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Chapter 6
Macroeconomics
Dornbusch Fischer & Startz
Dornbusch, Fischer & Startz
Aggregate Supply: Wages, Prices and
Employment
The AS curve describes the price adjustment mechanism of the economy.
The price‐output relation shown by the AS curve is built up from the links
among wages, prices, employment and output.
The link between inflation and unemployment is shown by the Phillips
Curve.
The theory of AS is one of the least settled areas of Macroeconomics.
Problem is on the understanding of why prices and wages are slow to adjust.
Unemployment is not always at a natural level and output does not always
respond to changes in demand.
This leads to a variety of AS model.
Consensus: SRAS is relatively flat and LRAS is vertical.
In fact, the main result of all modern models is that:
the SRAS is positively sloped while the LRAS is vertical.
h SRAS i ii l l d hil h LRAS i i l
In the classical model, there is no unemployment in the sense we know.
In equilibrium, everybody is working in the classical economy but there is
some unemployment.
This level of unemployment is due to movement of people as they change
jobs—frictional unemployment.
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There is an amount of frictional unemployment that is consistent with the
full employment level of output q*.
The rate of unemployment associated with the FE level is termed the natural
rate of unemployment.
The AS curve and the price adjustment mechanism
The AS curve can be described by an equation:
Wages, Prices and Output: The Facts
The classical model of macroeconomics holds that the economy is always at
full employment (N*).
Any unemployment that is observed is purely frictional—transitory
unemployment as workers move from one job to the next.
Because there is no voluntary unemployment, there can be no relation
between labor market conditions and the behavior of wages.
Wages, w, are determined by productivity and the effects of money on prices
and not by unemployment. (w is independent of the unemployment rate, u.)
This is not true in the real world because of two things:
1] evidence of fluctuations in u shows that not all unemployment is frictional.
2] there is an observed systematic (negative) relationship between the rate of
change of wages and unemployment
change of wages and unemployment.
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The Phillips Curve (PC)
In 1958, Phillips showed an empirical regularity in UK data on the rate of
change in w and u.
The main finding is that there is an inverse relationship between u and the rate
of increase w.
In other words, there is a tradeoff between wage inflation and unemployment.
Let wt + 1 be the future wage and let wt be the current period wage.
Then wage inflation is defined as:
(1)
Let u* denote the natural rate of unemployment.
The Phillips curve then states the following:
(2)
where e measures the responsiveness of wages to unemployment.
Wages are falling when u > u*.
Note: The Phillips curve implies that w and p are slow to adjust to changes in
AD.
To show this, suppose Ms rises.
The effect (through ISLM) will be to raise prices but for the economy to
return to equilibrium, wages must also rise proportionally.
By the PC, u must fall for wages to rise above their previous levels. This can
be shown by rewriting the PC:
(2a)
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WageUnemployment Relationship
The PC suggest that wages are slow to adjust, unlike in the classical model
where w is fully flexible.
In the PC, wages are sticky or slow to adjust to ensure full employment at
every point in time.
One can rewrite the PC to derive a relation between the amount of
employment and the level of money wage.
Let N and N* be the actual and natural levels of employment respectively.
One can define u and u* as:
(3)
Then using this in [2], we get the following:
(2b)
Or rewriting in terms of wage levels:
(4)
(4)
[4] shows the wage‐employment relation:
the current w is equal to the previous w adjusted for the level of
employment.
The higher is N relative to N
The higher is N relative to N *, the higher is the current w.
, the higher is the current w.
At N = N , wt + 1 = wt. This can be shown graphically:
*
w
Ns
wt
N* N
The extent of response of w to changes in N depends on ε.
The WN curve can also shift over time.
If there is overemployment (N > N*) this period, the Ns curve shifts up next
period.
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From Phillips Curve to the Aggregate Supply Curve
Four steps are needed to derive the AS curve.
relate output to employment
relate prices to costs
relate wages to employment through the PC.
combine these three relations to derive AS
combine these three relations to derive AS.
The Production Function
This links the level of employment of labor to the level of output.
The simplest production function states that q is proportional to
employment N:
q = aN (5)
a is the input coefficient that measures labor productivity (q/N).
A higher a implies higher productivity.
Costs and Prices
The guiding principle is that the firm will supply output at a price that will at
least cover its costs.
Assume that firms base their price on the labor cost of production.
If one unit of labor produces a units of output, the labor costs is w/a and is
called the unit labor cost.
Assume that firms set the price as a markup, z, on labor cost:
(6)
The markup should cover the cost of other factors of production that firms use.
If competition is imperfect in the industry, the markup will include monopoly
profits.
E l
Employment, wages and the AS
d h AS curve
Substitute [6] in the PC equation [4] :
and rearrange to get:
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(7)
Since output is proportional to employment where N = q/a and N * = q */a,
then using these in [7] gives us:
p
AS'
AS
This can be shown as an upward sloping curve: q* q
Properties of the AS curve
• The AS curve is flatter the smaller is the impact of output and
employment changes on current wages.
The smaller is ε, the flatter is AS. The coefficient λ captures this.
• The position of the AS schedule depends on the past level of prices.
The curve passes through q* at pt + 1 = pt .
• The AS curve shifts over time.
If q is maintained above q*, w will rise and are passed on to increased p.
The Effects of Monetary Expansion
Assume that from the initial equilibrium position
(AS = AD at q* and pt + 1 = pt), nominal money stock is increased.
p
Short‐Run effects
AS
The increase in Ms lowers i
The increase in M lowers i and raises output.
and raises output
At the original price, there is an excess demand
po
(that raises prices and shifts AD curve up to ADn.
ADn
The magnitude of increase in p from (po to pn)
AD
and q depends on λ .
q* q
The rise in p is due to higher labor costs as
production and employment rises.
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AS''
p
AS'
Medium‐Term Effects AS
At E' output is above normal. E''
p' E'
This means that prices will keep on rising po
(by equation 7) in the next period.
ADn
The AS curve shifts reflecting an increase in wages AD
in response to the high level of employment. q*
q q
The second period AS curve, AS', passes the vertical line at p'.
Long‐Term Adjustment
Wages will continue to rise for as long as output is above normal.
As increasing cost of production raises prices, the AS curve will shift up and
output will decline to its full employment level (q*).
The upward shifting AS curve gives a series of equilibrium positions on the
AD curve.
curve
In the long‐run at E'', prices have risen in the same proportion to as the
nominal money stock so that real money stock is where it was from the
start—so are the interest rates, output and employment.
Neutrality of Money
In the LR, when w and p have adjusted fully, the model has the same
predictions as the classical case:
An increase in money stock has no real effects.
That is, money is neutral and affects prices only.
The crucial difference between this model and the classical case is that in
The crucial difference between this model and the classical case is that in
this model, money is neutral only in the longrun but not in the shortrun.
In this model, prices and output rises when money rises in the short‐run and
medium‐run.
Note that in the adjustment process, the real wage is assumed constant.
The crucial assumption driving the non‐neutrality result is the slow
adjustment of wages and prices.
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Expectations augmented PC
We modify the PC as follows:
(2c)
A constant real wage, gw = , is implied by (6). Therefore:
(2d)
This modern PC
This modern PC has two critical properties:
has two critical properties:
1] Expected inflation is passed one for one into actual inflation
2] Unemployment is at the natural rate when actual is equal to expected .
The link between GDP and unemployment is shown by Okun’s Law:
A two percent increase in GDP leads to a one percent decline in the
unemployment rate:
(8)
where ω ≈ 2.
Using (8) in (2d) and noting that π =(pt+1/pt) –1 and πe = (pt+1e/pt) –1, we
obtain the AS equation arising from the EAPC:
We can rewrite the AS equation above to get an approximate version:
(9)
The AS curve implied by (9) is upward sloping and has the properties of the
The AS curve implied by (9) is upward sloping and has the properties of the
labor supply curve.
This results from 2 assumptions: the markup is fixed and output is
proportional to employment
Supply shocks
Definition: Supply shock – a disturbance to the economy whose first impact is
a shift in the AS curve.
S
Supply shocks, usually a leftward shift of AS, can be managed by
l h k ll l f d hif f AS b db
expansionary AD policy.
This stabilizes output but raises prices.
A contractionary AD policy stabilizes prices but leads to a decline in output.