Aggregate%20supply,%20inflation%20and%20Phillips%20curve

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Lecture XII

• Aggregate supply, inflation and Phillips curve

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XII.1. Short- and long-term
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Lecture II VIII long-term static model

• All assumptions of a general equilibrium model
  fulfilled flexible prices (and wages), full
  information, etc.
• Long-term enough for prices to adjust and markets
  to clear
• Aggregate supply vertical, level of (potential)
  product determined by production function
• Aggregate demand is a decreasing function of
  price
• Says law ensures that AD equals AS
• Classical dichotomy amount of money determines
  prices (and all other nominal values), but not
  real variables

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Lecture X Keynesian model

• Assumptions of general equilibrium model not
  fulfilled
• Depression free resources (labor) ? prices
  constant
• Aggregate demand - decreasing function of the
  price
• Aggregate supply - at constant prices - is
  horizontal
• Adjustment towards equilibrium quantity (not
  price) adjustment, and aggregate supply adjusts
  to aggregate demand (opposite to classical,
  long-term model)
• Money is not neutral, amount of money in the
  economy has an impact on aggregate demand
• Aggregate demand can be influenced by policies to
  adjust to aggregate supply

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Real world

• In the long-term, the prices do adjust and
  markets do clear, indeed
• When capital fixed, then product is determined by
  employment and after full adjustment, labor
  market is in equilibrium as well and this
  equilibrium generates full employment and
  potential product
• In the long-term AS is vertical (classical)
• In the short-term price and wages are not very
  flexible, for several reasons
• Low and/or slowly spreading information, slow
  reaction of firms (they do not change wages and
  prices immediately), etc.
• This applies in every moment of economic cycle,
  not only in depression
• In the short-term, AS is horizontal (Keynesian)

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XII.2 AD x AS model

• Aggregate demand both in short- and long-run
  decreasing function of price
• Aggregate supply
• In the long-run vertical at potential product,
  long-run aggregate supply (LRAS)
• In very short-run (ISLM) horizontal at fixed
  price, short-run aggregate supply (SRAS)
• In medium term positively sloped AS (see bellow)
• Shifts in AD
• In the long-run, do not change product, but
  over-all price level consistent with classical
  model
• In very short-run, do change the level of product
  (and employment), but price is fixed consistent
  with original version of Keynesian model

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Long-run shifts of ADpermanent change that
contracts AD
LRAS
P
Y
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Short-run shift of AD(external shock that
contracts AD)
P
SRAS
Y
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From short- to long-run (1)

• Short-run equilibrium
• AD equals AS, adjustment through quantities ? AS
  adjusts to AD
• Price fixed, equilibrium as state of rest, there
  can be excess supply on labor market (involuntary
  unemployment)
• Actual product can be lower/higher than potential
  one
• Long-run equilibrium
• AD equals AS
• Simultaneous adjustment of all prices generates
  equilibrium on all markets
• Actual product equal to potential one

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Long-run equilibrium
P
LRAS
E
SRAS
AD
Y
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From short- to long-run (2)

• Intuitive interpretation
• Fixed price corresponds either to the depression
  (Keynes) or to very short-run, when prices (and
  wages) are fixed in all economies and at (almost)
  all situations (exceptions e.g.
  hyperinflations)
• Long-run equilibrium prices and wages had to
  react to changes in demand/supplies on all
  markets (including labor) and their adjustment
  cleared all markets simultaneously

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Adjustment in the long-run
P
LRAS
SRAS1
A
SRAS2
Y
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Adjustment - summary

• Aggregate demand both in short- and long-run
  decreasing function of price
• Aggregate supply
• In the long-run vertical at potential product,
  long-run aggregate supply (LRAS)
• In very short-run (ISLM) horizontal at fixed
  price, short-run aggregate supply (SRAS)
• In medium term positively sloped AS
• Shifts in AD
• In the long-run, do not change product, but
  over-all price level consistent with classical
  model
• In very short-run, do change the level of product
  (and employment), but price is fixed consistent
  with original version of Keynesian model

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XII.3 Short-term aggregate supply

• Adjustment process (from short- to long-term)
  might take long time ? an obvious question
• how does the aggregate supply look like in this
  adjustment period? ? increasing function of price
• Model?
• No unified theory till today
• 3 plausible models, all taking into account that
  prices do adjust, but with time lag, slowly
  (sticky prices)

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XII.3.1 Wage rigidity sticky wages

• Originally F.Modigliani (1944) downward wage
  rigidity
• In general wages rigid in both directions,
  reasons
• Long term wage contracts, eventually implicit
  contracts, power of the unions
• Intuitively if wages rigid, then price increase
  lowers real wage ? firms increase employment ?
  product increases and supply increasing function
  of the price

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Model (1)

• Model only for the situation, when product
  smaller or equal to potential product
• Labor market
• Either in equilibrium natural unemployment
  (employment, product)
• Or product smaller than potential, unemployment
  higher than natural, supply of labor higher than
  demand and unemployment determined by demand
  (when D?S, amount realized on the market always
  given by min (D,S))

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Model (2)

• Wage negotiations
• Nominal wage always negotiated at the expected
  price Pe , so both firms and workers have in mind
  targeted real wage, so wT a W wT . Pe
• Employment given by demand ? firms then decide
  according price P
• - (W/P) wT . (Pe /P)
• if P Pe , then (W/P) wT
• if P gt Pe , then (W/P) lt wT
• if P lt Pe , then (W/P) gt wT
• Unexpected growth of price means fall of real
  wage ? higher employment ? higher product
  conversely, fall of price ? lower product
• Higher price ? higher AS (and vice versa)

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W/P
P
AS
E
E
N
Y
Y
N
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Model (3)

• Difference between actual and expected price
  reflects price movements
• One possible interpretation in moment t
  expectation equals price
• real price, determining real wage, is price in
  moment t1
• Generalization

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Wage rigidity weaknesses of the model

• Model with rigid wages explains the relation
  between price movements and aggregate supply in
  the situation, when product is lower or equal to
  potential one
• Does not cover situations, when product increases
  over potential level
• compare impact of wage growth when initially
  product is on potential level
• Real wages move against the cycle

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XIII.3.2 Wrong perception of price level by
workers

• Starting assumption firms always know prices,
  workers only expect them and will know real price
  only with a time lag
• Demand for labor
• Supply of labor
• Always and ratio
  reflects a degree of wrong perception of price
  level by workers

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Model (1)

• Demand for labor decreasing function of real
  wage
• Supply of labor increasing function of expected
  real wage, can be written as
• Labor supply curve shifts according the ratio
  P/Pe
• Model explains the relation between price and AS
  even when product is higher than a potential one
• Model assumes simultaneous clearing of all markets

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Wrong price perception price increase

• Demand decreasing function of real wage
• Supply increasing function of
• initial supply
• Unexpected price increase ? labor supply shifts
  to the right ? real wage fall ? new equilibrium
  with higher employment

W/P
N
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Model (2)

• Price increase ? employment increase
• AD increasing function of price
• In general again

AS
P
Y
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XIII.3.3 Incomplete price information

• Assumptions
• No difference between firms and workers
• On the markets, agents know
• Quite well the price of goods they produce
• not so well the price of most other goods
• Agents produce one good and consume many goods

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Model

• Unexpected increase of overall price level, then
  each agent
• as producer perceives the increase of the price
  of its product and feel incentives to increase
  production
• as a consumer doesnt perceive the price increase
  as an overall one, as he doesnt know all other
  prices
• Main idea at change of absolute price level,
  agent wrongly assumes the change of only relative
  prices (of his product) ? increases supply
  because of increase of price
• Formally again

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XII.3.4 Summary

• Particular models of short term aggregate supply
  differ, but do not exclude each other exclusively
• All models generate AS that in the short run
  is increasing function of price

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Interpretation

• Variations from potential (natural) product are
  proportional to variations of actual price from
  expected one
• Actual price higher than expected ? product
  higher than potential and vice versa
• In graphical terms short term AS is increasing,
  slope 1/?
• Expected price becomes a model parameter
• When actual and expected price equal, product on
  potential level
• Change of expected price shifts AS curve
• Dynamics

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AS in long and short term
P
LRAS
AS
Y
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XII.4 Model AD-AS
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Equilibrium

• Juxtaposing AD and AS
• AD ? static model
• AS ? dynamics, expected price
• Equilibrium in AD-AS model
• Mathematically solution of system of equations
• Graph intersection of AD and AS curves
• Economic interpretation
• AD at given price, other variables adjust to
  keep markets of both goods and money in
  equilibrium
• AS equation to determine price, initial
  condition expected price Pe

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Medium term adjustment (1)

• Impacts of exogenous changes of either fiscal or
  monetary origin
• Initial situation long term equilibrium, i.e.
  product, employment and unemployment at natural
  values
• Initial condition for AS expected price Pe
• Exogenous change shifts AD
• If AS was horizontal (depression), then change of
  equilibrium given by one of short term
  multipliers and price remains constant
• Positively sloped AS new equilibrium, when
  product higher than potential and price higher as
  well
• New short term equilibrium

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Medium term adjustment (2)

• In medium term, people start to correct their
  expectations, the adjustment continues
• Expected price continues to increase and with
  delay continues to do so till expected price
  differs from an actual one
• However, this is possible only at long term
  equilibrium, at vertical AS and natural product
• Stimulation of AD ends up by adjustment back to
  potential product, but with higher price

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Medium term adjustment (3)
LRAS
P
C
B
A
Y
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Conclusions

• Closer to the real world
• Short run product differs from potential one,
  money is not neutral
• Long run product equal to potential (variables
  on natural levels), money is neutral
• What is short run, how to control adjustment to
  natural values?
• and mainly according which criteria?

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XII.5. Phillips curve

• Original version A.W.Phillips, 1958
• Assumption of inverse relationship between growth
  of wages and unemployment
• respectively, between growth of prices
  (inflation) and unemployment
• At the beginning of 1960s, it seemed -
  statistically - the data confirm this assumption

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XII.5.1. Theory (1)

• Phillips empirically observed reality
• 1960 Samuelson a Sollow theory
• Increasing AS ? relation between change of
  product and change of price level
• Inverse relation between the difference of
  product from potential one and difference of
  unemployment from natural one
• Okuns law

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Theory (2)

• Product higher than potential one suppresses
  unemployment bellow natural rate ? increase of
  wages and (under the assumption of no labor
  productivity growth) of prices
• Phillips empirical observation can be written as
• Inflation is negatively related to the difference
  between actual and natural rate of unemployment

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Inflation

• L V inflation defined as a monetary phenomenon
• Here theory, based on an empirically observed
  Phillips curve
• Original version of Phillips curve theory of
  demand-pull inflation, i.e. inflation, generated
  by the increase of aggregate demand, that
  decreases unemployment bellow a natural level,
  with subsequent increase of nominal wages and
  price

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Conclusions for economic policies

• Phillips curve implies that high inflation (that
  usually accompanies economic growth) means lower
  unemployment and vice versa
• If this is a theoretically proved truth, then -
  consistently with Keynesian policy recommendation
  (fiscal and monetary policies) - a famous policy
  trade-off was formulated
• If a country is ready to tolerate higher
  inflation, then aggregate demand can be
  stimulated consistently towards potential product
  and keep unemployment low all the time
• On the contrary, if there is a danger of economic
  over-heating (too high inflation and product
  above potential level), the the economy might be
  slowed-down and inflation (and growth) lowered at
  the costs of higher unemployment

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XII.5.2. Empirical problems and inflationary
expectations
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Data after 1970

• After 1970, the data in developed economies
  contradicted both Phillips curve and the theory
  of demand pull inflation (see previous slide)
• Inflation was high even at low growth and and
  high unemployment
• A specific name stagflation
• Problem quickly it was clear that Phillips curve
  is not a representation of a theoretical truth
  (at least not in its original version)
• Consequently policy recommendations, based of
  inflation - unemployment trade-off, are not
  generally valid

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Phillips curve - a wrong concept? (1)

• Two 1968 contributions
• M.Friedman The Role of Monetary Policy
• E.Phelps Money-Wage Dynamics and Labor-Market
  Equilibrium
• Original Phillips curve
• For a period, when long-term average inflation is
  zero and workers expect the next years inflation
  zero as well. This was true until 1960s.
• Inflation/unemployment trade-off not a long-term
  concept, as there is always some level of
  unemployment a natural rate (see L VI)

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Phillips curve - a wrong concept? (2)

• Original Phillips curve wage negotiations, when
  with high unemployment and expectation of zero
  inflation, firms easily find workers, ready to
  take a low wage.
• Positive inflation expectation workers negotiate
  much harder for higher nominal wages to keep real
  wages unchanged.

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Phillips curve - a wrong concept? (3)

• Define expected price as Pe and expected
  inflation as
• and original Phillips curve can be expressed
• However, whenever , than inflation might
  rise, even with high unemployment
• ? no unemployment x inflation trade-off

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Phillips curve - a wrong concept? (4)

• No permanent inflation/unemployment trade-off
  consequences
• Permanent positive inflation, which generates an
  expectation about a positive inflation further
  on
• Unemployment can not for a longer period of
  time be kept bellow a certain level (natural
  rate, consistent with full employment output)
• Over time, Phillips curve trade-off disappears

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Expectations-augmented Phillips curve

• Suppose that
• than
• This fits the data for the period even beyond
  1970 rather well.
• Back to more usual notation
  than
• ? expectations-augmented Phillips curve

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XII.5.3. Cost-push inflation

• Even without demand pressures, economy might
  suffer from even higher inflation because of
  increase of costs
• Usually as a consequence of exogenous shocks
• Oil socks in 1970s
• Consequences for economic policies, dilemma
• Either prevent higher inflationary expectations,
  but at the cost of temporary slow-down in
  economic growth and increase of unemployment
• Or stimulate aggregate demand, overcome
  stagnation, but inflation will not only be
  higher, but higher inflationary expectations will
  be generated

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Literature to L XII

• Mankiw, Ch. 9
• Holman, Ch. 10