Aggregate Supply and Demand

Session 12
 Introduction
• The AS/AD model is the basic macroeconomic tool for studying output
fluctuations and the determination of the price level and the inflation
rate.

• The model can be used to

– explain how the economy deviates from a path of smooth growth over time,
– explore the consequences of government policies intended to reduce
unemployment and output fluctuations, and maintain stable prices
 LM1 at M/P1
Deriving the AD Curve i P2< P1

LM2 at M/ P2
E1

Interest rate
• At IS-LM equilibrium both i1
goods and money market are
in equilibrium i2 E2
• AD curve plots the points
when both goods and money
market are in equilibrium at IS
different price levels
• Suppose prices decreases from Y1 Y2 Y
P1 to P2 Income, output (b)
– M/P increses from M/P1 to
M/P2  LM shifts from LM1 P
to LM2
– Interest rates decreases from i1
P1 E1
to i2, and output increases
from Y1 to Y2
• The AD schedule maps out the IS-
LM equilibrium holding E2
P2
autonomous spending and the
nominal money supply constant AD
and allowing prices to vary
Y1 Y2Y
DERIVATION OF THE AD CURVE
 LM1 at M1/P
Shifts in AD i M2> <M1

LM2 at M2/ P
E1

Interest rate
• At IS-LM equilibrium both i1
goods and money market are
in equilibrium i2 E2
• AD curve plots the points
when both goods and money
market are in equilibrium at IS
different price levels
• Suppose M increases from M1 Y1 Y2 Y
to M2 Income, output (b)
– M/P increases from M1/P to
M2 /P LM shifts from LM1 P
to LM2
– At interest rates decreases E2
from i1, and output increases P1
E1
from Y1 to Y2

• How will you plot the IS curve

shift AD
• All changes in the IS-LM curve
(except price change) leads to Y1 Y2 Y
shift of the AD SHIFT OF THE AD CURVE
 Keynesian Supply Curve
• The Keynesian supply curve
is horizontal, indicating
firms will supply whatever
amount of goods is
demanded at the existing
price level
– Since unemployment
exists, firms can obtain
any amount of labor at
the going wage rate
– Since average cost of
production does not
change as output
changes, firms willing to
supply as much as is
demanded at the
existing price level
 Keynesian Supply Curve
• Intellectual genesis of the Keynesian AS curve is found in the Great
Depression, when it seemed firms could increase production without
increasing P by putting idle K and N to work
• Additionally, prices are viewed as “sticky” in the short run  firms
reluctant to change prices and wages when demand shifts
– Instead firms increase/decrease output in response to demand shift  flat AS
curve in the short run
 The Production Function and
Potential Output
• Y depends upon inputs (labor = N, capital = K) and technology (A)
𝑌 =𝐹 (𝐾 , 𝑁 , 𝐴)
• Potential output (Y*) can be defined as the output when all the
available capital stock and labor force is in full employment
 Classical Supply Curve
• The classical supply
curve is vertical,
indicating that the same
amount of goods will be
supplied, regardless of
price
– Based upon the
assumption that the
labor market is in
equilibrium with full
employment of the
labor force
– The level of output
corresponding to full
employment of the
labor force =
potential GDP, Y*
 Micro vs Macro: (Aggregate) Supply Curve
• In microeconomics, short run supply curve is inelastic, while the long-run
supply curve is elastic

• In macro, it is reverse when compare supply curve from micro with aggregate
supply curve from macro

• In micro, the price rise was essentially a rise in price of one commodity while
keeping the price for all other goods constant
– Thus, the good experiencing relative rise in prices could be produced more by
diverting labour and capital from goods that have become ‘relatively cheaper’

• In macro, “price” refers to nominal price level of all the goods, and price rise
(inflation) is the general rise in prices for all goods.
– Thus, diverting labour from one sector to another only raise prices, not the overall
output in the longrun
Flexibility and Rigidity in Different Markets
• Asset market: Most flexible. Reduction in interest rate can translate
into quick changes in the bond prices/exchange rates.

• Goods market: Prices respond to the changed demand/market

conditions in relatively longer time.

• Labour market: Most inflexible. It can take year to revise the

contracts, though conditions in goods and asset markets may alter
in between.

• Mismatch in the rigidity/flexibility in different markets creates the

need for macroeconomic management
 Classical Supply Curve Over Time
• Y* grows over time as the economy accumulates resources and
technology improves  AS curve moves to the right
• Y* is “exogenous with respect to the price level”
 illustrated as a vertical line, since graphed in terms of the
price level
 Labor-force, WFPR, and Unemployment

• The size of the labor force is determined from surveys

• Labor force = unemployed (U) + employed (E)

• Unemployed is one who is out of work and looking

for a job or expecting a recall from a layoff

• The unemployment rate measures the unemployed/workforce

• WFPR (Workforce participation rate): Labor-force/population in

16-64 age group
 Frictional Unemployment and the Natural
Rate of Unemployment
• Taken literally, the classical model implies that there is no involuntary
unemployment  everyone who wants to work is employed
– In reality there is some unemployment due to frictions in the labor market (Ex.
Someone is always moving and looking for a new job, there are some new
entrants and retirees, some firms are expanding while others are losing business)
• The unemployment rate associated with the full employment level of output
is the natural rate of unemployment
– Natural rate of unemployment is the rate of unemployment arising from normal
labor market frictions that exist when the labor market is in equilibrium

• What will happen to natural rate of unemployment if unemployment

benefits are made more generous
 Types of Unemployment
• Frictional Unemployment: Result of Matching
Behavior between Firms and Workers.

• Structural Unemployment: Result of Mismatch of

Skills and Employer Needs + Industry/Product
structural change

• Cyclical Unemployment:Result of Output being

below full-employment
 We will (mostly) focus on the slope of
the aggregate supply curve, and causes
that shifts the aggregate demand curve
 AS and the Price Adjustment Mechanism:
The Transition from Short to Long-Run
• Start with a short run AS and the Y* (which also gives you long run AS)
• Shift the AD curve (fiscal/monetary policy)
• The current output is higher than the full employment level
• Workers would ask for higher wages; costs and prices go up
• Supply curve for can be defined as:
where : Pt-1 is the price level next period, Pt is the price level today, Y* is potential output
The upward shifting horizontal lines correspond to successive snapshots of equation
Process continues until Y=Y*

Long-run AS t = ∞
P t3
t2 P
t1 t1
t2
t1
Price

Short-run AS Price t0
t0

Y
AD
Y* Y
 AS and the Price Adjustment Mechanism

• If output is above potential (Y>Y*), prices increase, higher next period

• If output is below potential (Y<Y*), prices fall, lower next period
• Prices continue to rise/fall over time until Y=Y*
– Today’s price equals tomorrow’s if output equals potential (ignoring price expectations)
The difference between GDP and potential GDP, Y-Y*, is called the output gap
 AS and the Price Adjustment Mechanism

• Speed of the price adjustment mechanism determined by the parameter 

– If  is large, AS moves quickly (the counter clock-wise rotations in Figure a)
– If  is small, prices adjust slowly
•  is of importance to policy makers:
– If  is large, the AS mechanism will return the economy to Y * relatively quickly
– If  is small, might want to use AD policy to speed up the adjustment process
 AS and the Price Adjustment Mechanism:
The Transition from Short to Long-Run
• Start with a short run AS and the Y* (which also gives you long run AS)
• Shift the AD curve
• The current output is below the full employment level
• Workers would not like, but finally will accept wage cuts; leading to cost and price reductions
• Supply curve for can be defined as:
where : Pt-1 is the price level next period, Pt is the price level today, Y* is potential output
Process continues until Y=Y*
Would the policy maker like to wait for this process

Long-run AS t = ∞
P t3
t2 P
t1
Price

Short-run AS Price t0
t0 t1
t2
t1
Y
AD
Y Firms are stuck with prices that are too high
Y*
 AD Curve
• AD shows the combination of
the price level and level of
output at which the goods and
money markets are
simultaneously in equilibrium

Shifts in AD due to:

1. Policy measures (changes in G,
T, and MS)
2. Consumer and investor
confidence
 AD Relationship Between
Output and Prices
• Key to the AD relationship between output and prices is the dependency of AD on
real money supply
– Real money supply = value of money provided by the central bank and the banking
system
– Real money supply is written as , where is the nominal money supply, and P is the
price level

• For a given level of , high prices result in low OR high prices mean that the
real value of the number of available dollars is low and thus a high P = low level of
real AD
• Lower prices for a given money stock can also translate into wealth effect (to the
extent money is part of portfolio)
 AD and the Money Market
• For the moment, ignore the goods market and focus on the money market
and the determination of AD
• The quantity theory of money offers a simple explanation of the link
between the money market and AD
– The total number of dollars spent in a year, NGDP, is P*Y
– The total number of times the average dollar changes hands in a year is the
velocity of money, V
– The central bank provides M dollars

 The fundamental equation underlying the quantity theory of money is

the quantity equation:
 AD and the Money Market

• If the velocity of money is assumed constant, above equation

becomes

• This is an equation for the AD curve

• For a given level of M, an increase in Y must be offset by a decrease in
P, and vice versa
– Inverse relationship between Y and P as illustrated by downward sloping AD
curve
• An increase in M shifts the AD curve upward for any value of Y
 Changes in the Money Stock and AD
• An increase in the nominal
money stock shifts the AD
schedule up in proportion
to the increase in nominal
money
– Suppose corresponds to
AD and the economy is
operating at P0 and Y0
– If money stock increases by
10% to , AD
shifts to AD’  the value of
P corresponding to Y0 must
be P’ = 1.1P0
– Therefore

 real money balances and

Y are unchanged

In short run you look at the rightward shift, in the long run you look at the upward shift
• To begin with,
economy is at the
AD Policy & the
full employment Keynesian Supply Curve
• An adverse
demand shock
Long-run AS
shifts the AD
t=∞

Price
leftward
• The firms respond
by cutting
production, output P SRAS
declines
• The government
may wait for AD
market to correct
on its own, by firm Pt
cutting the wages
and costs in the AD’
long-run
Y’ Y* Y
 • To begin with,
economy is at the AD Policy & the
full employment
• An adverse
Keynesian Supply Curve
demand shock
Long-run AS
shifts the AD
t=∞

Price
leftward
• The firms respond
by cutting
production, output P SRAS
declines
• The government
respond by raising AD
(↑ 𝐺the AD,↓ 𝑇 ,↑ 𝑀 𝑆 )
AD’’
AD’

Y’ Y* Y
• In the classical case, AS
schedule is vertical at FE
AD Policy & the Long-Run
level of output
– Unlike the Keynesian case,
Supply Curve
the price level is not given,
but depends upon the
interaction between AS
and AD
P
t =∞
Long-run AS

• Suppose AD increases to
AD’
– Spending increases to E’
BUT firms can not obtain
the N required to meet the E’’
increased demand in the
long-run
Price
– Firms hire more workers
& wages and costs of Short-run AS
production rise  firms E’ t0
must charge higher price
– The increase in price
reduces the real money
stock, , and leads
to a reduction in spending

– Move up AS and AD AD AD’

curves to E’’ where AS =
AD’
Y* Y
 Adjustment
Paths of Price
Level and
Output

How will the

intertemporal
path of output
and prices look
like if you are to
start with a
recession?
• To begin with,
economy is at the full
AD Policy & the
employment Keynesian Supply Curve
• An adverse demand
shock shifts the AD
Long-run AS
leftward
t=∞

Price
• The firms respond by
cutting production,
output declines
R
• From the initial P SRAS
point of recession
(R), prices will
decrease overtime, AD
while the output
Pt
will increase
towards potential AD’
output level
Y’ Y* Y
 Supply Side Economics
• Supply side economics focuses on AS as the driver in the economy
• Potential GDP changes every year, but the changes do not depend on the price
level
• Thus, the potential output is exogenous to price level
• Changes in the potential output over a short-period are relatively small, a few
percent a year
 Supply Side Economics
• Supply side policies are those that encourage growth in
potential output  shift AS to right.
– Such policy measures include:
– Removing unnecessary regulation, Maintaining efficient legal
system, Encouraging technological progress
– These measures will improve resource allocation and
marginal product of labor and capital

• Politicians use the term supply side economics in reference to

the idea that cutting taxes will increase AS
• They claim that this rise in AS due to tax-cut could be to the
extent that tax collections will actually increase, rather than fall
 Supply Side Economics
• Cutting tax rates has an
impact on both AS and AD
– AD shifts to AD’ due to
increase in disposable
income
• Shift is relatively large
compared to that of the
AS (Why ?)
– AS shifts to AS’ as the
incentive to work increases
• In short run, move to E’: GDP
increases, tax revenues fall
proportionately less than tax
cut (AD effect)
• In the LR, moves to E’’: GDP
is higher, but by a small
amount, tax collections fall as
the deficit rises, and prices
rise (AS effect)
 Supply Side Economics
• Supply side policies are useful, despite previous example
– Only supply-side policies can permanently increase output
– Demand side policies are useful for short run results

• Many economists support cutting taxes for the incentive effect, but
with a simultaneous reduction in government spending
– Tax collections fall, but the reduction in government spending minimizes
the impact on the deficit
 AS and AD in the Long Run
• In the LR, AS curve moves to the
right at a slow, but steady pace
• Movements in AD over long
periods can be large or small,
depending largely on
movements in money supply
– Movements in AS slightly
higher after 1990
– Big shifts in AD between 1970
and 1980
– Prices increase when AD moves
out more than AS
– Output determined by AS, while
prices determined by the
relative shifts in AS and AD
 AS and AD in the medium-run
• Aggregate supply curve describes, for each given price level, the quantity of
output firms are willing to supply
– Upward sloping since firms are willing to supply more output at higher prices
(while the AS is flat in the short-run, the counterclockwise curves represent the
medium-run)

• Aggregate demand curve shows the combinations of the price level and the
level of output at which the goods and money markets are simultaneously in
equilibrium
– Downward sloping since higher prices reduce the value of the (real) money supply,
which reduces the demand for output

• Intersection of AS and AD curves determines the equilibrium level of output

and price level
• In a recession we are on the
flat part of the aggregate Aggregate Demand and Nonlinear
supply curve
Aggregate Supply
• Demand
management policies can be
effective at boosting the
economy without having
much
effect on the price level.

• However, as the economy

approaches full
employment,
policymakers must be wary
of too much stimulus to
avoid running the
aggregate
demand curve up the
vertical portion of the

aggregate supply curve

 AS, AD, and Equilibrium
• Shifts in either the AS or AD
schedule result in a change
in the equilibrium level of
prices and output
– Increase in AD  increase
in P and Y
– Decrease in AD  decrease
in P and Y
– Increase in AS  decrease
in P and increase in Y
– Decrease in AS  increase
in P and decrease in Y
Aggregate Supply and the Phillips
Curve
Session 13 to 15
 Introduction
• Further develop the AS side of the economy; examine the dynamic
adjustment process from the short run to the long run
– The price-output relationship is based upon links between wages, prices,
employment, and output
 link between unemployment and inflation = Phillips Curve
– Translate between unemployment and output, inflation and price changes

• NOTE: theory of AS is the least settled area in macro

– Don’t fully understand why W and P are slow to adjust, but offer several
theories
– All modern models differ in starting point, but reach the same conclusion:
SRAS is flat, LRAS is vertical
 Recession and Unemployment
• Recession: Technically defined as two consecutive quarters of negative GDP
growth rate (shaded area)
• U.S. unemployment over several decades
– Several periods of high unemployment: early 1960s, mid 1970’s, early-mid 1980’s, early
1990s, late 2000s, and the current period
– Several periods of low unemployment: late 1960’s, early 2000, and 2007
 The Phillips Curve
• In 1958 A.W. Phillips
published a study of
wage behavior in the
U.K. between 1861 and
1957
• The main findings are
summarized in Figure
® There is an inverse
relationship between
the rate of
unemployment and
the rate of increase in
money wages
® From a policymaker’s
perspective, there is a
tradeoff between
wage inflation and
unemployment
 The Phillips Curve
• The PC shows the rate of growth of wage inflation decreases with increases in
unemployment
– If Wt = wage this period
Wt+1 = wage next period
gw = rate of wage inflation, then

• If * represents the natural rate of unemployment, the simple PC is defined as:

∗
𝑔 𝑤 =− 𝜀(𝜇−𝜇 )
• where  measures the responsiveness of wages to unemployment
– Wages are falling when  > * and rising when  < *
– ( - *) is called the unemployment gap
For wages to rise above
previous levels, u must fall
𝑊• −𝑡 +1𝑊
Take the𝑡 two sides together ∗
=− 𝜀 (𝜇 −𝜇 ) below the natural rate
𝑊𝑡
𝑊 𝑡 +1 − 𝑊 𝑡 =𝑊 𝑡 (− 𝜀 (𝜇 − 𝜇∗ )) Higher wages translates into
cost and price rise in the
𝑊 𝑡 +1=𝑊 𝑡 [1 − 𝜀 (𝜇 − 𝜇 ∗ )]
medium-run
 The Policy Tradeoff
• PC quickly became a
cornerstone of
macroeconomic policy
analysis since it suggests
that policy makers could
choose different
combinations of u and
 rates
– Can choose low u if
willing to accept high 
(late 1960’s)
– Can maintain low  by
having high u (early
1960’s)
• In reality the tradeoff
between u and  is a
short/medium run
phenomenon
 = inflation rate
– Tradeoff disappears as
AS becomes vertical
Phillips curve (PC) shows the relationship between
unemployment and inflation
 Story Does not Remains the Same
• The behavior of  and u in the
US since 1960  does not fit
the simple PC story
– Individuals are concerned
with standard of living, and
compare wage growth to
inflation
– If wages do not “keep up” with
inflation, standard of living falls
– Individuals form
expectations as to what 
will be over a particular
period of time, and use in
wage negotiations (e)
• Rewrite the PC to reflect this
as:
𝑔 𝑤 =Π 𝑒 − 𝜀(𝜇 − 𝜇∗ )
 The Inflation Expectations-Augmented
Phillips Curve
• If maintaining the assumption of a constant real wage, W/P, actual  will equal
wage inflation (rise in W should match the rise in P)
• The equation for the modern version of the PC, the expectations augmented PC, is:

𝑒
Π=Π − 𝜀 (𝜇 − 𝜇∗ )

NOTE:
1. e is passed one for one into actual 
2. u = u* when e = 
 The Inflation Expectations-Augmented
Phillips Curve
• The modern PC
intersects the natural
rate of u at the level of
expected inflation

• Figure illustrates the

inflation expectations-
augmented Phillips
curve for the 1980s and
early 2000

• The height of the SRPC

depends upon e

• At u* the inflation
equals e
 The Inflation Expectations-Augmented
• Changes in expectations Phillips Curve
shifts the curve up and
down
– The role of e adds another
automatic adjustment
mechanism to the AS side
of the economy
• When high AD moves the
economy up and to the left
along the SRPC,  results
– if persists, people adjust
their expectations
upwards, and move to
higher SRPC
 The Inflation Expectations-Augmented
Phillips Curve
• After 1960, the original PC
relationship broke down
• How does the augmented PC
hold up?
𝑒
=Π − 𝜀 (𝜇 − 𝜇∗ )
• To test the augmented PC,
need a measure of e  best
estimate is last period’s
inflation, e = t-1
• Figure illustrates the
augmented PC using the
equation:

 Appears to work well in most

periods

Note the vertical axis: It is like acceleration

 Rational Expectations
• The augmented PC predicts that actual  will rise above e when u < u*
• So why don’t individuals quickly adjust their expectations to match the
model’s prediction?
– The PC relationship relies on people being WRONG about  in a very
predictable way
– If people learn to use the equation to predict , e should always equal ,
and thus
Πu = = u* Π 𝑒 − 𝜀 (𝜇 − 𝜇∗ )

• Robert Lucas modified the model to allow for mistakes

– He argued that a good economics model should not rely on the public making
easily avoidable mistakes
– So long as we are making predictions based on information available to the
public, then the values we use for e should be the same as the values the
model predicts for 
– Surprise shifts in AD will change u, but predictable shifts will not
 AS and the Price Adjustment Mechanism
Presume that RBI expands
money supply by 10 % each year,
and wages are raised by 10%
each year
How will AS-AD move overtime

RBI governor goes on

holiday for a year without
t2
others knowing this (or RBI
decides not to raise money Price t1
supply, but did not publicize
this) t0

How would this affect AS- t1

t0
AD model
Y* Y
 AS and the Price Adjustment Mechanism
Presume that RBI expands t0 t1
P
money supply by 10 % each
year targeting 4 percent
inflation and expecting 6
percent real growth, and wages
are raised by 4% each year
How will AS-AD move overtime

Unfortunately, the growth turns

out to be zero percent only for t2
the year. t1

How would this affect AS-AD t0

model t2

Economy is operating t1
t0
beyond full employment in t2
Y
 Rational Expectations
• The argument over rational expectations is as follows:
– The usual macroeconomic model takes the height of the PC as being pegged
in the SR by e, where e is set by historical experience
– The rational expectations model has the SRPC floating up and down in
response to available information about the near future
• Individuals use new information to update their expectations

• Both models agree that if money growth were permanently increased,

the PC would shift up in the LR, and  would increase with no LR change
in u
– The RE model states that this change is instantaneous, while the traditional
model argues that the shift is gradual
 AD Policy & the Long-Run
• Central bank increases
money supply
Supply Curve
• The AD shifts outward
• The shift of AD leads to
price rise (inflation) and
u<u*. P
t =∞
Long-run AS

• Consequently, workers to
revise their inflation
expectations
E’’
• In the long-run the output
reverts back to Y* with Price
higher prices
Short-run AS
• Under rational expectation E’ t0
model, this should have
happened instantaneously

AD AD’

Y* Y
 The Wage-Unemployment Relationship and
Sticky Wages
• In neoclassical theory of supply, wages adjust instantly to ensure that
output always at the full employment level, BUT in real world output is
not always at the full employment level, and the PC suggests that wages
adjust slowly in response to changes in u

• The key question in the theory of AS is “Why does the nominal wage
adjust slowly to shifts in demand?” OR “Why are wages sticky?”
• Wages are sticky when wages move slowly over time, rather than being
flexible, causing the economy to deviate from the full employment level
 Many Reasons: Why don’t rational expectations
explain how the world operates?
• Each school of thought has to explain why there is a PC, or the reasons for wage
and price stickiness

• Some prices simply can’t be adjusted quickly: ‘Sticky prices’

– labor contracts often set wages for 3 years in advance
– Many loans/deposits are linked to fixed rate

• Agents learn slowly: misperception/imperfect information model

– A producer knows more about the price of own product than other goods
– Need to distinguish whether the rise in price of his product is due to genuine
demand rise (microeconomic) or the general rise in prices
– When nominal wages rises, worker may believe that their real wages have
gone up, thus willing to work more. It takes time to calculate their real wages

• Menu costs
– benefit of setting prices exactly right < the cost of making price changes.
 The Wage-Unemployment Relationship and Sticky Wages
• Coordination failures
– If nominal money supply is raised by the central bank, the AD shifts
outward.
– Despite higher demand, the firm raising prices first might suffer, if others
do not follow

• Insider-outsider model
– Those in the jobs are the one who negotiate with the employer, not the
unemployed fellows
– Unemployed would prefer firms to cut wages and create more jobs, firms effectively
negotiate with the workers who have jobs
– Costly for firms to turn over their labor force—firing costs, hiring costs, training
costs

• Efficiency wages and costs of price changes

– Focus on wage as a means of motivating labor
– Paying higher wages than the market wages, addresses principal agent
 The Wage-Unemployment Relationship and
Sticky Wages
• To clarify the assumptions about wage stickiness, let’s link the relationship
between gw and the level of employment:

If N* = full employment level of employment

N = actual level of employment
u = share of N* that is not employed, then

• Substitute this in Philips Curve and we have the PC relationship between

E, e, and gw:
 The Wage-Unemployment Relationship and
Sticky Wages

( )
∗
𝑁−𝑁
𝑒
𝑊 𝑡 +1=𝑊 𝑡 (1+ Π + 𝜀 )
𝑁∗

• The wage next period is equal to the wage that prevailed this period, but
with an adjustment for the level of employment and e
– At full employment, N* = N, this period’s wage equals last period’s, plus an
adjustment for e
– If N > N*, the wage next period increases above this period’s by more than e
since gw - e > 0
The Wage-Unemployment Relationship and
Sticky Wages
• Figure illustrates the wage-employment relationship, WN
• The extent to which the wage responds to employment levels depends on the
parameter 
• If  is large, N has large effects on wages and the WN line is steep

𝑊 𝑡 +1=𝑊 𝑡 (1+ Π + 𝜀
𝑒
( 𝑁−𝑁
𝑁∗
 The Wage-Unemployment Relationship and
Sticky Wages
• The PC relationship also implies WN relationship shifts over time
• If there is is positive, WN shifts up to WN’ for the next year
• If is negative, WN curve shifts down to WN’’ for the next year
 Result: Changes in AD that alter the u this period will have effects on wages in subsequent
periods

What is the value of

 The Wage-Unemployment Relationship and
Sticky Wages
• Explanation of wage stickiness has one central element  the labor
market involves long-term relationships between firms and workers
– Working conditions, including the wage, are renegotiated periodically, but not
frequently, due to the costs of doing so

• At any time, firms and workers agree on a wage schedule to be paid to

currently employed workers
– If demand for labor increases and firms increase hours of work, in the SR
wages rise along the WN curve
– With demand up, workers press for increased wages, but takes time to
renegotiate all wages (staggered wage-setting dates)
– During the adjustment process, firms are also resetting P to cover increased
cost of production
• Process of W and P adjustment continues until economy back at full employment
level of output
 Upward Sloping
Short/Medium Run AS
The combination of wages that
are preset for a period of
time and wage P
t =∞
Long-run AS

adjustments that are

staggered generates the
gradual wage, price, and
output adjustment we E’’
observe in the real world.
Price
This accounts for the gradual
Short-run AS
vertical movement of the E’ t0
short-run aggregate
supply curve.

AD AD’

Y* Y
 From the Phillips Curve to the AS Curve
The transition from the PC to
the AS curve requires four
steps:
1. Translate output to
employment
2. Link prices firms charge to
costs
3. Use Phillips curve
relationship between
Wages and Employment
4. Combine 1-3 to derive
upward sloping AS curve
Translate output to employment
• Close relationship between
unemployment/employment
and output in SR
• Okun’s Law defines this
relationship:
• Estimate  to be close to 2 
each point of u costs 2%
points of GDP
From the Phillips Curve to the AS Curve

The transition from the PC to Link prices to costs

the AS curve requires four • Firms supply output at a price
steps: that at least covers costs of
production
1. Translate output to
employment
2. Link prices firms charge to • If each unit of N (labour)
costs produces ‘a’ units of output,
the labor costs of production
3. Use Phillips curve
per unit is W/a
relationship between W
and E
• Firms set price as a markup, z,
4. Combine 1-3 to derive
on labor costs to cover all
upward sloping AS curve
other costs excluding labour:
 From the Phillips Curve to the AS Curve
• Okun’s law 𝑌 −𝑌 ∗ ∗
∗
=−𝜔 (𝑢 −𝑢 )
𝑌
• Price and wage link

• Wage equation from Phillips curve

𝑊 𝑡 + 1 =𝑊 𝑡 ¿
• Aggregate Supply

𝑃 𝑡 +1= 𝑃 𝑡 ¿

𝑃 𝑡+1=𝑃 𝑒𝑡+1 [ 1+𝜆(𝑌 −𝑌 ∗)]

This is the equation for the aggregate supply curve
 From the Phillips Curve to the AS Curve

• Figure shows AS curve

implied by equation
• If the initial i.e.

• If Y > Y*, next period the AS

curve will shift up to AS’ due
to rise in
• If Y < Y*, next period AS will
shift down to AS’’ due to
decline in𝑃 𝑒
𝑡 +1

Thus, expected inflation will

continue to shift the AS
Aggregate Supply curve under conditions in which
wages are less than fully flexible.
 Inflation Inertia
• The height of the Phillips Curve is . Thus, when the economy
remains at full employment, then the inflation rate is , and supply
𝑒
curve continues to shift upward as 𝑃 𝑡 + 1> 𝑃𝑡

• Full employment is also termed as nonaccelerating inflation rate of

unemployment or NAIRU

• “Why is our money ever less valuable? Perhaps it is simply that we

have inflation because we expect inflation, and we expect inflation
because we’ve had it.”
Robert Solow
 Anticipated vs Unanticipated Inflation
• Anticipated inflation
– Given the past history people do expect to have inflation and
ask their employer to give pay rise based on that. Producers
also takes it in account while pricing and making long term
contracts.
– Inflation is also important when loans or deposits are made

• Unanticipated inflation
– Actual inflation may turn out to be different than the
expected inflation. All the contracts signed based on
expectations can have implications of redistribution of wealth.
 The Costs of Perfectly anticipated inflation
• Suppose an economy has been experiencing inflation of 5% and
the anticipated rate of inflation is also 5%, then all contracts will
build in the expected 5% inflation
– Nominal interest rates account for the inflation (To get 3% real
interest rate, You ask for nominal interest rate of 3% + 5% = 8%)
– Long term labor contracts account for the inflation

®Inflation has no real costs, except for two qualifications

The Costs of Perfectly anticipated inflation

• The costs of holding currency rise along

with the rate of inflation, and the demand
for currency decreases
• The inconvenience of reducing money holding
is metaphorically called the shoe-leather cost of
inflation, because walking to the bank more
often induces one’s shoes to wear out more
quickly.

• When changes in inflation require printing

and distributing new pricing information,
then, these costs are called menu costs.

• These are drain on real resources

 The Costs of Imperfectly anticipated inflation
• Most contracts are written in nominal terms

• Forced redistribution
– Long term lenders charged nominal interest rate as 3% over and above expected
inflation (5%), incidentally the actual inflation rate turned out be 15%. If inflation is
unexpectedly high, debtors repay loans in cheaper currency.
– There was a forced redistribution from lender to borrower.
– Life becomes a lottery or game in which many of are forced to participate against
our wishes

• Allocative efficiency
– Relative prices also becomes unstable leading to distortions in allocative efficiency
– The firms need to differentiate between the ‘pure’ microeconomic rightward shift of
demand induced price rise vs ‘pure’ inflation induced price rise
– The possibility of unexpected inflation introduces an element of risk, which might
prevent some from making some exchanges they otherwise would undertake
 Negative inflation rates (Deflation)
• Like inflation, deflation can also lead to forced redistribution
– Great depression and Burma in 1930s

• Nominal interest rate has to be zero or more than that. This effectively
raises the real interest rate, creating disincentives for investments.
– Monetary policy becomes an ineffective tool since it’s not possible to reduce
the interest rate in case of recession.
– Fiscal policy becomes the only tool to raise aggregate demand

• Given the wage rigidity, firms would find it difficult to reduce real wages
when a particular sector/industry is facing troubles

• The best policy is to stay away from deflation.

– Have 2-3% inflation which helps in proper functioning of the labor markets.
• Initial response to the great depression was a pro-cyclical
policy where the government raised tax-rates and curtailed
expenditure during recession to contain fiscal deficit

Economic Survey, 2021

Business Cycle under Various Fiscal Policy
Stance

Higher Fiscal Multipliers

During Economic Slowdown

Economic Survey, 2021

United Kingdom (1987 – 2019)
Source: UK
Economic Accounts
(ONS) & OBR (UK)
Public Sector net
Balance = Net
lending by General
Govt and Public
Corporations
Private Sector Net
Balance = Net
lending by
Households,
Non Profit
Institutions serving
the Households and
private Non
Financial
Corporations
Economic Survey, 2021
United States (1987 – 2019)
Source: BEA (US)
Government net
Balance =Total
Government
Receipts Total -
Government
Expenditure
Private Sector
Net Balance=
Gross Private
Domestic
Investment -
Gross Private
Savings
(Domestic
business,
households &
institutions)
Economic Survey, 2021
 Trends in Government and Private sector
balances India (FY 1987 – FY 2019)
Economic Survey, 2021

Source: RBI, MoSPI

Note: Govt net balance = (Public Sector Financial & Non-Financial Corporations and General Govt Gross
Domestic Saving) – (Public Sector Financial &Non-Financial Corporations and General Govt Gross Capital
formation)
Private sector net balance = Private sector Gross Domestic Saving – Private sector Gross Capital formation
For Households, total savings does not include gold and silver (to make it comparable).