Aggregate Supply. Reading. On real wages, also see Basu and Taylor (1999), Journal of Economic. Mankiw, Macroeconomics: Chapters 9.4 and 13.1 and.

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1 Aggregate Supply Dudley Cooke Trinity College Dublin Dudley Cooke (Trinity College Dublin) Aggregate Supply 1/38 Reading Mankiw, Macroeconomics: Chapters 9.4 and 13.1 and.2 On real wages, also see Basu and Taylor (1999), Journal of Economic Perspectives. Dudley Cooke (Trinity College Dublin) Aggregate Supply 2/38

2 Plan Classical Model: Price and Wage Flexibility. Keynes Model: Nominal Wage Rigidity. New Keynesian Model: Price Rigidity. Implications for the Real Wage. Dudley Cooke (Trinity College Dublin) Aggregate Supply 3/38 Demand vs. Supply Side So far we have assumed that prices are exogenous and we focused solely on the demand side of the economy. We studied two things: 1 How fiscal and monetary policy affect output, given prices. 2 How a change in prices affects output. If we want a more complete picture of the economy s reaction to policy we need to account for the supply side. To model the supply side requires a description of the labor market, that is, labor demand, labor supply and wages. Dudley Cooke (Trinity College Dublin) Aggregate Supply 4/38

3 Deriving an Aggregate Supply Curve We also know that the goods and money markets determine equilibrium on the Demand Side In the same way the demand and supply of labor determine equilibrium on the Supply Side If we model firms supply decisions we are also forced to be explicit about their technology (i.e. the factors of production). Dudley Cooke (Trinity College Dublin) Aggregate Supply 5/38 Some Important Relationships Labor demand: firms demand more labor if the real wage is lower. l d = µ(w 0 p 0 ) + d; d > 0, µ > 0 }{{} real wage Labor supply: households supply less labor if their real wage is lower. l s = φ(w 0 p 0 ); φ > 0 We say that the labor market is in equilibrium when l s = l d. Then, w 0 = w and p 0 = p. The production function implicit here is simply y = l. Dudley Cooke (Trinity College Dublin) Aggregate Supply 6/38

4 Labor Market Equilibrium Labor market equilibrium is simple when the market clears. When demand is equated with supply, we have, l s = l d (w p d )= (φ + µ) l = φ(w p )= dφ (φ + µ) We can think of this as happening in the long-run (hypothetical situation). Dudley Cooke (Trinity College Dublin) Aggregate Supply 7/38 Labor Market Equilibrium: Diagram w p, realwage l s w p l d l l, labor Dudley Cooke (Trinity College Dublin) Aggregate Supply 8/38

5 The Natural Rate of Output Labor market equilibrium implies a long-run supply-side level of output, y (y = l, by technology). At this point, output is said to be at it s natural rate. The natural rate of output depends only on technology and preferences and is independent of monetary policy. From here on we denote the natural rate of output as y. Dudley Cooke (Trinity College Dublin) Aggregate Supply 9/38 The Classical AS and AD Model Wages and prices are flexible in the Classical model. In that case, the labor market is always in equilibrium. This implies: y = dφ (φ + µ) (1) The AS curve is vertical in (p, y)-space as (1) is independent of prices. The AD curve is as before, but with p 0 flexible. [ y = y = Ω a δt + h 0 + g + γ ] ɛ (ms p 0 ) ( Ω 1 δ + γk ) 1 > 0 ɛ We see an immediate result: monetary and fiscal policy cannot affect output. Only prices and wages will rise. Dudley Cooke (Trinity College Dublin) Aggregate Supply 10/38

6 Classical Model: Price and Wage Flexibility Real wage: (w 0 p 0 ) = (w 1 p 1 ) = (w p ). Labor market equilibrium, l d [(w p )] = l s [(w p )]. p, price level p p AS AD(g 1 ) AD(g 0 ) y = y y, Output Dudley Cooke (Trinity College Dublin) Aggregate Supply 11/38 Summary of Policy Results The impact of policy on output and prices are straightforward to workout: Monetary Policy: 1 Money is neutral, i.e., it has no effect on output: y / m s = 0. 2 Prices rise by the change in the money supply: p / m s = 1 (recall, in the ISLM model, rigid prices led to i, which raised investment and affected output). Fiscal Policy: 1 100% crowding out (via prices): y / g = 0 and p / g = ɛ/γ Dudley Cooke (Trinity College Dublin) Aggregate Supply 12/38

7 Classical Model: Key Facts Predictions: 1 The real wage is rigid at full employment. 2 Monetary and fiscal policies have no effects on output. The Classical Dichotomy holds (classical dichotomy: division between real and nominal variables - changes in nominal variables (prices or money supply) do not affect real variables (GDP)) 1 real variables (y, l, (w p )) determined in real markets 2 nominal variables (p, w, i ) determined in money markets. Dudley Cooke (Trinity College Dublin) Aggregate Supply 13/38 Keynes Model: Nominal Wage Rigidity Assume households set w 0 = w. As the money wage is rigid, we cannot be in equilibrium in the labor market. Labor demand will determine the level of labor supplied. Thus the AS is given by labor demand. The AS is: ( ) l d = µ(w p0 )+d If prices rise, the real wage falls. Labor costs fall, so more labor is demanded. As labor is demand determined (individuals are off their labor supply curves ) labor used in production also rises. Dudley Cooke (Trinity College Dublin) Aggregate Supply 14/38

8 Demand Determined Labor w p, realwage w p w p l s l<l l l d l, labor Dudley Cooke (Trinity College Dublin) Aggregate Supply 15/38 Keynesian Model: Price Flexibility and Nominal Wage Rigidity Nominal wage is: w = w 0, thus w p 0 > w p 1 if prices rise. Labor market is such that, for i = 0, 1, l = l d [(w p i )] Thus l s is irrelevant as labor is determined by demand conditions Again note that we are assuming the production function: y = l. We can draw the AD and AS in (p, y)-space and determine the effects of (expansionary) monetary policy or fiscal policies on equilibrium (p, y ): expansionary effect on output; prices also rise. Dudley Cooke (Trinity College Dublin) Aggregate Supply 16/38

9 The Keynesian AS and AD Model p>p P, Price Level p AS(w 0 = w) AD(m 1 ) AD(m 0 ) y y>y y, Output Dudley Cooke (Trinity College Dublin) Aggregate Supply 17/38 Monetary Policy with Rigid Wages The monetary transmission mechanism is somewhat different when there are sticky wages and flexible prices. m s p 0 (w p 0 ) l d y There is no liquidity effect in the way we studied before. We could re-introduce this by assuming a fraction of prices were fixed. Dudley Cooke (Trinity College Dublin) Aggregate Supply 18/38

10 The Keynesian AS and AD Model Labor demand determines the aggregate supply relationship: y = d µ(w p 0 ) AD curve (as before and p 0 floating): y = Ω [ a δt + h 0 + g + γ ] ɛ (ms p 0 ) We find prices and output (p, y ) as w is exogenous. Result is that monetary policy can affect output and prices. Dudley Cooke (Trinity College Dublin) Aggregate Supply 19/38 Summary of Policy Results We can see the effects of policy using labor demand only. Money multiplier: y / m s = µ ( p / m s ) > 0 Fiscal policy: less-than-100% crowding out: y / g = µ ( p / g) > 0 Note (try this at home): to find y explicitly use labor demand in the AD and eliminate the price level. Dudley Cooke (Trinity College Dublin) Aggregate Supply 20/38

11 Keynes Model: Key Facts Main predictions: 1 The real wage is countercyclical, i.e. (w p 0 ) moves in the opposite direction from output, y. 2 Monetary and fiscal policies can affect output. Dudley Cooke (Trinity College Dublin) Aggregate Supply 21/38 New Keynesian Model: Price Rigidity Sticky prices imply p 0 = p is fixed or exogenous. Workers are always on their labor supply curve and w 0 is free to move. What the key idea here? Now output is demand determined, i.e. y = y d. (in exactly the same way labor was with fixed wages). What matters is that firms hire the quantity of labor needed to produce the amount of output demanded, y d. They are always willing to meet demand. Dudley Cooke (Trinity College Dublin) Aggregate Supply 22/38

12 The New Keynesian AS and AD Model Basic insight: The labor market is not relevant for our AD-AS equilibrium. The AS is: p 0 = p This should look very familiar. It is what we implicitly assumed in the lectures on the AD curve. Monetary policy will generate a liquidity effect, exactly the same way as before. Dudley Cooke (Trinity College Dublin) Aggregate Supply 23/38 New Keynesian Model: Flexible Wages and Rigid Prices The price level is p 0 = p, thus w 0 p < w 1 p if wages rise. Labor market condition now reads, for i = 0, 1. y d i = l s [(w i p)] Actual l d is irrelevant. Firms hire the quantity of labor needed to produce y d. Production function also as before: y = l and we can easily represent the AD and AS equations in (p, y)-space. Dudley Cooke (Trinity College Dublin) Aggregate Supply 24/38

13 The New Keynesian AS and AD Model p, Price Level p p 0 = p AD(g 1 ) AD(g 0 ) y y>y y. Output Dudley Cooke (Trinity College Dublin) Aggregate Supply 25/38 Monetary Policy when Prices are Sticky The AD Curve can be written down in the following way: y = Ω [ a δt + h 0 + g + γ ] ɛ (ms p 0 ) We simple equate output with the amount demanded. So, if p 0 = p, then y d = y = Ω [...p]. Using the AS and AD again we see the result immediately. If p 0 = p then an increase in m s affects y. As usual, Monetary Policy also works when prices are sticky. Dudley Cooke (Trinity College Dublin) Aggregate Supply 26/38

14 Summary of Policy Results Note: policy results are exactly that same as the other lecture. Money is effective: y / m s = Ω (γ/ɛ) Less-than-100% crowding out (via the ISLM interest rate change) : y / g = Ω As before (with IS and LM), ( y / m s ) / ( y / g) = γ/ɛ. The intuition remains the same, except we should note that wages rise and workers move along there labor supply curves. Dudley Cooke (Trinity College Dublin) Aggregate Supply 27/38 New Keynesian Model: Key Facts Main predictions 1 The real wage is procyclical: moves in the same direction as output. 2 There is no involuntary unemployment as workers are always on their labour supply curves. 3 Monetary and fiscal policies affect output but have no effect on prices. Dudley Cooke (Trinity College Dublin) Aggregate Supply 28/38

15 On Real Wage Cyclicality Each model studied predicts a different relationship between output and the real wage. In particular, 1 Classical Model: an acyclical real wage; corr (w p, y) = 0. 2 Keynes Model: a countercyclical real wage; corr (w p, y) < 0. 3 New Keynesian Model: a procyclical real wage; corr (w p, y) > 0. Dudley Cooke (Trinity College Dublin) Aggregate Supply 29/38 What the data say Large body of empirical literature on the cyclical behavior of real wages (different data, sample periods, real wage definitions). 1 Real wages have changed from being mildly countercyclical during the interwar period to being modestly procyclical during the postwar period. 2 Real wages have switched from being countercyclical to being procyclical before the onset of major oil price shocks in the 1970s 3 Monetary shocks have caused real wages to be countercyclical during the Great Depression but led to falls in real wages and output during the postwar period. 4 We need to be a little careful, however, as the results will also depend on the source of the shock (e.g., demand or supply shocks). Dudley Cooke (Trinity College Dublin) Aggregate Supply 30/38

16 Real Wages and the Business Cycle, Basu and Taylor, 1999 in JEP Dudley Cooke (Trinity College Dublin) Aggregate Supply 31/38 Real Wages and Output, Mankiw Dudley Cooke (Trinity College Dublin) Aggregate Supply 32/38

17 Cyclicality of Wages Why does this matter? If wages are rigid, unemployment is involuntary. That is a big deal. We might also have made the wrong assumption in our model. This means that the intuition we developed could be misleading. As a follow up, if we have the wrong idea of how the economy works then we can t give reliable advice to policymakers and we can t distinguish the effects of fiscal and monetary policy in the data. Dudley Cooke (Trinity College Dublin) Aggregate Supply 33/38 A Final Comment on Wage Setting Consider Keynes model. That is, wage rigidity. We know only labor is demand determined. That is; y = l d = d µ(w p 0 ) We also know that the NR of output, y, requires market clearing. The question is: how do we set wages? Basically, we want to keep the real wage constant. That is, we want to figure out what the price will be next period and set the wage accordingly. In other words, labor demand should actually be written as: y = d µ(w p e 0) Dudley Cooke (Trinity College Dublin) Aggregate Supply 34/38

18 Phillips Curve So the wage is set on the basis of what we expect will happen to the price level. If our guess is correct we will be at the natural rate, y. The difference between actual and expected prices must determine the difference between the natural rate and the actual level of output. y 0 = y + α (p 0 p e 0) y 0 / p 0 = α > 0 where α comes from technology. This is one representation of the Phillips Curve. However, it should be clear that it is simply a re-expression of the AS curve when wages are sticky. Dudley Cooke (Trinity College Dublin) Aggregate Supply 35/38 Summary of the ADAS Model I The IS and LM conditions describe the demand side of the economy: IS: combinations of real output and the interest rate such that planned and actual expenditures on real output are equal (depends on MPC and interest sens. y of investment). LM: combinations of output and the interest rate such that the money market is in equilibrium, for a given price level (depends on income and interest sens. y of money demand). Dudley Cooke (Trinity College Dublin) Aggregate Supply 36/38

19 Continued... We considered three mechanisms to determine the slope of the AD curve (through deflation): 1 Keynes effect (the most standard one, via the interest rate) 2 Pigou effect (money as wealth) 3 Tobin-Fisher effect (wealth redistribution) The position of the AD curve is affected by fiscal and monetary policy (with a given price level). Dudley Cooke (Trinity College Dublin) Aggregate Supply 37/38 Summary of the ADAS Model II Different types of nominal rigidities have different implications for the AS curve. We identified three cases: 1 flexible prices: vertical AS and acyclical real wage and no effect of monetary policy. 2 fixed wages: upward sloped AS and countercyclical real wage and monetary policy is effective. 3 fixed prices: flat AS and procyclical real wage and monetary policy is effective. We have also seen how the AS and PC relate to one another. Dudley Cooke (Trinity College Dublin) Aggregate Supply 38/38

Aggregate Supply. Dudley Cooke. Trinity College Dublin. Dudley Cooke (Trinity College Dublin) Aggregate Supply 1 / 38

Aggregate Supply. Dudley Cooke. Trinity College Dublin. Dudley Cooke (Trinity College Dublin) Aggregate Supply 1 / 38 Aggregate Supply Dudley Cooke Trinity College Dublin Dudley Cooke (Trinity College Dublin) Aggregate Supply 1 / 38 Reading Mankiw, Macroeconomics: Chapters 9.4 and 13.1 and.2 On real wages, also see Basu