Aggregate Supply, Prices and Adjustment to Shocks

1
Aggregate Supply, Prices and Adjustment to Shocks

• Week 6
• Begg, Fischer Dornbusch
• Chapter 25

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The Classical Model of Macroeconomics

• The CLASSICAL model of macroeconomics is the
  polar opposite of the extreme Keynesian model.
• It analyses the economy when wages and prices are
  fully flexible.
• In this model, the economy is always at its
  potential level.

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The Classical Model of Macroeconomics

• Excess demand or supply are rapidly eliminated by
  wage or price changes so that potential output is
  quickly restored.
• Monetary and fiscal policy affect prices but have
  no impact on output.
• In the short-run before wages and prices have
  adjusted, the Keynesian position is relevant
  whilst the classical model is relevant to the
  long-run.

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The Taylor Rule again

• Previously it was assumed that prices were fixed
  and so we talked in terms of a simple Taylor Rule
  where interest rates responded to the output part
  of the rule.
• Here, we allow prices to vary and think in terms
  of the Taylor Rule where interest rates respond
  to both output and inflation.
• In this case, higher inflation leads to the bank
  raising the interest rate, thus reducing
  aggregate demand and output.

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The Macroeconomic Demand Schedule

• The macroeconomic demand schedule (MDS) shows the
  combinations of inflation and output for which
  aggregate demand equals output when the interest
  rate is set by a Taylor Rule.
• Higher inflation is associated with lower
  aggregate demand and lower output.

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The Macroeconomic Demand Schedule

• Movements along the schedule are determined by
• the reaction of interest rate decisions to
  inflation
• and the responsiveness of aggregate demand to
  interest rate changes

• It will be flat when
• interest rate decisions respond a lot to
  inflation
• and aggregate demand is highly responsive to
  interest rate changes.
• It will be steep when
• interest rate decisions do not respond much to
  inflation
• and aggregate demand responds little to interest
  rate changes.

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The Macroeconomic Demand Schedule

• Shifts in the schedule reflect al other shifts in
  aggregate demand not caused by the effects of
  changes in inflation on real interest rate
  decisions
• if fiscal policy eases up
• if net exports rise
• if monetary policy eases

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Aggregate supply and potential output

• The Aggregate Supply Schedule shows the output
  firms wish to supply at each inflation rate
• When prices and wages are completely flexible,
  output is always at potential output
• Potential output depends upon
• the level of technology
• the quantities of labour demanded and supplied in
  the long-run, when the labour market is fully
  adjusted
• In the short-run we can treat potential output as
  given

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The Classical Aggregate Supply Schedule

• The classical model has an aggregate supply curve
  which is vertical at potential output
• This means that equilibrium output can be reached
  at different levels of inflation
• In the classical model, people do not suffer from
  money illusion
• Consequently, only changes in real variables
  influence other real variables

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The classical aggregate supply schedule
This schedule shows the output firms wish to
supply at each inflation rate.
AS
Inflation
When wages and prices are flexible, output is
always at its potential level (Y).
Potential output is the economys
long-run equilibrium output.
Y
Output
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The Classical Aggregate Supply Schedule

• Better technology will shift AS to the right and
  hence increase potential output.
• Increased employment will also shift AS to the
  right and increase potential output
• as will the use of more capital.
• In the short-run, we can treat potential output
  as given.

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Equilibrium inflation
AS
Inflation
At A, the goods, money and labour markets are all
in equilibrium.
Y
Output
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Equilibrium inflation a supply shock
AS0
If the central bank pursues its target of ?0
when the economy is at potential output, it
must respond by reducing its target real interest
rate.
A
?
?0
Inflation
MDS0
Y0
Output
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Equilibrium inflation a demand shock
AS0
A
?
?0
Inflation
Since potential output is the same at B, the bank
must tighten its monetary policy in order to hit
its target of ?0 .
MDS0
Y0
Output
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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.

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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.

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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.

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The Short-run Aggregate Supply Schedule
Suppose the economy is initially at Y in
full- employment equilibrium at A, with inflation
?0
SAS
Inflation
A
? 0
Y
Y
Output
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The adjustment process

• When SAS and MDS are combined, changes in MDS
  lead mainly to a change in output in the
  short-run.
• Over time, deviations from full employment
  gradually change wage growth and short-run
  aggregate supply.
• The economy, therefore, gradually works its way
  back to potential output.

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A Lower Inflation Target
Starting from long-run equilibrium at E
AS
SAS
E
Inflation
?
With inflation at ? ' but wages unchanged, the
real wage rises bringing involuntary
unemployment.
MDS
Y
Output
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A temporary supply shocke.g. an increase in the
price of oil
SAS
Inflation
?
E
MDS
Y
Output
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Tradeoffs in monetary objectives

• Inflation targeting works well when all shocks
  are demand shocks.
• When shocks are supply shocks, stabilising
  inflation may lead to highly variable output.
• Conversely, a policy of stabilising output may
  lead to highly variable inflation.

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Tradeoffs in monetary objectives

• One way round this is to to steer a middle course
  by using a Taylor Rule, i.e. a rule that takes
  into account deviations of both inflation and
  output from their long-run levels.
• Another is to allow flexible inflation targeting
• because the inflation target is a medium-run one,
  this allows some discretion for reducing
  variability in output