Marcro micro econmiy david begg chapter 026

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


Introducing prices and the labour market
■

In discussing equilibrium within the ISLM model, it has been assumed that
–
–

■

prices are fixed
the supply-side of the economy can be
ignored.

These assumptions must now be
relaxed.
26.2


The price level and aggregate demand
■

The CLASSICAL model of macroeconomics

analyses the economy when wages and
prices are fully flexible.

■

The real money supply is the key variable
linking the aggregate demand for goods and
the price level.

■

The price level is the average price of all the
goods produced in the economy.
26.3


The macroeconomic demand schedule
LM0

r

Real money supply is nominal
LM1 money supply divided by the
price level – it influences the
position of LM.
IS

P
P0

Income

P1

MDS
Y0 Y1

Income

With price at P0, LM is located
at LM0, and given IS, real
income is in equilibrium at Y0.
At a lower price P1, LM is at
LM1, and real income at Y1.
The macroeconomic demand
schedule (MDS) connects
these points ...
26.4


The macroeconomic demand schedule
LM0

r

P
P0
P1
Y0

The MDS shows the different
LM1 combinations of the price level
and real income at which
IS1 planned spending equals
actual output once interest
IS0 rates are set to keep money
market equilibrium.
Income
Notice that a fall in price may
also shift IS by increasing the
MDS' value of household wealth via
the real balance effect.
MDS
The effect of this is to produce
Y1 Y2 Income a flatter schedule MDS'.
26.5


The labour market and aggregate supply
■

The aggregate supply schedule
–

■

shows the output that firms wish to
supply at each price level.

Given that output depends on inputs

employed, the labour market is the
starting point for analysing
aggregate supply.

26.6


Real wage

The labour market

w*

N*

LD is the labour demand
schedule: it shows how
AJ
LF
much labour firms demand
at each real wage.
The schedule LF shows
that more people will be in
the labour force at higher
values of the real wage.
LD AJ shows how many
workers have accepted
Employment, jobs at each real wage.
N
2 labour force

Equilibrium is where AJ = LD, at N*.
N2 – N* is the natural rate of unemployment.

26.7


Real wage

The labour market

w1

The unemployment that
occurs in equilibrium
(shown by N2 – N*) is
voluntary.

AJ
A

B

LF
C

w*

N1

N*

N2 N3

If the real wage is above its
equilibrium at w1, there is
unemployment given by
N – N 1.
LD 3
Of this, BC is voluntary,
but AB is involuntary.

Employment,
labour force

26.8


The aggregate supply
schedule

Price level

In the CLASSICAL model,
with no money illusion and
AS
flexible money wages, AS
is vertical at the level of
P
potential output.

Flexibility of wages and
MDS prices ensures that real
wage adjustment maintains
full employment in the
Yp
Output
labour market.
So overall equilibrium is shown where MDS = AS
at the potential output level Yp and price level P.
26.9


Price level

Monetary and fiscal policy
P'

AS
E'

P0

E

Yp

Changes in nominal money
supply or in fiscal policy
shift the MDS, altering the
level of aggregate demand

MDS' at each price.
But a shift from MDS to MDS'
MDS alters equilibrium from E to E';
price increases from P0 to P'
but output remains at Yp.
Output

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.

26.10


Fiscal policy
■

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.

26.11


The speed of adjustment
■

Adjustment in the Classical world is rapid,
so the economy is always at potential
output (full employment).

■

If wages and prices are sluggish, then
output may deviate from the potential level.

■

A "Keynesian" world of fixed wages and
prices may describe the short run period
before adjustment is complete.
26.12

Supply-side economics
■

The pursuit of policies aimed not at
increasing aggregate demand, but at
increasing aggregate supply.

■

A way of influencing potential output,
seen as critical in the Classical view
of the economy.
26.13


Adjustment in the labour market
Short-run
(3 months)

Medium run
(1 year)

WAGES

Largely
given

Beginning
to adjust

HOURS

Demanddetermined

EMPLOYMENT

Largely
given

Long-run
(4-6 years)
Clearing
the labour
market
Normal
work week

Hours/
employment
mix
Full
adjusting
employment
26.14


Short-run aggregate supply
■

If adjustment is not instantaneous, output may
diverge from Yp in the short run.

■

Firms may vary labour input
–

■

■

via hours of work (overtime or layoffs)

Wages may be sluggish in falling to restore full
employment in response to a fall in aggregate
demand
The short-run aggregate supply schedule shows
the prices charged by firms at each output level,
given the wages they pay.

26.15


Price level

The short-run aggregate supply schedule

P0

Suppose the economy is initially at Yp in fullemployment equilibrium at A, with price P0
SAS In response to a fall in
aggregate demand,
A
SAS1 firms in the short run
B
vary labour input, thus
moving along SAS to B.

SAS2

P2

A2

Yp

Output

In time, the firm is able to
negotiate lower wages,
and the SAS shifts to
SAS1 and then to SAS2,
until equilibrium is
restored at A2.

26.16


A fall in nominal money supply

Price level

AS

P
P'
P''
P3

SAS
E
E'
E3

MDS'

Starting from long-run
equilibrium at E:

a fall in nominal money
supply shifts MDS to MDS'
SAS'
Given wage levels, firms
SAS3 adjust to E' in the short run
With price at P' but wages
unchanged, the real wage
rises bringing involuntary
MDS unemployment.

As the labour market (wage)

adjusts SAS shifts e.g. to SAS'

Yp
Output
Equilibrium is eventually reached at E3, back at Yp.
26.17


An adverse supply shock:
e.g. an increase in the price of oil
Higher oil prices force
SAS' firms to charge more
for their output, so SAS
SAS shifts to SAS'

P

P'
P

equilibrium from E to E'

E'
E

MDS
Y'

Yp '

Output

Higher prices cause a
move along MDS, and
output falls to Y'
In time, unemployment
reduces wages and SAS
gradually shifts back to
SAS, so Yp is restored.

26.18