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Lecture: Aggregate Demand and Aggregate Supply
Macroeconomics IIWinter 2019/2020 – SGH
Jacek Suda
Overview
Goods Market
ISCurve
Money Market
LM/TR Curve
IS-LM/TR Model
Aggregate Demand
(AD)Curve
Aggregate Supply
(AS)Curve
AD-AS Model
• Last time• Short run: IS-LM/TR model
• Sticky/fixed prices
• Quantity adjustment
• Today• Short + long run = medium run
• Price changes
• Price changes (inflation) and output relation
• Price changes (inflation) and demand relation
Plan
Aggregate Supply
• Aggregate supply (AS) curve– describes for each given price level the quantity of output firms are willing
to supply
– Aggregate output
– Aggregate price level
• Obtained by combining Phillips curve with Okun’s law
• How does supplied output change if prices change?– Slope of aggregate supply in the:
– short run
– medium run
– long run
• Keynes– Sticky prices => short run– Demand drives supply
=> quantities adjust
• Neoclassical– Flexible prices => long run– Supply drives demand
=> prices adjusts
• Medium run?– Cambridge equation / quantitative theory of money:
M = k·PY
From the Short to the Long Run
P
P
Y
Y
M
YP
Time
Neoclassical long-run: change in money results in no change in output, only a change in the price level.
One-off increase in the money supply
Short-run: prices are sticky, output responds to change in demand
From the Short to the Long Run
M
Y
P
The Phillips Curve: the Beginning
• In 1958 Alban W. Phillips published a paper measuring the relationship between changes of nominal wages and the level of unemployment
• Negative relationship between wages and unemployment :• in years of high unemployment rate wages were stable or decreasing, • when unemployment was low wages raised quickly.
Źródło: Phillips (1958)
The Phillips Curve in Reality
Sources: Maddison (1991), Mitchell (1998)
United Kingdom1888 - 1975
Sixteen-country average, 1921-1938 and 1950-1973
The Phillips Curve in Theory
Infl
atio
n
Unemployment
Phillips curve
B
A
The trade-off:
reducing inflation from the high level at A to the lower inflation at B comes at a cost in an increase in unemployment.
The Phillips Curve in Theory: Algebra
Infl
atio
n
Unemployment
U
( ) ( )Phillips curve in point-slope form
b U U − = − −
U
-
U - U
b is the slope of thePhillips curve
Okun’s Law• In 1962 Arthur Okun published a paper analyzing the optimal level of GNP and the impact of
unemployment on GNP• Unemployment rate higher than natural rate of unemployment causes lower than potential level of output
• Increase of unemployment rate by 1 percentage point causes potential GDP/GNP to fall by 2 to 3 percentage points.
• Okun’s law: negative relation between changes in unemployment rate and the real GDP
Output Gap and Unemployment in Germany 1966-2015
Source: OECD, Main EconomicIndicators
Source: Mankiw (2010)
Changes in real GDP and unemployment rates in the US for 1951-2008
Okun’s Law in Theory
Y
U
Y Output
Un
emp
loym
ent
U
Output rises relativeto its trend level
Unemployment decreases
Okun’s Law in Theory
U
Y
( )( )
gap
gap
Y
U
Y YU U h
Y
−− = −
( ) ( )j
hU U Y Y
Y
− = − −
( ) ( )Okun's Law in point-slope form
U U j Y Y− = − −Output
Un
emp
loym
ent
U
Y
j measuresthe slope ofthe line
Okun‘s Law in Reality
(a) USA (b) Germany
Source: OECD
Phillips Curve + Okun’s Law = Aggregate Supply
( ) ( ) ( )( )
Note: the product of two negative slopes
became a positive slope!
gap
Aggregate supply curve
g aY
b j Y Y b j Y Y Y Y
− = − = −
( ) ( )Phillips curve in point-slope form
b U U − = − −
( ) ( )Okun's law in point-slope form
U U j Y Y− = − −
π
U
U
Y
Infla
tio
n
Unemployment
Infla
tio
n
Output
(a) Phillips curve (b) Aggregate supply
U
( ) ( ) Aggregate supply curve
g Y Y − = −
Y
( ) ( )Simple Phillips curve
b U U − = − −
The Aggregate Supply Curve
• Theoretical issues– Neutrality principle: in the long run nominal variables (prices) have no
impact on real variables (unemployment)
– Inflation in the long run is determined by the money supply growth rate
• Friedman and Phelps– In the long run, the Phillips curve and the supply curve have to be vertical
=> no trade-off between inflation and unemployment should be possible
– In the long run, the Phillips curve and aggregate supply are independent from inflation
The Breakdown of the Phillips Curve
The Long Run
(a) Phillips curve (b) Aggregate supply
Empirical Problems with Phillips Curve
(a) Eurozone (1971-2010) (b) UK (1970-2010)
Source: OECD, Economic Outlook
• The Philips curve disappeared in the 1970s.– During the oil crisis high unemployment was accompanied by a sharp rise
in inflation (stagflation)
• Philips curve reappeared (shortly) in the 1980s
• What was wrong with the original Phillips curve?– Problem 1: the initial version of the Phillips curve did not
incorporate inflation expectations
– Problem 2: it did not take into account other production costs (only labor costs)
• Solution:– Expectations augmented Phillips curve
Problems With Phillips Curve
• Let’s look at the determinants of inflation and how it can theoretically be linked to unemployment
• How do firms set their prices• In case of perfect competition firms takes prices as given
P = mc price = marginal cost
• In the case of imperfect competition (e.g. product differentiation: iPhone ≠ Samsung) firms have market power and set prices as a mark-up over marginal cost (mark-up pricing)
P = (1+q)·mc , q>0price = mark-up · marginal cost
The Theoretical Foundations of the Phillips Curve: Price setting
• Mark-up over the marginal cost reflects firm’s market power
• Approximate marginal costs by average / unit cost
• If labor is the only factor of production then
• Total cost = total labor cost = total wage bill = W·L• W: nominal hourly wage
• L : number of hours worked
• average costs = nominal unit labor cost = (W·L)/ Y
• Price set by a firm (approximating marginal cost by avergae cost):
P = (1+q)·mc = (1+q)· (W·L)/ Y
Nominal marginal cost vs price
• Real average/unit labor costs
Nominal unit labor cost (= wage bill) / nominal GDP = = (W·L)/(P·Y) = sL
• sL : labor share of output
• Real average labor costs = labor share of output, sL
• Unions want to maximize the labor share in GDP• Workers and unions care about real wage…
• …but can negotiate only about nominal wages, which real value depends on current and future inflation
• While negotiating nominal wage, unions and firms have to make anticipations on the evolution of the price level (and inflation expectations)
Real Wage
• Unions negotiate nominal wages (W) (and wage bill, W·L) based on their price expectations (Pe)
• Final labor share depends on the bargaining power of the unions:
• : „normal” (standard) labor share
• g : mark-up, representing the bargaining power of unions (depending on business cycle at the moment of negotiations)
• Wage
depends on the stage of the business cycle and inflation/price expectations
Wage Negotiations
LeL sYP
LWs )1( g+=
=
Ls
eL P
L
YsW )1( g+=
Wage Share of Value Added by Country and Selected Industries, 2014 (%)
Source : OECD STAN Base
• Firms set prices as mark-up over cost
• During negotiation of firms with unions wages are set as a mark-up over expected price level
• Price level depends on
battle of mark-ups and expected price level
• ... while the rate of change of prices, i.e. inflation, depends on changes of mark-ups and expected inflation
The Battle of the Mark-Ups
eLPs
Y
WLP )1)(1()1( gqq ++=+=
Y
WLP )1( q+=
eL P
L
YsW )1( g+=
eg
g
q
q +
+
+
+
=
11
• Mark-ups vary over the business cycle• Price mark-up, q, depends on market competitiveness
• Wage share mark-up, g, increases with union power during negotiations and increases during expansion (it’s pro-cyclical)
• The product of both mark-ups is also pro-cyclical: raises faster in periods of rapid economic growth and slows down during down-turns / recessions
• The higher economic activity and the higher postive output gap (or the more negative unemployment gap) the higher the inflation rate
• Aggregating various inflation expectations = underlying/expected inflation rate (reflecting inflation expectations) =>
• Phillips curve
• Inflation depends on1. Business cycle2. Past inflation or future inflation expectations
Inflation and Business Cycle
e =~
~+−= gapbU
Phillips Curve (expectations-augmented)
Infl
atio
n
Unemployment gap
C
B
A~
0
~)(~ +−−=+−= UUbbU gap
• So far: price setting behavior of firms depends only on labor cost
• Important non-labor costs• change in the price of raw materials, energy, oil
• exchange rate changes (e.g. depreciation) changing the price of imported inputs
• productivity of inputs, taxes
• Events that cause changes of these costs are called supply (as they change production costs) shocks (we treat them as exogenous and random)
• In case of unexpected increase in production costs firms raise prices above the expected level =>
• By adding supply shocks (s) we can get
expectations-augmented Phillips curve (with supply shocks)
Inflation and Supply Shocks
~>
sbU gap ++−= ~
Supply Shock: Nominal Oil Price (Euros per Barrel): 1950-2015
Source: British Petroleum; IMF
Supply Shock: Oil Price ($ per Barrel): 1985-2017
Source: http://cafim.sssup.it/~giulio/other/oil_price/report.htm
Nominal oil price ($/barrel) Real oil price ($/barrel)
Monthly oil prices in 1982 dollars computed as 100*P(i)/I(t), P(t) nominal oilprice and I(t) price index CPI-U (Consumer Price Index For All UrbanConsumers).
• Once inflation expectations and supply shocks are taken into account, the apparent puzzle of the vanishing Phillips curve can be solved
• If the underlying level of inflation is very stable and there are no supply shocks, then we can observe the inverse relationship between inflation and unemployment
• We could observe raising inflation and raising unemployment (i.e. stagflation) in presence of
– increase in inflation expectations
– supply shocks
– increase in the natural unemployment rate
The Vanishing Phillips Curve?
The Vanishing and Returning Phillips Curve: Europe, 1970-2004
Infl
atio
n(%
)
Unemployment (%)
Augmented Phillips and Aggregate Supply Curve
Infl
atio
n
Unemployment
Infl
atio
n
Output
(a) Phillips curve (b) Aggregate supply
C
B
U
A
B
C
AS
Y
A
Underlying inflation with s=0
sbU gap ++−= ~
Law sOkun'
gapgap YhU −= hbasaYgap =++= ,~
• Philips Curve
• In the long run• Expectations on supply shocks are zero ( )
• shocks are unexpected !
• Actual inflation must be equal to the underlying inflation ( )
=>
• Philips curve must be vertical in the long run
=> No permanent trade-off between inflation and unemployment
• natural unemployment rate = NAIRU = Non-Accelerating Inflation Rate of Unemployment
• In the long run AS curve is also vertical
Philips Curve in the Long Run
sbU gap ++−= ~
~)( =E
0)( =sE
UUU gap == 0
YYYgap == 0
Source: OECD, Economic Outlook
Equilibrium Unemployment Rates (NAIRU)
From the Short to the Long Run
Infl
atio
n
Unemployment
Infl
atio
n
Output
(a) Phillips curve (b) Aggregate supplyU Y
1 1A A
Long-run ASLong run
Short-run Phillips curve
Short-runAS
Inflation equals underlying inflation, no supply shock.
From the Short to the Long Run
Infl
atio
n
Unemployment
Infl
atio
n
Output
(a) Phillips curve (b) Aggregate supply
B
U Y
1 1A A
B
Long-run ASLong run
2
Short-run Phillips curve
Short-runAS2
In the short run: trade-off between u and • Inflation above underlying inflation => lower real wages => increased employment => lower unemployment rate and higher output
From the Short to the Long Run
Infl
atio
n
Unemployment
Infl
atio
n
Output
(a) Phillips curve (b) Aggregate supplyU Y
1 1A A
Long-run ASLong run
2 2
Short-run Phillips curve
Short-runAS
In the long run: underlying inflation will adjust• Inflation above underlying inflation => inflation expectations increase => new short run Phillips curve=> increase of unemployment
to natural level
• AS curve (aggregate supply curve) = level of output that firms want to sell at given inflation rate
• The short run AS curve shifts when• the underlying inflation changes
• the natural unemployment rate changes
• the trend/potential GDP changes
• supply shocks (temporary or permanent) hit
Shifts of the AS Curve
sY
YYasaYgap ++
−=++= ~)(~
Aggregate Demand
• Aggregate demand curve: AD curve– all the combinations of output and inflation such that the market for
goods is in equilibrium (IS) and the money market is in equilibrium (TR/LM)
• Derived by analyzing the effect of price changes in IS-TR/LM model using Fisher equation
• How does a change in prices affect the demand– The slope of AD curve in:
– short run
– medium run
– long run
The Fisher equation
• Fisher equation links real (r) and nominal (i) interest rates r = i - πe
– πe : expected inflation between today and tomorrow
– r : real intrest rate today
– i : nominal intrest rate
• Central bank sets/controls the nominal interest rate i and influences expectations
• Borrowing and money market use nominal interest rate– Borrowers like high inflation (it lowers the real value of debt)
– Lenders prefer low inflation
– Indexation solves the distinction
The Aggregate Demand in the Long Run
• In the long run ,
• Long run AD curve (LAD) crosses the long run AS curve (LAS) in that point
• Output in the long run is determined by trend growth rate• Real interest rate is determined by the same factors,
• Inflation in the long run is determined by the central bank inflation target– In the long run inflation expectations and underlying inflation equal inflation
target
== ,YY
~=== e
rr =
The Aggregate Demand in the Long Run
• In the long run the Taylor rule indicates
• Central bank sets inflation target => inflation is indepedent from output
+==+−+= riiYbaii gap ,)(
LAD=inflation target
Output gap
Infl
atio
n
The Aggregate Demand in the Short Run
• Taylor rule
• Interest rate changes with changes in both output (output gap) as well as inflation – For a>1 (e.g. ECB, Poland) => increase of inflation causes more than
proportional increase in i => increase r (since r≈i-e)
• Inflation change shifts TR curve• Higher inflation leads to increase of nominal interest rate (at every
level of output) => TR curve shifts up
gapYbaii +−+= )(
The Aggregate Demand (1)
Taylor rule
gapYbaii +−+= )(
gap
i
Ybari +
−++= )(
( ) gapYbaari ++−+=
changes when Changes
)1(
+ Fisher equation,
Effect of price changes on TR curve
+= ri
Infl
atio
n
Output gap
Inte
rest
rat
eOutput gap
A
A
TR
0
0
TR curve
Along TR, is held constant at
.
The Aggregate Demand (2)
gapgap YbiYbari +=+++==
:Aat
0)(
We start from long run
equilibrium where Ygap=0
and =
i
Intersection of TR i IS curves yield
equilibrium point
IS
AD
A´
TR´
A
A´
A
TR
Higher inflation triggers higher
interest rate via Taylor rule: TR shifts
up to TR’.
IS
0
0
Now suppose inflation increases to ´.
Increase of nominal interest rate
reduces demand (point A’)
The Aggregate Demand (3)
Output gap
Output gap
Inte
rest
rat
eIn
flat
ion
i´
i
AD
A´
A
0
Aggregate Demand in the Short Run
Output gap
Infl
atio
n
• AD curve is determined by changes in the IS-LM/TR equilibrium due to change in inflation
AD slopes downward:
• When inflation rises, the central bank raises the nominal interest rate i (for a>0) leading to increase of real interest rate (a>1) r reducing the demand for goods and services.
AD curve shifts in response to changes in:
• the inflation target (its increase shifts AD to the right)
• demand shocks to, e.g. G, T, W, q,... - positive shock (shifts IS curve right) shifts AD curve to the right
LADInfl
atio
n
Output
AD
AS
LAS
Aggregate Demand and Supply: Short and Run Long Run
Y
Simulation of Economic Fluctuations in AD-AS model
• Now that we have built our AS-AD model, we can see how fluctuations emerge
• What are the effects• Supply shock
• Demand shock (e.g. fiscal policy changes)
• Changes in monetary policy
• Policy reactions / responses to shocks
LAD
An Adverse Supply Shock (1)
Infl
atio
n
0
A
Output gap
AD
AS
LASStarting point: Short-run= long-runequilibrium at point A
LAD
AS´LAS
AS
AD
An Adverse Supply Shock (2)
0
B
Stagflation : both unemployment and inflation increase (point B)
(inflation increase =>i,rincrease => demand falls )
A
Supply shock s>0 shifts AS curve from AS do AS‘.
Infl
atio
n
Output gap
An Adverse Supply Shock (3)• Point B is not long run equilibrium
• How quickly economy comes back to A depend on how inflation expectation are formed and on underlying inflation • if rational expectations anchored on inflation target, , then once
supply s is over (s=0) AS=ASRE and economy returns to equilibrium point A.
LAD
AS´LAS
AS=ASRE
AD
0
B
A
Infl
atio
n
Output gap
== ~e
~AS´´
AS´´´ • if adaptive expectations then underlying inflation goes initially up, shifting AS curve up (AS’’, AS’’’,...) and inflation only gradually reverts to inflation target
LAD
Positive Demand Shock (1)
Infl
atio
n
0
A
Output gap
AD
AS
LASStarting point: Short-run= long-runequilibrium at point A
LAD
LAS
ASAD
Positive Demand Shock (2)
0
B
t=1: Higher inflation and higher output in point B
A
Positive demand shock eshifts AD curve to AD‘ and equilibrium from A to B.
Infl
atio
n
Output gap
AD’
LAD
LAS
ASAD
Positive Demand Shock (3)
0
B
If inflation expectations and underlying inflation
react to higher inflation in point B, AS curve shifts up
A
As long as e >0 then AD curve remains at AD’
Infl
atio
n
Output gap
AD’
t=2: Point C: e >0, AD’ + AS’ t=3: Point D: e >0, AD’ + AS’’
AS’AS’’
CD
LAD
LAS
ASAD
Positive Demand Shock (4)
0
B
Equilibrium point E is given by AD and AS’’ with underlying inflation
different from .
A
Once e =0 AD curve returns to AD(e.g. at t=4 )
Infl
atio
n
Output gap
AD’
How quickly AS shifts down back to A depend
again on inflation expectations and
expectations revision
AS’’
E
D
Demand Shock in AD-AS Model
• Demand shocks, as they do not change long run level of output, affect output only in the short run.
• Permanent increase of government expenditures yields increase of inflation and inflation expectations => AS curve shifts up => output level returns to trend / potential level but inflation increases
• If the central bank accepts higher level of inflation (or if it decides to increase inflation target) then economy will feature higher inflation but unchanged level of output.
A Shift in Monetary Policy (1)
• Central bank lowers inflation target
• In the long run LAD shifts down, no effect on output
1221 , →
LAD
Infl
atio
n
0
A
Output gap
AD
AS
LAS
LAD’
1
2
A Shift in Monetary Policy (2)
• Central bank lowers inflation target
• In the short run change of target affects output
1221 , →
Taylor rule
• Assumption: a > 1; lowering inflation target increases nominal interest rate ceteris paribus: TR curve shift up
• Note: If 0 < a < 1, increase of inflation target increases nominal interest rate ceteris paribus: TRshifts up but less than shift of target. This case is unstable and we will not consider here.
+ Fisher equation
+ rearraning....
lukaYbaii +−+= )(
lukaYbari +−++= )(
lukaYbaari ++−+= )1(
IS
Inte
rest
rat
e
Output gap
A
A
TR
Intersection of TR i IS curves yield
equilibrium point
0
Infl
atio
n
Output gap
1i
• Central bank lowers inflation target• In the short run change of target affects output
1221 , →
Lowering inflation target shifts TR
curve up
AD curve shifts left, point B
Inflation rate on TR’ curve is above the
new inflation target: nominal interest rate
increases => investment , Y
AD
AS
0
AD’
1
TR’
2
B
B
A Shift in Monetary Policy (3)
IS
Inte
rest
rat
e
Output gap
A
A=E
TR
Since , inflation expectations and
underlying inflation must adjust
0
A Shift in Monetary Policy (4)
Infl
atio
n
Output gap
• Central bank lowers inflation target 1221 , →
Lowering underlying inflation (graduał or
immiedate) shifts AS curve down
This lasts until output reaches its
potential/trend level while inflation reaches inflation rate (point E)
AD
0
AD’
1
TR’
2
B
B
AS
AS’’
E
LAD
LAD’
r
2 >As inflation decreases, TR curve shifts right
But1122 irri =++=
LAS
Policy Responses to Shocks
• What can policy makers do in case of a demand or supply shock?
LAD
AS´LAS
AS
AD
Adverse Supply Shock (Again)
0
B
A
Adverse supply shock s>0 shifts AS
curve to AS‘(adverse/negative
because output falls)
Stagflation: both unemployment and
inflation increase, point B.
(inflation ↑=> i,r ↑=> demand )
Infl
atio
n
Output gap
AD´
AS´LAS
LAD
AD
• Fighting resulting unemployment with expansionary demand policies (e.g. increasing government expenditures, G)
0
B
C
Outcome: lowering
unemployment at a cost of increased inflation in
the long-run(point C)
A
Fighting Adverse Supply Shock: Increasing Demand
Infl
atio
n
Output gap
LAD
AD´´
AS´LAS
AD
0
B
D
A
Fighting Adverse Supply Shock: Decreasing Demand
• Fighting inflation due to adverse supply shock through a contractionary demand policy (e.g. reducing government expenditures, G)
Infl
atio
n
Output gap
Outcome:successfully fight π but
at a cost of increased unemployment
(point D)
Only when s=0 economy returns to the long-run
equilibrium at A
AS
LAD
LAS
ASAD
Negative Demand Shock
0
B t=1: Smaller inflation but fall of output and increase of unemployment in point B
A
An adverse demand shock e shifts AD curve to AD’ and brings the economy from point A to point B.
Infl
atio
n
Output gap
AD’
LAD
LAS
ASAD
Negative Demand Shock: Increasing Demand
0
B t=2: Return to the equilibrium point
(point C=A).
C=A
Increase in government expenditures shifts AD curve to the right
Infl
atio
n
Output gap
AD’
• Fighting unemployment with expansionary fiscal or nonetary policy (e.g. increasing government expenditures, G)
