Macro Lecture 8: Aggregate Supply Curves

Transcription

1 Macro Lecture 8: Aggregate Supply Curves Review: Aggregate Demand/Aggregate Supply Model Figure 8.1 summarizes the basics of the aggregate demand/aggregate supply model: AD Question: How many final goods and services would be purchased if the actual inflation rate () were percent, given that all other factors relevant to demand remained the same? AD Equilibrium Goods and services Goods and services = purchased produced AD = C + I + G + GDP Figure 8.1: Aggregate demand/aggregate supply Question: How many final goods and services would be produced if the actual inflation rate () were percent, given that all other factors relevant to supply remained the same? Preview: Aggregate Supply Curves Long Run Aggregate Supply (LR) Curve The long run aggregate supply (LR) curve is vertical. It acts as a place mark for potential GDP,, as illustrated in figure 8.2. We shall shortly explain precisely what we mean by potential GDP. LR Aggregate Supply () Curve Question: How many final goods and services would be produced if the actual inflation rate () were percent, given that all other factors relevant to supply remained the same? π E Claims: The curve: Is upward sloping. Intersects the LR curve at the expected inflation rate, E. Figure 8.2 illustrates our claims. To justify these two claims recall that the actual inflation rate equals the change in the price level expressed as a percent. Figure 8.2: LR and curves

2 2 Inflation Rate Now, we will introduce the notion of the expected inflation rate, how we expect prices to change in the future. The expected inflation rate is important because the costs firms incur are often determined for a specified period of time in the future. For example, an airline may sign a one-year contract to purchase aviation fuel at a specified price during the upcoming year. Similarly, owners of firms and their workers decide on a certain wage for a specified period of time in the future. Often, the wage is set for one year. This can be done formally or informally. At Amherst College, this is done informally. In early spring, the administration consults with various groups of faculty and staff; then, in May, all Amherst employees receive a letter telling them what their salary will be in the upcoming academic year. In other industries, there are formal negotiations. In the automobile industry, the officials of the United Auto Workers (UAW) conduct formal negotiations with GM, Ford, and Chrysler. When they reach a settlement a legal contract is drafted by lawyers and signed by officials of the union and auto firms. This document is a legally binding agreement in which the wage is set for the duration of the contract. The expected inflation rate that affects the annual increase in wages in the upcoming year: Inflation Rate Upcoming Year s Wage Rate When the expected inflation rate is high, workers will demand and firm owners usually agree to a large wage increase. When the expected inflation rate is low, a more modest wage increase typically results. To make our discussion more straightforward assume that the only costs firm incur are labor costs: Simplifying Assumption: Labor is the only input firms use. Stable Start Benchmark Case Suppose that GDP has been stable for many, many years. Furthermore, suppose that all prices and also wages have been increasing by a steady 2.0 percent during this time. Since both prices and wages have been increasing by 2.0 percent, the purchasing power of workers has been constant. 1 In that sense, we are starting off with a stable situation. Stable Start Benchmark Case GDP Actual inflation rate () Annual wage increase 2,000 Since prices have been increasing by 2.0 percent for many, many years, would not everyone expect prices to continue to increase at this rate? Consequently, the expected inflation rate would equal 2.0 percent: Inflation Rate ( E = ) Both the actual inflation rate and the expected inflation rate equal 2.0 percent. Now, we can define potential GDP, : Potential GDP: GDP whenever the actual inflation rate turns out to equal the expected inflation rate. An economy s potential GDP is determined by by the resources (labor, factories, machines, tools) and the technomogy available to the economy. Figure 8.3: LR curve and potential GDP Figure 8.3 illustrates the long run aggregate supply (LR) curve. It is a vertical line denoting potential GDP,. It indicates what GDP equals when the actual inflation rate turns out to equal what we expect. Next, we introduce the aggregate supply () curve by considering a typical firm, Mr. Atkins apple orchard. 1 We are implicitly assuming that there is no productivity or population growth. We will address these issues later. LR

3 3 Mr. Atkins Apple Orchard and the Aggregate Supply () Curve Suppose that the price of apples last year was $0 per pound. Since Mr. Atkins maximizes his profit he produces the quantity of output at which marginal revenue equals marginal cost. The marginal cost curve is upward sloping and since the apple industry is perfectly competitive, marginal revenue equals the price. Figure 8.4 P Last Year = 0 illustrates Mr. Atkins profit maximizing quantity: pounds if apples. Next, consider the current year. Since the expected inflation rate is 2.0 percent, Mr. Atkins has agreed to continue to give his workers a 2.0 percent wage increase just as Figure 8.4: Effect of expected inflation on the current MC curve he has done for many, many previous years. Question: How, if at all, would Mr. Atkins marginal cost curve be affected? Answer: Since wages increased by 2.0 percent and the only costs Mr. Atkins incurs are labor costs, the marginal cost curve shifts up by 2.0 percent as seen in figure 8.5. Inflation Rate equals 2.0 percent Wages increase by 2.0 percent Marginal Cost curve shifts up by 2.0 percent By focusing on Mr. Atkins apple orchard we shall now show the aggregate supply () curve: Is upward sloping. Intersects the long run aggregate supply (LR) curve at the expected inflation rate ( E ). P Last Year = 0 Figure 8.5: Effect of expected inflation on the current MC curve Recall the series of questions the aggregate supply () curve answers: Question: How many final goods and services would be produced if the actual inflation rate () were percent, given that all other factors relevant to supply remained the same? We will now consider three scenarios: Scenario 1: The actual inflation rate () in the current year equals the expected inflation rate ( E ). Scenario 2: The actual inflation rate () in the current year is greater than the expected inflation rate ( E ). Scenario 3: The actual inflation rate () in the current year is less than the expected inflation rate ( E ).

4 4 Scenario 1: The actual inflation rate in the current year equals the expected inflation rate, 2.0 percent in our example. How many bushels of apples would Mr. Atkins produce? Question: If the actual inflation rate in the current year were 2.0 percent, what would happen to the price of apples? Answer: The price of apples would rise by 2.0 percent from $0 to $2. P This Year = 2 P Last Year = 0 MR This Year Question: How, it at all, would Mr. Atkins marginal revenue curve be affected? Answer: Since the price of apples increases by 2.0 percent, the marginal revenue curve shifts up by 2.0 percent as seen in figure 8.6. Figure 8.6: Effect of actual inflation on the current MR curve Question: Would Mr. Atkins profit maximizing level of production increase, decrease, or remain the same? Answer: Since both the marginal cost and margina revenue curves have shifted up by 2 percent, the profit maximizing level of production will remain the same. Question: Is there anything special about Mr. Atkins s apple orchard compared to other apple orchards? Answer: No. Consequently, each apple orchard would produce the same number of apples it produced in the previous year. Question: Is there anything special about apple production compared to the production of other goods? Answer: No. Consequently, the producers of all goods and services would produce the same amount. Question: Would GDP in the current year be greater than, less than, or equal to potential GDP,? Answer: Equal. LR Potential GDP ( ): GDP whenever the actual inflation rate turns out to equal what is expected. Generalization: Whenever the actual inflation rate () equals the expected inflation rate ( E ), GDP equals potential GDP. Figure 8.7 illustrates the one point that we have just found on the aggregate supply () curve. This point represents our stable start benchmark. Figure 8.7: Actual inflation equals expected inflation Stable start benchmark

5 5 Scenario 2: The actual inflation rate in the current year is greater than the expected inflation rate, 2.0 percent. For example, suppose that the actual inflation rate in the current year were percent. How many bushels of apples would Mr. Atkins produce? P This Year = 3 Question: What would happen to the price of apples? % Answer: The price of apples would rise by more than 2.0 percent, percent in our P Last Year = 0 example. Question: How, it at all, would Mr. Atkins marginal revenue curve be affected? Answer: The marginal revenue curve shifts up by percent from $100 to $103 as shown in figure 8.8. Figure 8.8: Actual inflation more than expected Question: Would Mr. Atkins profit maximizing level of production increase, decrease, or remain the same? Answer: Since the marginal revenue curve has shifted up by more than the marginal cost curve the profit maximizing level of production will increase. Question: Is there anything special about Mr. Atkins apple orchard compared to other apple orchards? Answer: No. Consequently, each apple orchard would produce more apples than it produced in the previous year. Question: Is there anything special about apple production compared to the production of other goods? Answer: No. Consequently, the producers of all goods and services would produce more. MR This Year Question: Would GDP in the current year be greater than, less than, or equal to potential GDP,? Answer: Greater. LR Generalization: Whenever the actual inflation rate () were greater than the expected inflation rate ( E ), GDP is greater than potential GDP,. Figure 8.9 illustrates the second point on the aggregate supply () curve. Figure 8.9: Second point on the curve

6 6 Scenario 3: The actual inflation rate in the current year is less than the expected inflation rate, 2.0 percent. For example, suppose that the actual inflation rate in the current year were percent. How many bushels of apples would Mr. Atkins produce? Question: What would happen to the price of apples? Answer: The price of apples P This Year = 1 % would rise by less than 2.0 P percent, percent in our Last Year = 0 example. Question: Would Mr. Atkins marginal revenue curve be affected? If so, how? Answer: The marginal revenue curve shifts up by percent from $100 to $101 as shown in figure Figure 8.10: Actual inflation less than expected MR This Year Question: Would Mr. Atkins profit maximizing level of production increase, decrease, or remain the same? Answer: Since the marginal revenue curve has shifted up by less than the marginal cost curve the profit maximizing level of production will decrease. Question: Is there anything special about Mr. Atkins apple orchard compared to other apple orchards? Answer: No. Consequently, each apple orchard would produce fewer apples than it produced in the previous year. Figure 8.11: Third point on the curve Question: Is there anything special about apple production compared to the production of other goods? Answer: No. Consequently, the producers of all goods and services would produce less. LR Question: Would GDP in the current year be greater than, less than, or equal to potential GDP? Answer: Less. Generalization: Whenever the actual inflation rate () were less than the expected inflation rate E, GDP is less than potential GDP,. Figure 8.11 illustrates the third point on the aggregate supply () curve. To plot the aggregate supply () curve we need only connect the blue points as shown in figure The aggregate supply () curve: Is upward sloping. Intersects the long run aggregate supply (LR) curve at the expected inflation rate. LR Figure 8.12: curve

7 7 Aggregate Supply () Curve Shifts Recall the questions answered by the aggregate supply curve: Question: How many final goods and services would be produced if the actual inflation rate () were percent, given that all other factors relevant to supply remained the same? When all other factors relevant to supply do not remain the same the aggregate supply () curve can shift. Since the aggregate supply () curve and Intersects the long run aggregate supply (LR) curve at the expected inflation rate ( E ), the expected inflation rate( E ) is one of those other relevant factors: E increases E decreases curve shifts up curve shifts down The expected inflation rate ( E ) is important, but we can t determine it precisely. No tables exist citing the expected inflation rate ( E ). We will proceed by introducing adaptive expectations which we will justify intuitively. No doubt it s imperfect, but nevertheless it gives us a sense about the actual inflation rate we expect. Adaptive Expectations Principle: The expected inflation rate depends on the actual inflation rate in the recent past. To justify adaptive expectations, consider two scenarios: Scenario 1: The actual inflation rate () during the last year or so was about 1 percent. Scenario 2: The actual inflation rate () during the last year or so was about 10 percent. Question: In which scenario would the expected inflation rate ( E ) be higher? Answer: Scenario 2. Other factors also influence our expectations, so the adaptive expectations principle is not precise, but in most cases it serves us well. Summary: The Aggregate Supply Curves See Figure 8.13 The aggregate supply () curve intersects the long run aggregate supply (LR) at the expected inflation rate ( E ). π E LR Question: How many final goods and services would be produced if the actual inflation rate () were percent, given that all other factors relevant to supply remained the same? Potential GDP ( ): Equals (Actual) GDP when the actual inflation rate () turns out to equal the expected rate ( E ) The aggregate supply () curve is upward sloping The long run aggregate supply (LR) is a place mark for potential GDP ( ).. Aggregate Supply Curve Shifts: Whenever the expected inflation rate ( E ) changes. When the expected inflation rate ( E ) increases the aggregate supply () curve shifts up. When the expected inflation rate ( E ) decreases the aggregate supply () curve shifts down. Adaptive Expectations: While we cannot determine precisely what the expected inflation rate ( E ) equals, it seems reasonable to believe that it depends on the actual inflation rate () in the recent past. Figure 8.13: Aggregate supply curves