14. aggregate supply unemployment and inflation
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Aggregate Supply,Aggregate Supply,UnemploymentUnemployment
and Inflationand Inflation
Aggregate Supply, Unemployment and Inflation
Aggregate Supply
AGGREGATE SUPPLY
• Different views on the shape of the AS curve
O
Pric
e le
vel
National output
P
AS
Contrasting views on the aggregate supply curve:(a) Extreme Keynesian
OAD1
Pric
e le
vel
National outputY1
P
Contrasting views on the aggregate supply curve:(a) Extreme Keynesian
AS
YF
Contrasting views on the aggregate supply curve:(a) Extreme Keynesian
O Y1
Pric
e le
vel
National output
AD2
P
AS
YFY2
AD1
O
AS
Pric
e le
vel
National output
Y
Contrasting views on the aggregate supply curve:(b) Extreme Monetarist / New Classical
Contrasting views on the aggregate supply curve:(b) Extreme Monetarist / New Classical
AS
P1
O
Pric
e le
vel
National output
AD1
Y
Contrasting views on the aggregate supply curve:(b) Extreme Monetarist / New Classical
AS
O
P1
Pric
e le
vel
National output
AD2
P2
Y
AD1
O
Pric
e le
vel
National output
AS
Contrasting views on the aggregate supply curve:(c) Moderate view
Contrasting views on the aggregate supply curve:(c) Moderate view
O
AS
Pric
e le
vel
National outputY1
P1
AD1
Contrasting views on the aggregate supply curve:(c) Moderate view
P2
O
AS
Y1
Pric
e le
vel
National outputY2
P1
AD2
AD1
AGGREGATE SUPPLY
• Different views on the shape of the AS curve
• Short-run aggregate supply
AGGREGATE SUPPLY
• Different views on the shape of the AS curve
• Short-run aggregate supply– the microeconomic foundations
Q1
Short-run response of a profit-maximising firmto a rise in demand
MC
AR1
MR1
£
Q
P1
AR1
MR1
P1
Q1
AR2
MR2
£
Q
MC
Short-run response of a profit-maximising firmto a rise in demand
MR1
P1
Q1 MR2Q2
P2
£
Q
MC
Short-run response of a profit-maximising firmto a rise in demand
AR1
AR2
AS short run
The short-run aggregate supply curve
National output
AD1
P1
Y1
AD2
P2
Y2
AD3
P3
Y3
Pric
e le
vel
AGGREGATE SUPPLY
• Different views on the shape of the AS curve
• Short-run aggregate supply– the microeconomic foundations
• Long-run aggregate supply
AGGREGATE SUPPLY
• Different views on the shape of the AS curve
• Short-run aggregate supply– the microeconomic foundations
• Long-run aggregate supply– the interdependence of firms
AS (long run) AS2 (short run)
AD1
Pric
e le
vel
National output
a
AD2
bc
AS1 (short run)
The long-run AS curve when firms are interdependent
AGGREGATE SUPPLY
• Different views on the shape of the AS curve
• Short-run aggregate supply– the microeconomic foundations
• Long-run aggregate supply– the interdependence of firms– investment
Effect of investment on the long-run AS curve
AD1
Pric
e le
vel
National output
a
AS1 (short run)
AS (long run)
AS2 (short run)
AD1
Pric
e le
vel
National output
a
AD2
b
d
AS1 (short run)
Effect of investment on the long-run AS curve
AGGREGATE SUPPLY
• Different views on the shape of the AS curve
• Short-run aggregate supply– the microeconomic foundations
• Long-run aggregate supply– the interdependence of firms– investment– expectations
AGGREGATE SUPPLY
• LRAS: monetarist / new classical model– flexible real wage rates
ASL
O
Number of workers
Rea
l wag
e ra
te (W
/ P
)
ADL
We
Qe
N
a b
The aggregate labour market: Monetarist / New Classical analysis
O
Number of workers
Rea
l wag
e ra
te (W
/ P
)
ADL
We
Qe
a b
Assume nowthat AD rises
NASL
The aggregate labour market: Monetarist / New Classical analysis
O
Number of workers
Rea
l wag
e ra
te (W
/ P
)
ADL
We
Qe
a b
Prices rise.Real wage ratefalls below We
e.g. to W1
W1
NASL
The aggregate labour market: Monetarist / New Classical analysis
O
Number of workers
Rea
l wag
e ra
te (W
/ P
)
ADL
We
Qe
a b
This gives anexcess demand
for labour of d c.Real wage rate
will rise back to Wec d
W1
NASL
The aggregate labour market: Monetarist / New Classical analysis
AGGREGATE SUPPLY
• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion
AGGREGATE SUPPLY
• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion– natural level of unemployment
O
Number of workers
Rea
l wag
e ra
te (W
/ P
)
ADL
We
Qe
a b
NASL
The aggregate labour market: Monetarist / New Classical analysis
AGGREGATE SUPPLY
• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion– natural level of unemployment– implications for shape of LRAS
• LRAS: Keynesian models
AGGREGATE SUPPLY
• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion– natural level of unemployment– implications for shape of LRAS
• LRAS: Keynesian models– wage and price rigidity
N
ADL1
ASL
Keynesian analysis of the aggregate labour market: fall in ADL
O
Number of workers
Rea
l wag
e ra
te (W
/ P
)
We
Qe
a b
ADL2
Q2
Assumption:wage rates are
sticky downwardsc
AGGREGATE SUPPLY
• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion– natural level of unemployment– implications for shape of LRAS
• LRAS: Keynesian models– wage and price rigidity– hysteresis
Keynesian analysis of the aggregate labour market: hysteresis
O
Number of workers
Rea
l wag
e ra
te (W
/ P
)
We
Qe
a b
ADL1ADL2
c
Q2
Assume that thereis now a recovery:
ADL rises back to ADL1.
NASL
O
Number of workers
Rea
l wag
e ra
te (W
/ P
)
We
Qe
a b
ADL1ADL2
c
Q2
There will be amovement up
along ASL2
ASL2
d eWe2
Keynesian analysis of the aggregate labour market: hysteresis
NASL
AGGREGATE SUPPLY
• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion– natural level of unemployment– implications for shape of LRAS
• LRAS: Keynesian models– wage and price rigidity– hysteresis– expectations of output changes
AGGREGATE SUPPLY
• LRAS: monetarist / new classical model– flexible real wage rates– no money illusion– natural level of unemployment– implications for shape of LRAS
• LRAS: Keynesian models– wage and price rigidity– hysteresis– expectations of output changes– long-run money illusion
AGGREGATE SUPPLY
• AS, AD and inflation
– demand-pull inflation
O
National output
Pric
e le
vel
AS
ADAD1
P1 b
AD2
Subsequentsupply response
AS1
P2
P3
aP0
d
c
Demand-pull inflation
O
National output
Pric
e le
vel
AS
AD
P0
AD1
P1
ab
AD2
c
Subsequentdemand response
AS1
d
P2
P3
AD3
P4
e
Demand-pull inflation
O
National output
Pric
e le
vel
AS
AD
P0
AD1
P1
ab
AD2
c
AS1
d
P2
P3
AD3
P4
e
Subsequentsupply response
AS2
P5f
Demand-pull inflation
O
National output
Pric
e le
vel
AS
AD
P0
AD1
P1
ab
AD2
c
AS1
d
P2
P3
AD3
P4
e
AD4
Subsequentdemand response
AS2
fP5
P6
g
Demand-pull inflation
AGGREGATE SUPPLY
• AS, AD and inflation
– demand-pull inflation
– cost-push inflation
O
National output
Pric
e le
vel
AS
ADAD1
P1
AS1
P2
P3
Subsequentdemand response
AS2
d
P0
ab
c
Cost-push inflation
O
National output
Pric
e le
vel
AS
AD
P0
AD1
P1 ab
c
AS1
d
P2
P3
P4 Subsequentsupply response
AS2
AS3
e
Cost-push inflation
AGGREGATE SUPPLY
• AS, AD and inflation
– demand-pull inflation
– cost-push inflation
– what causes inflation in practice?
Expectations Augmented Phillips
Curve
Aggregate Supply, Unemployment and Inflation
EXPECTATIONS AUGMENTED PHILLIPS CURVE
• Incorporating expectations into a Phillips equation
• Adaptive expectations
• The accelerationist theory– attempting to reduce unemployment below
the ‘natural’ level
0
4
8
12
16
20
0
P (%).
U (%)6 8I (Pe = 0)
.
b
The accelerationist theory of inflation
a
IV (Pe = 12%).
III (Pe = 8%).
II (Pe = 4%)
P (%).
U (%)6
a
b c
d
8I (Pe = 0)
.
.
e
The accelerationist theory of inflation
f
0
4
8
12
16
20
0
EXPECTATIONS AUGMENTED PHILLIPS CURVE
• Incorporating expectations into a Phillips equation
• Adaptive expectations
• The accelerationist theory– attempting to reduce unemployment below
the ‘natural’ level
– the long-run Phillips curve
Un
0
4
8
12
16
20
0
P (%).
U (%)6 8
The long-run Phillips curve
EXPECTATIONS AUGMENTED PHILLIPS CURVE
• Incorporating expectations into a Phillips equation
• Adaptive expectations
• The accelerationist theory– attempting to reduce unemployment below
the ‘natural’ level
– the long-run Phillips curve
– effects of deflationary policies
0
2
4
6
8
10
12
14
16
18
20
22
24
0
P (%).
U (%)8 13
J
X (Pe = 20%).
k
The effects of deflation
0
2
4
6
8
10
12
14
16
18
20
22
24
0
P (%).
U (%)8 13
k
X (Pe = 20%).
XI (Pe = 18%).
XII (Pe = 16%).
l
J
m
The effects of deflation
0
2
4
6
8
10
12
14
16
18
20
22
24
0
P (%).
U (%)8 13
k
l
m
a
J
The effects of deflation
• How quickly can inflation be eliminated?– the ‘short, sharp shock’– the slow route
• Explanations of stagflation– clockwise Phillips loops
EXPECTATIONS AUGMENTED PHILLIPS CURVE
Year 20
20
0
P (%).
U (%)Un
ab
c
Year 0, 1
Clockwise Phillips loops
Year 5
Year 4
0
20
0
P (%).
U (%)Un
ab
c
d
e f
Year 0, 1
Year 2
Year 3
Clockwise Phillips loops
0
20
0
P (%).
U (%)Un
ab
c
d
e f
h
i
J
Year 0, 1, 10
Year 2, 9
Year 3, 8
Year 4, 7
Year 5, 8
Clockwise Phillips loops
g
• How quickly can inflation be eliminated?– the ‘short, sharp shock’– the slow route
• Explanations of stagflation– clockwise Phillips loops– rightward shifts in the long-run Phillips
curve
EXPECTATIONS AUGMENTED PHILLIPS CURVE
• How quickly can inflation be eliminated?– the ‘short, sharp shock’– the slow route
• Explanations of stagflation– clockwise Phillips loops– rightward shifts in the long-run Phillips
curve
• Policy implications of the model
EXPECTATIONS AUGMENTED PHILLIPS CURVE
• How quickly can inflation be eliminated?– the ‘short, sharp shock’– the slow route
• Explanations of stagflation– clockwise Phillips loops– rightward shifts in the long-run Phillips
curve
• Policy implications of the model– shifting the long-run Phillips curve
EXPECTATIONS AUGMENTED PHILLIPS CURVE
0
2
4
6
8
10
12
14
16
18
20
22
24
26
0 1 2 3 4 5 6 7 8 9 10 11 12 13
75
74
8076
77
79
7173
7278
90
89
97
96
9188
95
82
8384
85
86
93
8792
94
81
Inflation (%)
Unemployment (%)
99
98
Phillips loops in the UK?
0001
02
0
2
4
6
8
10
12
14
16
18
20
22
24
26
0 1 2 3 4 5 6 7 8 9 10 11 12 13
75
74
8076
77
79
7173
7278
90
89
97
96
9188
95
82
8384
85
86
93
8792
94
81
Inflation (%)
Unemployment (%)
99
98
Phillips loops in the UK?
0001
02
0
2
4
6
8
10
12
14
16
18
20
22
24
26
0 1 2 3 4 5 6 7 8 9 10 11 12 13
75
74
8076
77
79
7173
7278
90
89
97
96
9188
95
82
8384
85
86
93
8792
94
81
Inflation (%)
Unemployment (%)
99
98
Phillips loops in the UK?
0001
02
0
2
4
6
8
10
12
14
16
18
20
22
24
26
0 1 2 3 4 5 6 7 8 9 10 11 12 13
75
74
8076
77
79
7173
7278
90
89
97
96
9188
95
82
8384
85
86
93
8792
94
81
Inflation (%)
Unemployment (%)
99
98
Phillips loops in the UK?
0001
02
0
2
4
6
8
10
12
14
16
18
20
22
24
26
0 1 2 3 4 5 6 7 8 9 10 11 12 13
75
74
8076
77
79
7173
7278
90
89
97
96
9188
95
82
8384
85
86
93
8792
94
81
Inflation (%)
Unemployment (%)
99
98
Phillips loops in the UK?
0001
02
0
2
4
6
8
10
12
14
16
18
20
22
24
26
0 1 2 3 4 5 6 7 8 9 10 11 12 13
75
74
8076
77
79
7173
7278
90
89
97
96
9188
95
82
8384
85
86
93
8792
94
81
Inflation (%)
Unemployment (%)
99
98
Phillips loops in the UK?
0001
02
Rational Expectations and the Phillips Curve
Aggregate Supply, Unemployment and Inflation
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE
• Assumptions
– flexible wages and prices
– rational expectations
• Aggregate supply & the Phillips curve: when expectations are correct
– short-run vertical AS curve
O
Pric
e le
vel
National output
AD1
SRAS1 (expected price level = P1)
Q1
AD2
a
P2
Q2
P1
(a) Adaptiveexpectationsb
The effects of an increase in aggregate demand
O
Pric
e le
vel
National output
AD1
SRAS1 (expected price level = P1)
P1
Q1
AD2
a
bP2
Q2
SRAS2 (expected price level = P3 )
P3
(a) Adaptiveexpectations
c
The effects of an increase in aggregate demand
O
Pric
e le
vel
National output
AD1
SRAS1 (expected price level = P1)
P1
Qn
AD2
a
bP2
Q2
SRAS2 (expected price level = P3 )
cP3
LRAS
(a) Adaptiveexpectations
The effects of an increase in aggregate demand
O
Pric
e le
vel
National output
AD1
SRAS1 (expected price level = P1)
Q1
P1
(b) Rationalexpectations
AD2
a
The effects of an increase in aggregate demand
O
Pric
e le
vel
National output
AD1
SRAS1 (expected price level = P1)
Q1
aP1
AD2
SRAS2 (expected price level = P3 )
P3
c
(b) Rationalexpectations
The effects of an increase in aggregate demand
O
Pric
e le
vel
National output
AD1
SRAS1 (expected price level = P1)
aP1
AD2
SRAS2 (expected price level = P3 )
cP3
Qn
LRAS = SRAS actual
(b) Rationalexpectations
The effects of an increase in aggregate demand
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE
• Assumptions
– flexible wages and prices
– rational expectations
• Aggregate supply & the Phillips curve: when expectations are correct
– short-run vertical AS curve
– short-run vertical Phillips curve
• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE
O
Pric
e le
vel
National output
AD1
SRAS1 (expected price level = P1)
P1
Qn
a
Q3
AD2
SRAS2
(expected price level = P2 )
P3
LRAS
P2
How a rise in aggregate demand could cause a rise in national output
AD3
b
O
Pric
e le
vel
National output
AD1
SRAS1
(expected price level = P1)
P1
Qn
a
Q3
AD2
SRAS2
(expected price level = P2 )
P3
LRAS
P2
How a rise in aggregate demand could cause a fall in national output
AD3
c
• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market– the labour market
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE
ASL2 ((W / P )e > W / P )
O
Rea
l wag
e ra
te (W
/ P
)
Number of workers
ADL
Q1
Underpredictionof inflation
Q2
ASL1 ((W / P )e = W / P )
Effects in the labour market of an underprediction of inflation
• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market– the labour market– implications for the Phillips curve
• Policy implications of rational expectations
• Real business cycles– persistent shifts in aggregate supply– turning points
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE
O
Infla
tion
(%)
Unemployment (%)
P e = P
. .P
e > P. .
P e < P
. .
New classical version of short-run Phillips curves
• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market– the labour market– implications for the Phillips curve
• Policy implications of rational expectations
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE
• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market– the labour market– implications for the Phillips curve
• Policy implications of rational expectations
• Real business cycles
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE
• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market– the labour market– implications for the Phillips curve
• Policy implications of rational expectations
• Real business cycles– persistent shifts in aggregate supply
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE
• Aggregate supply & the Phillips curve: when expectations are incorrect– the goods market– the labour market– implications for the Phillips curve
• Policy implications of rational expectations
• Real business cycles– persistent shifts in aggregate supply– turning points
RATIONAL EXPECTATIONS AND THE PHILLIPS CURVE
Modern Keynesian Views
Aggregate Supply, Unemployment and Inflation
MODERN KEYNESIAN VIEWS
• Modern developments of the Keynesian model
• Growth in equilibrium unemployment– higher structural unemployment– hysteresis
• The persistence of demand-deficient unemployment– payment of efficiency wages– insider power
MODERN KEYNESIAN VIEWS
• Incorporation of expectations
– expansion of aggregate demand
O
Infla
tion
(%)
Unemployment (%)
U1
P1
.I
II
Z
U2
P2
.c
a
b
Keynesian analysis of reflationary policies
MODERN KEYNESIAN VIEWS
• Incorporation of expectations
– expansion of aggregate demand
– contraction of aggregate demand
O
Infla
tion
(%)
Unemployment (%)
I
U2
b
U1
a
Keynesian analysis of deflationary policies
L
O
Infla
tion
(%)
Unemployment (%)
U1
Ia b
U2
c
Keynesian analysis of deflationary policies
MODERN KEYNESIAN VIEWS
• Incorporation of expectations
– expansion of aggregate demand
– contraction of aggregate demand
• Keynesian criticisms ofnon-intervention
Common Ground Among Economists?
Aggregate Supply, Unemployment and Inflation
COMMON GROUND AMONG ECONOMISTS?
• Short-run effects of changes in aggregate demand
• Long-run effects of changes in aggregate demand
• Role of expectations
• Importance of supply-side factors
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