PGP Macroeconomics

Session 12 and 13

1
Beyond ISLM

• IS-LM and Price Level ?

• P is not explained

• IS-LM and Supply conditions ?

• Nothing on resource use or scarcities

• Picture is incomplete without variable P and aggregate

supply
2
Making P variable: AD curve from IS-LM

• So far, we’ve been using the IS-LM model to analyze the

short run, when the price level is assumed fixed. As if
firms are willing to supply any amount at a given price.

• The aggregate demand relation captures the effect of the

price level on output demanded. It is derived from the
equilibrium conditions in the goods and financial markets.
3
From IS-LM To Aggregate Demand at all Possible Prices

LM(P2) P
r
LM(P1)

P2

P1
AD
IS
Y
Y Y2 Y1
Y2 Y1
AD: All (P,Y) such that
As P increases, M/P falls all goods and asset
Real balances fall, money markets are in equilibrium
demand > money supply, thus
r rises for all Y, LM shifts up Each point on AD is
P2>P1, so for higher P, Y is lower an IS-LM intersection 4
Why is the Aggregate Demand Curve Downward-
Sloping? Same reason as Micro?

• Liquidity Effect: higher aggregate price level reduces the

real money supply, leading to a rise in interest rate and a fall

in investment spending (and consumer spending).

• Wealth Effect: a higher aggregate price level reduces the

purchasing power of households’ existing wealth (real value

of their asset) and reduces consumer spending. 5

 Policy Shifts in Exogenous Variables
Money supply (nominal balances) increases, LM shifts down,
Y increases for all P, implies AD shifts out to the right.
Tax reduction or government spending increase shifts IS curve to the
right, thus Y rises for all P, this implies AD shifts to the right.
Any expansionary policy intervention shifts the AD to the right. Each
AD curve is drawn for a given level of Nominal Money supply

P
Policy
Waiting for the AS curve induced
to complete a medium-run shift in AD
model to study fluctuations
AD

Y
6
Changes in the price level through AD-AS
• Recall the AD curve
To determine Y and P both uniquely we need
one more reln between P and Y

• Must be the missing AS curve

P
AS
This is only one of the
possible shapes
E
p
AD

Y
y 7
What AS looks like:
Time frame makes a difference

3 basic shapes:

(a) very P (b) short run

P short run
(ISLM) SRAS
or
AS
Y
Y
P
LRAS

(c) long run

8
Y
Labour demand and Output

• In the short-run, capital is fixed and firms change their

output by changing labour input.

• What determines labour demand?

• Real wages.

• Real wage = Nominal wage/ Price of goods purchased.

• Which price? Current or future?

9
Labour demand and Output

• Nominal wages are negotiated/bargained.

• While bargaining nominal wages, that is going to be fixed

for some time in future, workers think about how much they
can buy in future with that wage.

• So relevant price is the future ‘expected’ price level.

• Therefore firms and workers negotiate contracts and fix the

nominal wage before they know what the actual price
level will turn out to be.
10
The wage setting process

• Contract money wage W is based on target real wage ω

and Pe:
W = Pe × ω

• Employment and output adjusted to profit maximizing level

corresponding to realized (actual) real wage W/P (recall
MPL = real wage).

• Since money wage is contracted and is fixed till contract

expires, this model is known as “sticky wage” model. 11
Evidence of Sticky Wage: US

12
The Sticky-wage model

• The nominal wage is the product of a target real wage

and the expected price level:
Target
real
e
W  ω P wage

W Pe
Realized  ω
real P P
wage Actual
price

Will the actual price be always equal to expected price ?

13
The Sticky-wage model
W Pe
ω
P P
If it turns out then
that
P Pe Unemployment and output are at
their natural rates.
e Real wage is less than its target, so
P P firms hire more workers and output
rises above its natural rate.
e
P P Real wage exceeds its target,
so firms hire fewer workers and
output falls below its natural rate.
14
A General Formula for Aggregate Supply

These two rules can be incorporated in a general

supply equation:

Y = Yn + α (P – Pe)
or P
LRAS
P = Pe + (1/α) (Y – Yn) AS

Pe

Yn Y

15
AS and LRAS

P LRAS Y  Y   (P  P e )

P Pe

P Pe AS
Different models
of agg. supply
P Pe imply the same
relationship
Y summarized by
Y the AS curve &
the equation.
(Yn)

16
Shape of the AS curve

• There are good reasons to believe that the AS curve is bow-

shaped in the real world; that is, the curve is steeper at high
levels of output than at low levels of output.

• At low level of GDP, lots of unutilized and under-utilized

resources available, so it is not terribly costly for firms to
increase output

• Firms do not require a big increase in prices to make them

willing to increase output by a given amount
17
Shape of the AS curve

• At very high levels of output, when unemployment is

below the natural rate and capital is being used at higher
than normal intensity levels, it is relatively costly for
firms to increase output further.

• Hence, a larger increase in prices is required to make

firms willing to increase their output.

18
Policy Implication

• When policymakers increase aggregate demand, output

rises (good) and prices rise (not good).
• So there is a trade-off

• How much of the bad thing (price increases) must we

tolerate to get some of the good thing (an increase
output)?

• The answer depends on how steep the AS curve is.

19
Policy Implication

• When President Reagan cut taxes in the US in the early

1980s, the economy was just coming out of a severe
recession, and was on the flatter part of the SRAS curve

• The tax cuts affected output a lot and inflation very little.

• In contrast, when President Bush proposed huge tax cuts

during the 2000 election season, US was on the steeper part of
the SRAS curve, so the tax cuts would likely have been
inflationary.
20
The Unemployment Rate and Money Wage

• Wage is determined by bargaining.

• Higher unemployment weakens bargaining power of

workers. Firms can pay lower wages and still keep
workers willing to work.

→Bargaining outcome is a lower wage.

21
Price – Output Relation: AS

• What happens to the level of output produced when price level

increases?

1. When the nominal wage is stuck, a rise in the price level

lowers the actual real wage, making labour cheaper

2. The lower real wage induces firms to hire more labour;

Ld = L (W/P)

3. The additional labour hired produces more output;Y = F (L) 22

23
Aggregate Supply
Given the expected
The Aggregate Supply Curve
price level, an increase
in output leads to an
Pe is fixed
increase in the price for this AS

level. If output is equal

to the natural level of
output, the price level is
equal to the expected
price level.

Remember: A particular AS is drawn for a

given expected price level, i.e. Pe is fixed
along a particular AS curve
24
Short-run to Long-run

• In the short run wage is contracted and therefore cannot be

renegotiated (or the cost of rewriting new contract is high).

• However if the actual price turns out to be higher than the

expected, given sufficient time, nominal wage will be re-
contracted to keep real wage the same.

• Therefore, over time, any deviation between actual and

expected price can be factored in in the wage setting process.

• Higher actual price level causes expected price to be revised

upward. 25
Aggregate Supply
The Effect of an Increase in the Expected Price Level on the
Aggregate Supply Curve

An increase in the
expected price
level shifts the
aggregate supply
curve up

26
LRAS
Why LRAS is vertical at Y = Y ?
Beginning with SRAS relation
P LRAS Y  Y   (P  P e )
Note that in the
long-run all
expectations are met
P Pe so that people would
end up having
realized price =
expected price.
Y Hence put P  P e
Y in above. This leaves
us with Y = Y
27
The Long Run Aggregate Supply Curve (LRAS)

• The long-run aggregate-supply curve is vertical at the

natural rate of output, which is the production of goods
and services that an economy achieves in the long-run
when unemployment is at its normal rate.
• This level of production is also referred to as potential output
or full-employment output.
• The natural rate of output is level of output towards which
the economy gravitates in the long run.
28
The Meaning of “Natural”

• The “natural” rate of unemployment is the rate to

which the economy gravitates in the long run.

• The natural rate is not necessarily the most desirable

one, nor is it constant over time.

• Monetary policy cannot change the natural rate, but

other government policies that strengthen labour
markets can.
29
Dynamics: Short-run to Long-run

Suppose a positive AD SRAS equation: Y  Y   (P  P e )

shock moves output
above its full capacity P LRAS SRAS2
level and P above the
level people had
expected.
SRAS1

P3  P3e
P2
P2e  P1  P1e AD2
Over time,
P e rises, AD1
SRAS shifts up, Y
and output returns
Y2
to its natural rate. Y 3  Y1  Y
30