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 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 LD 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