as - ad. aggregate supply –relates output and price level –labor market aggregate demand...
TRANSCRIPT
AS - AD
• Aggregate Supply– relates output and price level– labor market
• Aggregate Demand– relates output and price level– IS - LM
Aggregate Supply
As output rises….
P = W(1 + m)W = PeF(u,z)
P = Pe(1 + m)F(u,z)
For fixed Pe, as Y rises, u falls so P rises
why?Hiring pushes up
wages.
Note: Pe fixed in the short run.
AS (in detail)
U – number of workers unemployed
N – workforce (constant)
L - workers employed
U = N - L
Unemployment rate
u = (N - L)/N
=1-L/N
Production function
Y=AL A – productivity
u = 1-Y/(AN)
AS (in detail)
P = Pe(1 + m)F(u,z)
u = 1-Y/(AN)
P = Pe(1 + m)F(1-Y/(AN),z)
AS relation,
as Y ↑ u↓
u ↓ F(u,z) ↑
F(u,z) ↑ P↑
So AS is upward sloping
AS
• Slopes up• Shifts
– Change in Pe
• Rise in expectations• Shifts AS up
– Productivity A ↑ AS shifts right/down– Markup m↑ AS shifts up– Change in z, labor market
conditions
Aggregate Demand
• How does a price increase affect equilibrium GDP on an IS – LM graph.– LM shifts up (left)– Y* falls
• AD slopes down• Shifts – anything else that
affects IS – LM– Autonomous spending– Policy (both kinds)
• Exception – supply side tax effects
Problems
• Show how an increase in the money supply would affect the equilibrium level of output, interest rates and prices using and IS – LM and AS – AD diagram.
• The 1990s saw an increase use of IT in business which improved productivity. Show the short run effect on an AS-AD graph.
Problems
Show how an decrease in government spending would affect the equilibrium level of output, interest rates and prices using and IS – LM and AS – AD diagram.
Show the effect of an increase in oil prices has on an AS-AD graph.
Medium Run
• Expectations adjust • P=Pe
• Unemployment at its natural rate
1 = (1 + m)F(un,z)
• Output at its natural rate
un = 1-Yn/(AL)
AS?
1 = (1 + m)F(1-Yn/(AL),z)
Vertical at the natural rate of output
Medium run
• What if Y* < Yn ?– P < Pe (short run)– medium run, Pe falls to P– AS shifts down/right– Y* rises to Yn
• Labor Market interpretation– u* > un
– as Pe falls, wages bid down– lower cost to production– AS shifts right
• Medium run Y* = Yn
Monetary policy: short and medium run
• Fed increase Ms
– AD shifts right– Y* and P* both rise– short run (P > Pe )
• Medium run– Pe rises– AS shifts up/left– Y* falls back to Yn
– P* rises further• Money neutrality (med run)
– changes in Ms • affect nominal variables• not real variables
Problem
Show how a decrease in the money supply would affect the equilibrium output and price levels on an AS-AD graph in the short and medium run.
What happens on the IS-LM graph in the short and medium run?
Problems AS-AD
Show the short and medium run effects of an increase in productivity.
Show the short and medium effects of a decrease in consumer confidence.
Show the short and medium run effects of an increase in oil prices.
Recessionary Gap Y* < Yn
Inflationary Gap Y* > Yn
Show an inflationary gap on an AS-AD graph, then show how the government could use tax policy to close the gap.
Show a recessionary gap on an AS-AD graphs, then show how monetary policy could be used to close the gap.
Gov’t Spending
How does an increase in government spending affect the AS-AD graph in the short & medium run?
Does Gov’t spending affect productivity?
Show the changes in the graph for both cases.
Key Equations
P = W(1 + m) (PS)
W = PeF(u,z) (WS)
1 = (1 + m)F(un,z)
u = 1-Y/(AL)
P = Pe(1 + m)F(1-Y/(AL),z) (AS)
Unemployment & Inflation
Inverse relationCan the Fed lower U? Increase
MS
If inflation is caused by AD shift to the rightoutput rises, unemployment falls
Fed can lower U at a cost of higher p
True? Check the data.
PC relation to WS
W = PeF(u,z) (WS)P = W(1 + m)(PS)
Let F(u,z) = 1 – au + z
So WS & PS become
P = Pe(1 + m)(1 – au + z)
Do some math….
p = pe + - m au + z
inverse relation does exist
Wage – Price Spiral
Explains inverse relation• u falls• wages bid up• prices rise• workers demand higher wages
– etc. etc.• higher p
“Tight labor market” – late 1990s
Shifts in PC
• Expectations• markup
– input costs– market power
• labor market condtions• Anything that shifts AS, shifts
PC
Monetary Policy and the PC
The Fed tries to lower u below the natural rate…..
Show on AS-AD and the PC for the short and medium run.
Review Problems
Show a Phillips curve graph and an AS-AD graph starting from an inflationary gap. Show the medium run adjustment.
If the Fed acts to close an inflationary gap, what would they do? Show the result on an AS-AD graph and a PC graph.
Story of the Great Inflation
• Productivity falls• oil prices rise
– Effect on Yn, un
– Monetary policy reaction
• Fed tried to keep u at the old level
• expectations rose
Both shifts and a return to the natural rate
Mr. Burn’s brain
What’s behind the Fed’s decisions in the 70’s?• Bad thinking
– Ignoring natural rates– Expectations– “old” PC
• Bad data– Couldn’t see the change in the
natural rates• Cared more about
unemployment than inflation
Intellectual history & the PC
• “Old” PC (1940-50s)– Empirical relationship– Use in Cowles commission
models• Edmund Phelps / Milton
Friedman (late 60s)– Argue against the permanent
output/inflation tradeoff– 70s proved them right– “Old Keynesian” econometric
models abandoned
Expectations and the PC
pt = pt e + - m aut + z
Static expectations
pt e = pt-1
Rational expectations
pt e = pt + et
et – forecast error
Policy Effectiveness
Under rational expectations, what happens when the Fed increases the money supply?
PC and AS vertical
(with an error term)
P & p rise, not real effect
Money is neutral.
Policy is ineffective. Why?
Problem
Starting from the natural rate of unemployment, if the Fed acts to lower inflation, show the SR & MR effects.
P=Pe(1+ )m F(u,z)
W = PeF(u,z)
= p pe + - m au + z
P = W(1+ )m
M/P = L(i,Y)
un = ( m + z)/a
Equations
P=Pe(1+ )m F(u,z) AS (sort of)
W = PeF(u,z) WS
= p pe + - m au + z SRPC
P = W(1+ )m PS
M/P = L(i,Y) Money Demand
un = ( m + z)/a MRPC/natural rate of u
Equations
More Review
The government becomes more aggressive about breaking up monopolies lowering the pricing power of firms. Show the impact on the following graphs.• real wage / unemployment• AS – AD• Phillips curve• IS – LM
More Review
The recent housing market decline led to an decrease in autonomous consumption and investment. Show that short run change and the medium run adjustment, assuming passive policy on the following graphs:• IS-LM• AS-AD• Phillips Curve
Review problem
Show an inflationary gap on graphs of AS-AD and IS-LM. Use the graph to explain how tax policy could be used to close the gap..
Review Problem
Show the short run effect of a tax increase on an expenditure diagram. Show the short and medium effects on IS-LM and AS-AD diagrams.
Review Problem
Keynes once advocated that the government should bury boxes of money and let people dig them up to stimulate to economy.
Starting from the natural rates or unemployment and output, show the short and medium run effects of an increase in government spending that does not change the natural rates for AS-AD and the Phillip’s curve.
Review Problem
Currently the Fed is increasing the money supply and keeping interest rates low to mitigate the recession.
Starting from a recessionary gap, show the effect of an increase in the money supply on an AS-AD graph and the Phillip’s Curve.
Practice Problem
The financial crisis has led to a decrease in lending and therefore an fall in the money supply.
Starting from the natural rates of output and unemployment, show the resulting change on AS-AD and Phillips curve graphs in the short run.
Goals
• Connect output, unemployment and inflation
• Use equations• Explain both short and medium
runs
y, u and pActually,
we’ll use gy – growth rate
Okun’s Law
Connects u and y
ut – ut-1 = - b(gy,t – gn)
gn - “normal” or natural growth rate of output
- growth rate of potential GDP
p and Y
Focus on AD and monetary policy
M/P rises, LM & AD shift right
Y rises
Let Y = g(M/P)
Assumes fiscal policy and autonomous expenditures are fixed.
Log differencing the equation:
gy,t = gm,t - pt
small macro model
ut – ut-1 = - b(gy,t – gn)
pt - pet = (a un - ut)
gy,t = gm,t – pt
MR implications:p= pe ; u = un ; gy,t = gn
pt = gm,t – gn
Problem
Let gn = 3%, un = 6%, gm,t = 8% = 1.0, = 0.5a b
Find the medium run values of gy,t , ut and pt
Using those as starting values, find the short run (one period) values if gm,t rises to 9%.
Find the new medium run values after expectations adjust to the new gm,t.
Problem
Let gn = 3%, un = 6%, gm,t = 7% = 1.0, = 0.5a b
Find the medium run values of gy,t , ut and pt
Using those as starting values, if the Fed wants to lower inflation to 2% in the medium run, to what level should they set gm,t ? Find the short run (after one period) values if they make this change.
Show these changes including the medium run adjustment on a graph of AS-AD and a PC graph.
Sacrifice Ratio
• Lowering pt in the MR has a cost of higher ut in the SR.
• To measure this cost
Sacrifice Ratio = -Du/Dp=excess unemployment/
decrease in inflation
For the previous problem….
Credibility
Problem
Let gn = 3%, un = 5%, gm,t = 5%
= 1.0, = 0.5a b
Find the medium run values of gy,t , ut and pt
Using those as starting values, the Fed increases gm,t to 8%. Find the new SR values (one period).
Find the new medium run values.
Show these changes on a graph of AS-AD and a PC graph.
Time Consistency
TC problem: conflict between long term plan/policy and short term incentive
- grading- dieting- shutting down failed banks- monetary policy
Long term goal: maintain inflation target
Short term incentive: lower unemployment
Reason for an independent Fed.
Expectations and the PC
pt - pet = (a un - ut)
Static expectations
pt e = pt-1
Rational expectations
pt e = pt + et
et – forecast error
Policy Ineffectiveness
Policy does not have real effects if• Expectations are rational.• Wages and prices adjust
immediately.– MR is short– Contracts?
• Sacrifice ratio?– Credibility– Evidence?
Problem
Let gn = 2%, un = 7%, gm,t = 8%
= 1.0, = 0.5a b
Find the medium run values of gy,t , ut and pt
The Fed wants to reduce inflation to 2% in the medium run. What value should they choose for gm,t ? Find the new SR values (one period) if they do this.
Find the new medium run values.
Show these changes on a PC graph.
What is the sacrifice ratio?
Review Questions
• The strong growth in the 1990s is often attributed to technology use by firms. Show the short and medium run changes on an AS-AD graph.
• One story explaining the Great Depression is the stock market crash reduced consumer spending. The government then tried to boost the economy with increased spending. Show both changes on an AS-AD graph explaining changes in equilibrium prices and output.
• Show how a change in the markup would affect the graph of the Phillip’s curve in the short and medium run.
Goals
• Connect output, unemployment and inflation
• Use equations• Explain both short and medium
runs
y, u and pActually,
we’ll use gy – growth rate
Okun’s Law
Connects u and y
ut – ut-1 = - b(gy,t – gn)
gn - “normal” or natural growth rate of output
- growth rate of potential GDP
p and Y
Focus on AD and monetary policy
M/P rises, LM & AD shift right
Y rises
Let Y = g(M/P)
Assumes fiscal policy and autonomous expenditures are fixed.
Log differencing the equation:
gy,t = gm,t - pt
small macro model
ut – ut-1 = - b(gy,t – gn)
pt - pet = (a un - ut)
gy,t = gm,t – pt
MR implications:p= pe ; u = un ; gy,t = gn
pt = gm,t – gn
Problem
Let gn = 3%, un = 6%, gm,t = 8% = 1.0, = 0.5a b
Find the medium run values of gy,t , ut and pt
Using those as starting values, find the short run (one period) values if gm,t rises to 9%.
Find the new medium run values after expectations adjust to the new gm,t.
Problem
Let gn = 3%, un = 6%, gm,t = 7% = 1.0, = 0.5a b
Find the medium run values of gy,t , ut and pt
Using those as starting values, if the Fed wants to lower inflation to 2% in the medium run, to what level should they set gm,t ? Find the short run (after one period) values if they make this change.
Show these changes including the medium run adjustment on a graph of AS-AD and a PC graph.
Sacrifice Ratio
• Lowering pt in the MR has a cost of higher ut in the SR.
• To measure this cost
Sacrifice Ratio = -Du/Dp=excess unemployment/
decrease in inflation
For the previous problem….
Credibility
Problem
Let gn = 3%, un = 5%, gm,t = 5%
= 1.0, = 0.5a b
Find the medium run values of gy,t , ut and pt
Using those as starting values, the Fed increases gm,t to 8%. Find the new SR values (one period).
Find the new medium run values.
Show these changes on a graph of AS-AD and a PC graph.
Time Consistency
TC problem: conflict between long term plan/policy and short term incentive
- grading- dieting- shutting down failed banks- monetary policy
Long term goal: maintain inflation target
Short term incentive: lower unemployment
Reason for an independent Fed.
Expectations and the PC
pt - pet = (a un - ut)
Static expectations
pt e = pt-1
Rational expectations
pt e = pt + et
et – forecast error
Policy Ineffectiveness
Policy does not have real effects if• Expectations are rational.• Wages and prices adjust
immediately.– MR is short– Contracts?
• Sacrifice ratio?– Credibility– Evidence?
Problem
Let gn = 2%, un = 7%, gm,t = 8%
= 1.0, = 0.5a b
Find the medium run values of gy,t , ut and pt
The Fed wants to reduce inflation to 2% in the medium run. What value should they choose for gm,t ? Find the new SR values (one period) if they do this.
Find the new medium run values.
Show these changes on a PC graph.
What is the sacrifice ratio?
Review Questions
• The strong growth in the 1990s is often attributed to technology use by firms. Show the short and medium run changes on an AS-AD graph.
• One story explaining the Great Depression is the stock market crash reduced consumer spending. The government then tried to boost the economy with increased spending. Show both changes on an AS-AD graph explaining changes in equilibrium prices and output.
• Show how a change in the markup would affect the graph of the Phillip’s curve in the short and medium run.
Problem
Starting from the natural rate of output, show the short and medium run effects of a tax cut that leads to increased productivity. Is it possible that the equilibrium price level rises?
Do tax cuts pay for themselves?
Laffer Curve
• Tax revenue vs. tax rates– Tax rate = 0%?– Tax rate = 100%?
• Laffer curve peaks somewhere in between.
Cross country analysis says ~50%