1. Chapter 26 Aggregate supply, the price level, and the speed of adjustment David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

2. 26.1 Introducing prices and the labour market n In discussing equilibrium within the IS-LM model, it has been assumed that – prices are fixed – the supply-side of the economy can be ignored. n These assumptions must now be relaxed.

3. 26.2 The price level and aggregate demand n The CLASSICAL model of macroeconomics analyses the economy when wages and prices are fully flexible. n The real money supply is the key variable linking the aggregate demand for goods and the price level. n The price level is the average price of all the goods produced in the economy.

4. 26.3 The macroeconomic demand schedule (MDS) connects these points... MDS The macroeconomic demand schedule Real money supply is nominal money supply divided by the price level – it influences the position of LM. Income r P IS LM 0 Y0Y0 P0P0 With price at P 0, LM is located at LM 0, and given IS, real income is in equilibrium at Y 0. At a lower price P 1, LM is at LM 1, and real income at Y 1. LM 1 Y1Y1 P1P1

5. 26.4 MDS The macroeconomic demand schedule Income r P IS 0 LM 0 Y0Y0 P0P0 LM 1 Y1Y1 P1P1 The MDS shows the different combinations of the price level and real income at which planned spending equals actual output once interest rates are set to keep money market equilibrium. Notice that a fall in price may also shift IS by increasing the value of household wealth via the real balance effect. IS 1 Y2Y2 The effect of this is to produce a flatter schedule MDS'. MDS'

6. 26.5 The labour market and aggregate supply n The aggregate supply schedule – shows the output that firms wish to supply at each price level. n Given that output depends on inputs employed, the labour market is the starting point for analysing aggregate supply.

7. 26.6 The labour market Employment, labour force Real wage LD LD is the labour demand schedule: it shows how much labour firms demand at each real wage. LF The schedule LF shows that more people will be in the labour force at higher values of the real wage. AJ AJ shows how many workers have accepted jobs at each real wage. N* N2N2 Equilibrium is where AJ = LD, at N*. N 2 – N* is the natural rate of unemployment. w*

8. 26.7 The labour market Employment, labour force Real wage LD LF AJ N* N2N2 w* The unemployment that occurs in equilibrium (shown by N 2 – N*) is voluntary. If the real wage is above its equilibrium at w 1, there is unemployment given by N 3 – N 1. N3N3 N1N1 w1w1 Of this, BC is voluntary, but AB is involuntary. AB C

9. 26.8 The aggregate supply schedule Output Price level Flexibility of wages and prices ensures that real wage adjustment maintains full employment in the labour market. So overall equilibrium is shown where MDS = AS at the potential output level Y p and price level P. MDS P In the CLASSICAL model, with no money illusion and flexible money wages, AS is vertical at the level of potential output. AS YpYp

10. 26.9 Monetary and fiscal policy Output Price level MDS P0P0 AS YpYp Changes in nominal money supply or in fiscal policy shift the MDS, altering the level of aggregate demand at each price. In the Classical model, a change in nominal money supply leads to an equivalent % change in nominal wages & prices. Real money supply, interest rates, output, employment and real wages ALL remain unchanged. E But a shift from MDS to MDS' alters equilibrium from E to E'; price increases from P 0 to P' but output remains at Y p. MDS' P' E'

11. 26.10 Fiscal policy n An increase in government expenditure in this model – bids up prices – so real money supply is lower – interest rates rise – private expenditure on consumption and investment falls – i.e. there is complete crowding out – all that changes is the composition of aggregate demand – the public sector becomes more important.

12. 26.11 The speed of adjustment n Adjustment in the Classical world is rapid, so the economy is always at potential output (full employment). n If wages and prices are sluggish, then output may deviate from the potential level. n A "Keynesian" world of fixed wages and prices may describe the short run period before adjustment is complete.

13. 26.12 Supply-side economics n The pursuit of policies aimed not at increasing aggregate demand, but at increasing aggregate supply. n A way of influencing potential output, seen as critical in the Classical view of the economy.

14. 26.13 Adjustment in the labour market Short-run (3 months) Medium run (1 year) Long-run (4-6 years) WAGES HOURS EMPLOYMENT Largely given Demand- determined Largely given Beginning to adjust Hours/ employment mix adjusting Clearing the labour market Normal work week Full employment

15. 26.14 Short-run aggregate supply n If adjustment is not instantaneous, output may diverge from Y p in the short run. n Firms may vary labour input – via hours of work (overtime or layoffs) n Wages may be sluggish in falling to restore full employment in response to a fall in aggregate demand n The short-run aggregate supply schedule shows the prices charged by firms at each output level, given the wages they pay.

16. 26.15 The short-run aggregate supply schedule Output Price level YpYp SAS P0P0 SAS 1 SAS 2 In time, the firm is able to negotiate lower wages, and the SAS shifts to SAS 1 and then to SAS 2, A A2A2 P2P2 until equilibrium is restored at A 2. Suppose the economy is initially at Y p in full- employment equilibrium at A, with price P 0 B In response to a fall in aggregate demand, firms in the short run vary labour input, thus moving along SAS to B.

17. 26.16 MDS' a fall in nominal money supply shifts MDS to MDS' Output Price level YpYp SAS P E MDS AS A fall in nominal money supply Starting from long-run equilibrium at E: E' P' Given wage levels, firms adjust to E' in the short run With price at P' but wages unchanged, the real wage rises bringing involuntary unemployment. P3P3 SAS 3 E3E3 Equilibrium is eventually reached at E 3, back at Y p. SAS' As the labour market (wage) adjusts SAS shifts e.g. to SAS' P''

18. 26.17 An adverse supply shock: e.g. an increase in the price of oil Yp'Yp' MDS Output P P SAS E SAS' Higher oil prices force firms to charge more for their output, so SAS shifts to SAS' Y' Higher prices cause a move along MDS, and output falls to Y' P' E' equilibrium from E to E' In time, unemployment reduces wages and SAS gradually shifts back to SAS, so Y p is restored.