Lecture: Aggregate Demand and Aggregate Supply

Transcription

1 Lecture: Aggregate Demand and Aggregate Supply Macroeconomics II Winter 2018/2019 SGH Jacek Suda

2 Overview Goods Market Money Market IS Curve LM/TR Curve IS-LM/TR Model Aggregate Demand (AD) Curve AD-AS Model Aggregate Supply (AS) Curve

3 Plan Last time Short run: IS-LM/TR model Sticky/fixed prices Quantity adjustment Today Short + long run = medium run Price changes Price changes (inflation) and output relation Price changes (inflation) and demand relation

4 Aggregate Supply Aggregate supply (AS) curve describes for each given price level the quantity of output firms are willing to supply Aggregate output Aggregate price level Obtained by combining Phillips curve with Okun s law How does supplied output change if prices change? Slope of aggregate supply in the: short run medium run long run

5 From the Short to the Long Run Keynes Sticky prices => short run Demand drives supply => quantities adjust Neoclassical Flexible prices => long run Supply drives demand => prices adjusts Medium run? Cambridge equation M = k PY P P Y Y

6 One-off increase in the money supply M From the Short to the Long Run Short-run: prices are sticky, output responds to change in demand M Y P Y P Neoclassical long-run: change in money results in no change in output, only a change in the price level. Time

7 The Phillips Curve: the Beginning In 1958 Alban W. Phillips published a paper measuring the relationship between changes of nominal wages and the level of unemployment Negative relationship between wages and unemployment : in years of high unemployment rate wages were stable or decreasing, when unemployment was low wages raised quickly. Źródło: Phillips (1958)

8 The Phillips Curve in Reality United Kingdom Sixteen-country average, and Sources: Maddison (1991), Mitchell (1998)

9 Inflation The Phillips Curve in Theory A The trade-off: reducing inflation from the high level at A to the lower inflation at B comes at a cost in an increase in unemployment. B Phillips curve Unemployment

10 Inflation The Phillips Curve in Theory: Algebra ( ) = b ( U U ) - Phillips curve in point-slope form b is the slope of the Phillips curve U - U U U Unemployment

11 Okun s Law In 1962 Arthur Okun published a paper analyzing the optimal level of DBN and the impact of unemployment of GNP Unemployment rate higher than natural rate of unemployment causes lower than potential level of output Increase of unemployment rate by 1 percentage point causes potential GDP/GNP to fall by 2 to 3 percentage points. Okun s law: negative relation between changes in unemployment rate and the real GDP Output Gap and Unemployment in Germany Changes in real GDP and unemployment rates in the US for Source: OECD, Main Economic Indicators Source: Mankiw (2010)

12 Unemployment Okun s Law in Theory Output rises relative to its trend level U U Unemployment decreases Y Y Output

13 Unemployment Okun s Law in Theory j measures the slope of the line U gap ( ) U U = h Y gap ( Y Y) Y U U h Y ( U U ) = ( Y Y ) j Y Y Output ( U U ) = j ( Y Y ) Okun's Law in point-slope form

14 Source: OECD Okun s Law in Reality (a) USA (b) Germany

15 Phillips Curve + Okun s Law = Aggregate Supply ( ) = b ( U U ) π Phillips curve in point-slope form U ( U U ) = j ( Y Y ) U Okun's law in point-slope form ( ) ( ) = ( ) = ( ) b j Y Y b j Y Y Y Y g a Aggregate supply curve Note: the product of two negative slopes became a positive slope! Y Y gap

16 Inflation Inflation The Aggregate Supply Curve ( ) = b ( U U ) Simple Phillips curve ( ) = g ( Y Y ) Aggregate supply curve U (a) Phillips curve Unemployment Y (b) Aggregate supply Output

17 The Breakdown of the Phillips Curve Theoretical issues Neutrality principle: in the long run nominal variables (prices)have no impact on real variables (unemployment) Inflation in the long run is determined by the growth in money supply Friedman and Phelps In the long run, the Phillips curve and the supply curve have to be vertical => no trade-off between inflation and unemployment should be possible In the long run, the Phillips curve and aggregate supply are independent from inflation

18 The Long Run (a) Phillips curve (b) Aggregate supply

19 Empirical Problems with Phillips Curve The Philips curve disappeared in the 1970s. During the oil crisis high unemployment was accompanied by a sharp rise in inflation (stagflation) Philips curve reappeared (shortly) in the 1980s (a) Eurozone ( ) (b) UK ( ) Source: OECD, Economic Outlook

20 Problems With Phillips Curve What was wrong with the original Phillips curve? Problem 1: the initial version of the Phillips curve did not incorporate inflation expectations Problem 2: it did not take into account other production costs (only labor costs) Solution: Expectations augmented Phillips curve

21 The Theoretical Foundations of the Phillips Curve: Price setting Let s look at the determinants of inflation and how it can theoretically be linked to unemployment How do firms set their prices In case of perfect competition firms takes prices as given P = mc price = marginal cost In the case of imperfect competition (e.g. product differentiation: iphone Samsung) firms have market power and set prices as a markup over marginal cost (mark-up pricing) P = (1+q) mc, q>0 price = mark-up marginal cost

22 Nominal marginal cost vs price Mark-up over the marginal cost reflects firm s market power Approximate marginal costs by average / unit cost If labor is the only factor of production then Total cost = total labor cost = total wage bill = W L W: nominal hourly wage L : number of hours worked average costs = nominal unit labor cost = (W L)/ Y Price set by a firm (approximating marginal cost by avergae cost): P = (1+q) mc = (1+q) (W L)/ Y

23 Real average/unit labor costs Real Wage Nominal unit labor cost (= wage bill) / nominal GDP = = (W L)/(P Y) = s L s L : labor share of output Real average labor costs = labor share of output, s L Unions want to maximize the labor share in GDP Workers and unions care about real wage but can negotiate only about nominal wages, which real value depends on current and future inflation While negotiating nominal wage, unions and firms have to make anticipations on the evolution of the price level (and inflation expectations)

24 Wage Negotiations Unions negotiate nominal wages (W) (and wage bill, W L) based on their price expectations (P e ) Final labor share depends on the bargaining power of the unions: s L : normal (standard) labor share g : mark-up, representing the bargaining power of unions (depending on business cycle at the moment of negotiations) Wage W L s L = = ( 1+ g ) s e P Y e W = ( 1+ g )sl P depends on the stage of the business cycle and inflation/price expectations Y L L

25 Wage Share of Value Added by Country and Selected Industries, 2014 (%) Source : OECD STAN Base

26 Firms set prices as mark-up over cost During negotiation of firms with unions wages are set as a mark-up over expected price level Price level depends on The Battle of the Mark-Ups WL P = ( 1+ q ) Y W = ( 1+ g )s battle of mark-ups and expected price level WL P = ( 1+ q ) = (1 + q )(1 + g ) s L P Y... while the rate of change of prices, i.e. inflation, depends on changes of mark-ups and expected inflation L Y L P e q g = q 1+ g e e

27 Mark-ups vary over the business cycle Price mark-up, q, depends on market competitiveness Wage share mark-up,, g, increases with unions power during negotiations and incrases during expansion (it s pro-cyclical) The product of both mark-ups is also pro-cyclical: raises faster in periods of rapid economic growth and slows down during down-turns / recessions The higher economic activity and the higher postive output gap (or the more negative unemployment gap) the higher the inflation rate Aggregating various inflation expectations = underlying/expected inflation rate (reflecting inflation expectations) => ~ e Phillips curve Inflation and Business Cycle bu + ~ = gap Inflation depends on 1. Business cycle 2. Past inflation or future inflation expectations =

28 Inflation Phillips Curve (expectations-augmented) = + ~ = b( U U ) + ~ bu gap ~ B A C 0 Unemployment gap

29 Inflation and Supply Shocks So far: price setting behavior of firms depends only on labor cost Important non-labor costs change in the price of raw materials, energy, oil exchange rate changes (e.g. depreciation) changing the price of imported inputs productivity of inputes, taxes Events that causes changes of these costs are called supply (as they change producton costs) shocks (we treat them as exogenous and random) In case of unexpected increase in production costs firms raise prices above the expected level => > ~ By adding supply shocks (s) we can get expectations-augmented Phillips curve (with supply shocks) = bu gap + ~ + s

30 Supply Shock: Nominal Oil Price (Euros per Barrel): Source: British Petroleum; IMF

31 Supply Shock: Oil Price ($ per Barrel): Nominal oil price ($/barrel) Real oil price ($/barrel) Monthly oil prices in 1982 dollars computed as 100*P(i)/I(t), P(t) nominal oil price and I(t) price index CPI-U (Consumer Price Index For All Urban Consumers). Source:

32 The Vanishing Phillips Curve? Once inflation expectations and supply shocks are taken into account, the apparent puzzle of the vanishing Phillips curve can be solved If the underlying level of inflation is very stable and there are no supply shocks, then we can observe the inverse relationship between inflation and unemployment We could observe raising inflation and raising unemployment (i.e. stagflation) in presence of increase in inflation expectations supply shocks increase in the natural unemployment rate

33 Inflation (%) The Vanishing and Returning Phillips Curve: Europe, Unemployment (%)

34 Inflation Inflation Augmented Phillips and Aggregate Supply Curve Underlying inflation with s=0 B B AS A C C A U (a) Phillips curve = bu gap + ~ + s Unemployment Y (b) Aggregate supply Output U gap = hy gap = ay gap + ~ + s, a = bh Okun's Law

35 Philips Curve In the long run Philips Curve in the Long Run = bu gap + ~ + s Expectations on supply shocks are zero ( E( s) = 0 ) shocks are unexpected! Actual inflation must be equal to the underlying inflation ( E( ) = ~ ) => U gap = 0 U = U Philips curve must be vertical in the long run => No permanent trade-off between inflation and unemployment natural unemployment rate = NAIRU = Non-Accelerating Inflation Rate of Unemployment In the long run AS curve is also vertical Y gap = 0 Y = Y

36 Equilibrium Unemployment Rates (NAIRU) Source: OECD, Economic Outlook

37 Inflation Inflation From the Short to the Long Run Inflation equals underlying inflation, no supply shock. Long run Long-run AS A Short-run Phillips curve 1 1 A Short -run AS U (a) Phillips curve Unemployment Y (b) Aggregate supply Output

38 Inflation Inflation From the Short to the Long Run In the short run: trade-off between u and Inflation above underlying inflation => lower real wages => increased employment => lower unemployment rate and higher output Long run Long-run AS 2 B A Short-run Phillips curve A B Short -run AS U (a) Phillips curve Unemployment Y (b) Aggregate supply Output

39 Inflation Inflation From the Short to the Long Run In the long run: underlying inflation will adjust Inflation above underlying inflation => inflation expectations increase => new short run Phillips curve=> increase of unemployment to natural level Long run Long-run AS 2 2 A Short-run Phillips curve 1 1 A Short -run AS U (a) Phillips curve Unemployment Y (b) Aggregate supply Output

40 AS curve (aggregate supply curve) = level of output that firms want to sell at given inflation rate The short run AS curve shifts when the underlying inflation changes Shifts of the AS Curve Y Y = ay gap + ~ ( ) + s = a + ~ + s Y the natural unemployment rate changes the trend/potential GDP changes supply shocks (temporary or permanent) hit

41 Aggregate Demand Aggregate demand curve: AD curve all the combinations of output and inflation such that the market for goods is in equilibrium (IS) and the money market is in equilibrium (TR ) Derived by analyzing the effect of price changes in IS-TR/LM model using Fisher equation How does a change in prices affect the demand The slope of AD curve in: short run medium run long run

42 The Fisher equation Fisher equation links real (r) and nominal (i) interest rates r = i - π e π e : expected inflation between today and tomorrow r : real intrest rate today i : nominal intrest rate Central bank sets/controls the nominal interest rate i and influences expectations Borrowing and money market uses nominal interest rate Borrowers like high inflation (lowers real value of debt) Lenders prefer low inflation Indexation solves the distcition

43 The Aggregate Demand in the Long Run In the long run, Y = Y, = Long run AD curve (LAD) crosses the long run AS curve (LAS) in that point Output in the long run is determined by trend growth rate Real interest rate is determined by the same factors, Inflation in the long run is determined by the central bank inflation target In the long run inflation expectations and underlying inflation equal inflation target e = = = ~ r = r

44 Inflation The Aggregate Demand in the Long Run In the long run the Taylor rule indicates i = i + a ( ) + bygap = i, i = r + Central bank sets inflation target => inflation is indepedent from output LAD=inflation target Output gap

45 The Aggregate Demand in the Short Run Taylor rule i = i + a ( ) + b Y gap Interest rate changes with changes in both output (output gap) as well as inflation For a>1 (e.g. ECB, Poland) => increase of inflation casuses more than propertioan incraeses in i => increase r (since r i- e ) Inflation change shifts TR curve Higher inflation leads to increase of nominal interest rate (at every output) => TR curve shifts up

46 The Aggregate Demand (1) Taylor rule i = i + a ( ) + b Y gap + Fishera equation, i i = r + = r a + + ( ) i + by gap Effect of price changes on TR curve i = ( r + (1 a) + a ) + bygap Changes when changes

47 Inflation Interest rate The Aggregate Demand (2) i = ( r + ) + i a 0 at A: = + by IS gap A = i + by gap TR TR curve Along TR, is held constant at Intersection of TR i. IS curves yield equilibrium point 0 A Output gap We start from long run equilibrium where Y gap =0 and = 0 Output gap

48 Inflation Interest rate The Aggregate Demand (3) Now suppose inflation increases to. i i IS A A TR TR Higher inflation triggers higher interest rate via Taylor rule: TR shifts up to TR. 0 Output gap A 0 A AD Output gap Increase of nominal interest rate reduces demand (point A )

49 Inflation Aggregate Demand in the Short Run AD curve is determined by changes in the IS-LM/TR equilibrium due to change in inflation AD slopes downward: A When inflation rises, the central bank raises the nominal interest rate i (for a>0) leading to increase of real interest rate (a>1) r reducing the demand for goods and services. A AD curve shifts in response to changes in: the inflation target (its increase shifts AD to the right) 0 AD Output gap demand shocks to, e.g. G, T, W, q,... - positive szok (shifts IS curve right) shifts AD curve to the right

50 Inflation Aggregate Demand and Supply: Short and Run Long Run LAS AS LAD AD Y Output

51 Simulation of Economic Fluctuations in AD-AS model Now that we have built our AS-AD model, we can see how fluctuations emerge What are the effects Supply shock Demand shock (e.g. fiscal policy changes) Changes in monetary policy Policy reactions / responses to shocks

52 Inflation An Adverse Supply Shock (1) LAS AS Starting point: Short-run = long-run equilibrium at point A A LAD AD 0 Output gap

53 Inflation An Adverse Supply Shock (2) B LAS AS AS Supply shock s>0 shifts AS curve from AS do AS. A AD LAD Stagflation : both unemployment and inflation increase (point B) 0 Output gap (inflation increase =>i,r increase => demand falls )

54 Inflation An Adverse Supply Shock (3) Point B is not long run equilibrium How quickly economy comes back to A depend on how inflation expectation are formed and on underlying inflation e = ~ = if rational expectations anchored on inflation target,, then once supply s is over (s=0) AS=AS RE and economy returns to equilibrium point A. B LAS AS AS AS AS=AS RE if adaptive expectations ~ then underlying inflation goes initially up, shifting AS curve up (AS, AS,...) and inflation only gradually reverts to inflation target A 0 AD LAD Output gap

55 Inflation Positive Demand Shock (1) LAS AS Starting point: Short-run = long-run equilibrium at point A A LAD AD 0 Output gap

56 Inflation Positive Demand Shock (2) AD LAS Positive demand shock e shifts AD curve to AD and equilibrium from A to B. AD AS B A LAD t=1: Higher inflation and higher output in point B 0 Output gap

57 Inflation Positive Demand Shock (3) As long as e >0 then AD curve remains at AD AD AD LAS D C AS B AS AS If inflation expectations and underlying inflation react to higher inflation in point B, AS curve shifts up A LAD t=2: Point C: e >0, AD + AS t=3: Point D: e >0, AD + AS 0 Output gap

58 Inflation Positive Demand Shock (4) AD AD LAS D AS Once e =0 AD curve returns to AD (e.g. at t=4 ) AS Equilibrium point E is given by AD and AS with underlying inflation different from. E A B LAD How quickly AS shifts down back to A depend again on inflation expectations and expectations revision 0 Output gap

59 Demand Shock in AD-AS Model Demand shocks, as they do not change long run level of output, affect output only in the short run. Permanent increase of government expenditures yields increase of inflation and inflation expectations => AS curve shifts up => output level returns to trend / potential level but inflation increases If the central bank accepts higher level of inflation (or if it decides to increase inflation target) then economy will feature higher inflation but unchanged level of output.

60 Inflation A Shift in Monetary Policy (1) Central bank lowers inflation target In the long run LAD shifts down, no effect on output 1 2 2, 1 AD LAS AS 1 2 A LAD LAD 0 Output gap

61 A Shift in Monetary Policy (2) Central bank lowers inflation target In the short run change of target affects output 1 2 2, 1 i i i = i + a ( ) + b Y luka = r + + a ( ) + b = r + (1 a) + a + b Y luka Y luka Taylor rule + Fisher equation + rearraning... Assumption: a > 1; lowering inflation target increases nominal interest rate ceteris paribus: TR curve shift up Note: If 0 < a < 1, increase of inflation target increases nominal interest rate ceteris paribus: TR shifts up but less than shift of target. This case is unstable and we will not consider here.

62 Inflation Interest rate A Shift in Monetary Policy (3) Central bank lowers inflation target, In the short run change of target affects output IS 1 TR TR B Intersection of TR i IS curves yield equilibrium point 1 i A Lowering inflation target shifts TR curve up 0 Output gap AS AD curve shifts left, point B 1 2 B A AD 0 AD Output gap Inflation rate on TR curve is above the new inflation target: nominal interest rate increases => investment, Y

63 Inflation Interest rate A Shift in Monetary Policy (4) Central bank lowers inflation target, As inflation decreases, TR curve shifts right But 2 2 i = r + r + = i 1 1 r IS B A=E 0 LAS TR TR Output gap AS Since >, inflation expectations and underlying inflation must adjust Lowering underlying inflation (graduał or immiedate) shifts AS curve down B A E AD 0 AS LAD AD LAD Output gap This lasts until output reaches its potential/trend level while inflation reaches inflation rate (point E)

64 Policy Responses to Shocks What can policy makers do in case of a demand or supply shock?

65 Inflation Adverse Supply Shock (Again) B LAS A AS AS AD Adverse supply shock s>0 shifts AS curve to AS (adverse/negative because output falls) LAD Stagflation: both unemployment and inflation increase, point B. 0 Output gap (inflation => i,r => demand )

66 Inflation Fighting Adverse Supply Shock: Increasing Demand Fighting resulting unemployment with expansionary demand policies (e.g. increasing government expenditures, G) Outcome: LAS lowering AS unemployment at a cost C of increased inflation in B the long-run (point C) A AD LAD AD 0 Output gap

67 Inflation Fighting Adverse Supply Shock: Decreasing Demand Fighting inflation due to adverse supply shock through a contractionary demand policy (e.g. reducing government expenditures, G) Outcome: LAS successfully fight π but AS at a cost of increased unemployment AS (point D) B D A AD LAD Only when s=0 economy returns to the long-run equilibrium at A AD 0 Output gap

68 Inflation Negative Demand Shock AD AD LAS AS An adverse demand shock e shifts AD curve to AD and brings the economy from point A to point B. A LAD B t=1: Smaller inflation but fall of output and increase of unemployment in point B 0 Output gap

69 Inflation Negative Demand Shock: Increasing Demand Fighting unemployment with expansionary fiscal or nonetary policy (e.g. increasing government expenditures, G) Increase in government LAS expenditures shifts AD curve to the right AD AD AS B C=A LAD t=2: Return to the equilibrium point (point C=A). 0 Output gap