor => hire more N. => cut N.
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. ●
Determines w.
ITF220 - Prof.J.Frankel

20. 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.
ITF220 - Prof.J.Frankel

21. Appendix II: 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.
ITF220 - Prof.J.Frankel

22. If actual real wage > warranted real wage ω,
Y < permanently .
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:
In the 1970s the upward trend of warranted w slowed sharply
<= productivity slowdown <= oil shocks.
In the US, employment continued to rise, but real w did not;
in Europe, real continued to rise, but employment did not.
ITF220 - Prof.J.Frankel

23. 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.
ITF220 - Prof.J.Frankel

24. One view: Europeans prefer job security; Americans prefer job growth.
The Netherlands may have found a “middle way.”
ITF220 - Prof.J.Frankel

25. “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 improved labor market efficiency.
source: Giuseppe Bertola (2001)
ITF220 - Prof.J.Frankel

26. Appendix III: Measures of output gap
Three measures of excess supply tend to move together.
Source: IMF, World Economic Outlook. .
ITF220 - Prof.J.Frankel

27. Inflation turned negative in 1930-33, along with the output gap, and again in 1938-39
ITF220 - Prof.J.Frankel

28. 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,