1. Diploma Macro Paper 2 Monetary Macroeconomics Lecture 6 Mark Hayes
Aggregate supply
and putting AD and AS together
Mark Hayes

2. Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market
KX and IS
(Y, C, I)
Labour market
(P, Y) AS
AD-AS
(P, i, Y, C, I)
Money
market (LM)
(i, Y)
IS-LM
(i, Y, C, I) AD
Foreign exchange
market
(NX, e)
IS*-LM*
(e, Y, C, NX)
AD*
AD*-AS
(P, e, Y, C, NX)

3. Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market
KX and IS
(Y, C, I)
Labour market
(P, Y) AS
AD-AS
(P, i, Y, C, I)
Money
market (LM)
(i, Y)
IS-LM
(i, Y, C, I) AD
Foreign exchange
market
(NX, e)
IS*-LM*
(e, Y, C, NX)
AD*
AD*-AS
(P, e, Y, C, NX)

4. Deriving the AD* curve Why AD* curve has negative slope: P  (M/P)
LM*(P2)
LM*(P1)
Why AD* curve has negative slope:
IS* 2 1 P
 (M/P)
 LM shifts left Y2 Y1 Y P
  P2
 NX P1
 Y
AD* Y2 Y1

5. Mundell-Fleming and the AD* curve
Previously P was fixed, now we are changing it.
NX is a function of  , not e.
We now write the M-F equations as:
This means that the diagram does not show us the eq’m for e but we do not need this explicit for AD*
𝑰𝑺 ∗ :𝒀= 𝒄 𝟏 (𝒀− 𝑻 )+𝑰 𝒊 ∗ + 𝑮 +𝑵𝑿()
𝑳𝑴 ∗ :( 𝑴 𝑷 ) =𝑳( 𝒊 ∗ ,𝒀)

6. The effect of an increase in demand in the ‘short run’ and the ‘long run’
AD2
AD1
A = initial (full employment) equilibrium Y P
LRAS C P2
SRAS2
B = new short-run eq’m after a boom in confidence B P1
SRAS1 A Y2
C = long-run equilibrium

7. Keynes’s original AD-AS model
expected
income AS AD D*
Effective demand
Equilibrium employment
employment, N

8. A post-Keynesian AD-AS model in P, Y space
LRAS AD
SRAS Y Y

9. P
LRAS AD
𝒀− 𝒀 =𝜶 𝑷− 𝑷 𝒆 Pe Y

10. Three models of aggregate supply
The imperfect-information model
The sticky-price model
The sticky-wage model
All three models imply:
agg. output
natural rate of output
a positive parameter
the actual price level
the expected price level

11. Three models of aggregate supply
The imperfect-information model
The sticky-price model
The sticky-wage model
All three models imply:
𝒀− 𝒀 =𝜶 𝑷− 𝑷 𝒆
Deviations in output
a positive parameter
Deviations in price level from expectation

12. The imperfect-information model
Assumptions:
All wages and prices are perfectly flexible, all markets clear
Each supplier produces one good, consumes many goods.
Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level.

13. The imperfect-information model
All suppliers know the nominal price of the good they produce, but do not know the general price level.
Supplier does not know general price level at the time of the production decision, so uses the expected price level, P e.
Suppose P rises but P e does not.
Supplier thinks it is their own relative price which has risen, so produces more.
With many producers thinking this way, Y will rise whenever P rises above P e.

14. The sticky-price model
Assumption:
Firms set their own prices (monopolistic competition).
Reasons for sticky prices:
long-term contracts between firms and customers
menu costs
firms not wishing to annoy customers with frequent price changes

15. The sticky-price model
An individual firm’s desired price is
where a > 0.
Suppose two types of firms:
firms with flexible prices, set prices as above
firms with sticky prices, must set their price before they know how P and Y will turn out:

16. The sticky-price model
Assume sticky price firms expect that output will equal its natural rate. Then,
To derive the aggregate supply curve, we first find an expression for the overall price level.
Let s denote the fraction of firms with sticky prices. Then, we can write the overall price level as…

17. The sticky-price model
price set by sticky price firms
price set by flexible price firms

18. The sticky-wage model
Assumes that firms and workers negotiate contracts and fix the money wage before they know what the price level will turn out to be.
The money wage they set is the product of a target real wage and the expected price level:
At the target real wage, the labor market is in equilibrium, meaning that unemployment equals its natural rate. This implies that output equals its natural rate (aka full-employment output).
Target real wage

19. I’ve included Figure 13-1 from the text here as a “hidden slide” in case you wish to “unhide” and include it in your presentation. This figure uses graphs to derive the aggregate supply curve under the assumption of sticky wages.
As you can see, three-panel diagrams do not translate well to the big screen. Fortunately, though, most students readily grasp the intuition on the preceding slide, which sums up as follows:
If the nominal wage is fixed, then increases in the price level cause the real wage to fall, which causes firms to hire more workers and produce more output.

20. The sticky-wage model If it turns out that then
Unemployment and output are at their natural rates.
Intuition for the positive relationship between P and Y, for a given value of the expected price level.
Real wage is less than its target, so firms hire more workers and output rises above its natural rate.
Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate.

21. Chart 4.6 Real product wages, labour market slack and productivity
Sources: ONS (including the Labour Force Survey) and Bank calculations.
(a) Headline unemployment rate less the central Bank staff estimate of the medium-term equilibrium unemployment rate. For details, see the box on pages 28–29 of the August 2013 Report.
(b) Private sector AWE total pay deflated by the market sector gross value added deflator.
(c) Market sector output per worker.

22. Summary & implications
Figure 13-3, p.357
Idiosyncracy alert:
If  is constant, then the SRAS curve should be linear, strictly speaking. However, in the text, it is drawn with a bit of curvature (which I have reproduced here). Y P
LRAS
SRAS
The following is not in the text, but you and your students may find it worthwhile:
There are good reasons to believe that the SRAS curve is bow-shaped in the real world; that is, the curve is steeper at high levels of output than at low levels of output. And there are good reasons why we should care about this.
Why the SRAS curve is bow-shaped:
At low levels of output, there are lots of unutilized and under-utilized resources available, so it is not terribly costly for firms to increase output, and therefore firms do not require a big increase in prices to make them willing to increase output by a given amount. In contrast, at very high levels of output, when unemployment is below the natural rate and capital is being used at higher than normal intensity levels, it is relatively costly for firms to increase output further. Hence, a larger increase in prices is required to make firms willing to increase their output.
Why the curvature matters:
When policymakers increase aggregate demand, output rises (good) and prices rise (not good). An important question arises: how much of the bad thing (price increases) must we tolerate to get some of the good thing (an increase output)? The answer depends on how steep the SRAS curve is.
When President Reagan cut taxes in the early 1980s, the economy was just coming out of a severe recession, and was on the flatter part of the SRAS curve; hence, the tax cuts affected output a lot and inflation very little. In contrast, when the current President Bush proposed huge tax cuts during the 2000 election season, we were on the steeper part of the SRAS curve, so the tax cuts would likely have been inflationary. Of course, by the time they were implemented, the economy was in recession, and in any case the bulk of the tax cuts were to be spread out over 10 or 11 years, so they have not proved inflationary.
Each of the three models of agg. supply imply the relationship summarized by the SRAS curve & equation.

23. Summary & implications
Suppose a positive AD shock moves output above its natural rate and P above the level people had expected.
SRAS equation:
SRAS2 Y P
LRAS
AD2
SRAS1
AD1
This graph has two lessons for students:
First, changes in the expected price level shift the SRAS curve (this should be clear from the equation, as should the fact that a change in the natural rate of output will shift the SRAS curve).
The second lesson concerns the adjustment of the economy back to full-employment output.
Over time, P e rises, SRAS shifts up, and output returns to its natural rate.

24. Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market
KX and IS
(Y, C, I)
Labour market
(P, Y) AS
AD-AS
(P, i, Y, C, I)
Money
market (LM)
(i, Y)
IS-LM
(i, Y, C, I) AD
Foreign exchange
market
(NX, e)
IS*-LM*
(e, Y, C, NX)
AD*
AD*-AS
(P, e, Y, C, NX)

25. Inflation, Unemployment, and the Phillips Curve
The Phillips curve states that  depends on
expected inflation,  e.
cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate
supply shocks,  (Greek letter “nu”).
 measures the responsiveness of inflation to cyclical unemployment.
where  > 0 is an exogenous constant.

26. The Phillips Curve and SRAS
𝒀− 𝒀 =𝜶 𝑷− 𝑷 𝒆
Phillips curve
𝒖− 𝒖 𝒏 =−𝟏/𝜷 𝝅− 𝝅 𝒆 −𝒗
SRAS curve: Deviations in output are related to unexpected movements in the price level.
Phillips curve: Deviations in unemployment are related to unexpected movements in the inflation rate.

30. Exogenous: M, G, T, i*, πe Phillips Curve (,u) Goods market
KX and IS
(Y, C, I)
Labour market
(P, Y) AS
AD-AS
(P, i, Y, C, I)
Money
market (LM)
(i, Y)
IS-LM
(i, Y, C, I) AD
Foreign exchange
market
(NX, e)
IS*-LM*
(e, Y, C, NX)
AD*
AD*-AS
(P, e, Y, C, NX)

31. Policy effectiveness and inflation targeting
Next term
Policy effectiveness and inflation targeting
Origins of the North Atlantic and Euro crises