aggregate supply, the price level, and the speed of adjustment

 The real money supply is the key variable linking the aggregate demand for goods and the price level.. MDS The macroeconomic demand schedule Real money supply is nominal money supply

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 IS-LM model, it has been assumed

that

– prices are fixed

– the supply-side of the economy can be ignored.

 These assumptions must now be

relaxed.

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.

The macroeconomic demand schedule (MDS) connects

these points

MDS

The macroeconomic demand schedule

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

Income

Income

r

P

IS

LM 0

Y 0

P 0

With price at P 0 , LM is located

at LM 0 , and given IS, real income is in equilibrium at Y 0

At a lower price P 1 , LM is at

LM 1 , and real income at Y 1

LM 1

Y 1

P 1

The macroeconomic demand schedule

Income

Income

r

P

IS 0

LM 0

Y 0

P 0

LM 1

Y 1

P 1

The MDS shows the different combinations of the price level and real income at which

planned spending equals actual output once interest rates are set to keep money market equilibrium.

Notice that a fall in price may also shift IS by increasing the value of household wealth via

the real balance effect.

IS 1

Y 2

The effect of this is to produce

a flatter schedule MDS'.

MDS'

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.

The labour market

Employment, labour force

LD

LD is the labour demand schedule: it shows how much labour firms demand

at each real wage.

LF

The schedule LF shows that more people will be in the labour force at higher values of the real wage.

AJ

AJ shows how many workers have accepted jobs at each real wage.

N* N 2

Equilibrium is where AJ = LD, at N*

N 2 – N* is the natural rate of unemployment.

w*

The labour market

Employment, labour force

LD

LF

AJ

N* N 2

w*

The unemployment that occurs in equilibrium (shown by N 2 – N*) is

voluntary.

If the real wage is above its equilibrium at w 1 , there is unemployment given by

N 3 – N 1

N 3

N 1

w 1

Of this, BC is voluntary, but AB is involuntary.

A B

C

The aggregate supply schedule

Output

Flexibility of wages and prices ensures that real wage adjustment maintains full employment in the

labour market.

So overall equilibrium is shown where MDS = AS

at the potential output level Y p and price level P.

MDS

P

In the CLASSICAL model, with no money illusion and flexible money wages, AS

is vertical at the level of potential output.

AS

Y p

Monetary and fiscal policy

Output

MDS

P 0

AS

Y p

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

at each price.

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.

E

But a shift from MDS to MDS' alters equilibrium from E to E'; price increases from P 0 to P' but output remains at Y p .

MDS'

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.

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.

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.

Adjustment in the labour market

Short-run (3 months)

Medium run (1 year)

Long-run (4-6 years)

WAGES

HOURS

EMPLOYMENT

Largely given

Demand-determined

Largely given

Beginning

to adjust

Hours/

employment

mix adjusting

Clearing the labour market

Normal work week

Full employment

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.

The short-run aggregate supply schedule

Output

Y p

SAS

SAS 2

In time, the firm is able to negotiate lower wages, and the SAS shifts to SAS 1 and then to SAS 2 ,

A

A 2

P 2

until equilibrium is restored at A 2 .

Suppose the economy is initially at Y p in

full-employment equilibrium at A, with price P 0

B

In response to a fall in aggregate demand, firms in the short run vary labour input, thus moving along SAS to B.

a fall in nominal money supply shifts MDS to MDS'

Output

Y p

SAS

MDS

AS

A fall in nominal money supply

Starting from long-run equilibrium at E:

E'

adjust to E' in the short run With price at P' but wages unchanged, the real wage rises bringing involuntary unemployment.

P 3

SAS 3

E 3

Equilibrium is eventually reached at E 3 , back at Y p

SAS'

As the labour market (wage) adjusts SAS shifts e.g to SAS'

P''

An adverse supply shock:

e.g an increase in the price of oil

Y p '

MDS

Output

P

P

SAS

E

SAS'

Higher oil prices force firms to charge more for their output, so SAS shifts to SAS'

Y'

Higher prices cause a

move along MDS, and

output falls to Y'

P'

In time, unemployment reduces wages and SAS gradually shifts back to SAS, so Y p is restored.