Topic 4: AS-AD Model Dealing with longer run; more variance; look at the role of wages and prices

Transcription

1 Topic 4: AS-AD Model Dealing with longer run; more variance; look at the role of wages and prices Aggregate Supply-Aggregate Demand (AS-AD) Model: Diagram General price level measured by some price index Income/output Y N is natural level of income; position of long-run equilibrium in this approach AD is aggregate demand o As price level declines, AD increases o Downward sloping SAS is SR aggregate supply o Cost of production increases as output increases o Upward sloping LAS is LR aggregate supply o Vertical line o At long-run equilibrium position Derivation of AD Function Downward sloping AD function is based on three possible mechanisms by which a rise in general price level reduces level of aggregate demand: 1. Monetary Policy Reaction Effect Based on proposition that priority of MP is to contain inflation i.e. central bank conducts MP to achieve long-run price target o Prices and wages don t change in short-run o They can adjust in the long-run In reaction to price level rising above or below target, adjusts rate of interest up or down to contain it o Basis of the Taylor Rule Reaction effect of central bank expressed by simple interest rate rule: o i = i n + a (P P T ) o P = P T, i = i n i n is the long-run neutral rate of interest P T is the price level target o If P > P T, then i > i n o If P < P T, then i < i n o If P = P T, then i = i n a is a parameter measuring degree to which central bank responds to any divergence between price level and price target o a is higher = central bank for vigorous in adjusting MP in response to divergences between price level and price target; operate more quickly If price level rises from P to P 1 due to some shock to the economy (e.g. wage increases), Central Bank increases interest rates shift of LM model up to LM 1 at higher price level o IS schedule contracts (move down); interest-sensitive expenditure is declining via multiplier process and thus national income/output declines from Y to Y 1

2 Can draw an AD, based on this case If price level goes up, interest rates increase and IS contracts, lower Y Mechanism to help explain the negative slope of AD Drawing AD curve based on a given target price level Long-run change in MP involves change in P T ; only in LR, independent of shocks is CB able to achieve price level target Price target interpreted as maximum long run price level CB is willing to accept o If actual LR price level is below price target, providing it s consistent with real income at natural level Y N so there s no output gap, CB will gladly lower price target to this level But there are circumstances where CB can t plausibly achieve P T in LR and have to revise or abandon it e.g. in the war o LR political limits to policy actions and objectives i.e. can t raise interest rates to such an extent that contracts AD in the economy o Normally set inflation targets that can be achieved 2. Wealth Effect Rise in general price level reduces real value of portfolio wealth, its purchasing power and thus, consumption expenditure o Portfolio wealth = value of wealth in financial form i.e. stock, shares, etc. If price level increases, purchasing power reduces, fall in consumption expenditure On the other hand: if price level falls, real value of wealth increases, promotes higher consumption (people think they are richer) P P/P C AD W P is the nominal value of portfolio wealth and W P/P its real value Weak effect: wealth effect weak because of inverse change in real value of debt causing consumption of debtors to change in opposite direction to net wealth holders o Two sides to financial assets wealth holder holds assets while debtor issues the assets/shares/bonds o If price level falls, real value of wealth goes up = higher consumption by wealth holders BUT real value of debt increases so debtors spend less o If price level increases, real value of wealth decreases = less consumption by wealth holders BUT real value of debt decreases so debtors spend more o Depend on propensity to spend of net wealth holders compared to debtors Restricted to liquid assets not matched by liabilities ( outside money ) Referring to change in price of goods and services not price of assets (constant) An effect sometimes employed to explain why AD slopes down 3. International Competitiveness Effect A stronger effect than wealth effect

3 In an open economy, an increase in general price level will, given the exchange rate and foreign price level, reduce international competitiveness and reduce NX and AD o Depreciation = lower imports, higher exports = higher NX = higher AD o Appreciation = higher imports, lower exports = lower NX = lower AD P (E. P / P*) X, M ( NX) AD Where E is the nominal exchange rate, P* foreign price level and (E. P / P*) is real exchange rate Real exchange rate measures relative prices between countries based on one currency o Nominal dollar. price index = price of domestically produced goods in foreign currency terms o P* is foreign price of goods More open economy = greater the effect = greater reliance of EG on international trade Slope of AD Function Depends on degree of sensitivity of AD to changes in price level via above effects: o On degree of openness of the economy (more open = AD flatter as price levels have larger effect on AD) o On degree of wealth dependent expenditures o On monetary policy behaviour and extent to which CB enforces prescribed interest rate rule (i.e. size of a where bigger a = higher slope) o Interest-sensitivity expenditures; if C and I are more interest-sensitive = flatter curve as it is more effective Shifts in AD Function Due to changes in AD independent of price level Hence, it represents changes in aggregate expenditure which are caused by factors other than a change in the price level: o FP expansion/contraction o Investment, consumption and/or export boom/slump o Depreciation (appreciation) of the exchange rate o Change in MP independent of changes in price level, P, involving a change in LR neutral rate of interest, i n, in order to achieve: (i) a new MP price level target, P T, or (ii) the existing price target, P T

4 Upward Sloping Short-Run Aggregate Supply (SAS) Function Various constructions of SAS found with different rationale for upward slope As output expands, costs of production increases price level increases Rising profits with income o As firms expand output, their profits rise Rising wages due to greater bargaining power afforded by a lower unemployment rate o As UE falls, workers with higher bargaining power get higher wages o Doesn t explain LR context More traditional rationale diminishing marginal productivity to variable inputs employed in production o Distinction between SR and LR o Based on Marshallian analysis: construct SAS so upward slope of function is attributable to diminishing returns to variable factors of production as the given capital stock is used more intensely to produce increasing output/income in SR o Marginal productivity of adding more inputs is lower output less efficient less skilled workers being increasingly hired and capacity constraints Price-Cost Relationship Suppose the following equation for the price level: o P = (Wl + Vz + dџf) (1+r) Where P is the price level Wl is wage cost per unit of output (significant in advanced economies) o W is money wage o l is coefficient of labour requirements per unit of output Vz is the cost of material inputs o V is price of material inputs variable o z is coefficient of system s requirement of material inputs per unit of output r is rate of profit F is value of capital stock (fixed) d is depreciation of fixed capital which is given џ is the degree of utilisation of productive capacity in which џ = Y/Y*, Y* is fullutilisation and 0<џ</=1 Costs of production based on costs of producing in short-run. rate of profit Assumptions of SAS Function The following assumptions underlie the SAS function: In SR, productive capacity is fixed and price of capital goods employed constant so that F is a fixed cost of production Technique of production is given Rate of depreciation per unit cost of capital stock utilised, dџf, is constant so that as output (income) changes, the cost of fixed capital per unit of output produced is constant Constant given rate of profit (or mark-up) on cost of production, r Given money wage, W, and price of material inputs, V, are constant in SR

5 Diminishing Returns to Variable Inputs Based on assumptions, systematic changes in price level as output changes in the SR can only stem from changes in cost of labour, Wl, and/or material inputs, Vz It is further assumed that both these variable inputs are subject to diminishing marginal returns, expressed: o l = f (Y) as output increases in SR, coefficient of labour must increase i.e. if you want to produce the same output as before, have to increase labour inputs o z = f(y) want to produce fixed number of output in SR (with fixed capital stock), firms must add increasing dose of material inputs to produce more output Which states that in SR, labour and material input requirements per unit of output are increasing functions of level of output (income) Therefore, increasing cost of production higher general price level Upward Sloping SAS Given W and V, diminishing marginal returns mean that Wl and Vz rise at an increasing rate with income so cost of production and price level increase up along SAS Notion is that for given productive capacity, as output/income increases and utilisation of capacity increases, o Application of variable inputs, including labour, energy, raw materials, to production, entails their diminishing returns o Causes price level to increase with output in SR Shifts in SAS Changes in aggregate money wage, W, and general price of material inputs, V Material inputs: change in general price of material inputs will stem mainly from change in price of important inputs to production with inelastic demand o E.g. oil for transport and energy o Change in their price will stem from change in circumstances of their production in relation to global demand o Including war, transport blockades, embargoes, natural disasters, poor climatic conditions (affecting agricultural productivity) and resource scarcity Wages: wage negotiations based heavily on expectations of price level because workers are concerned with their real wage, W/P, which determines their standard of living o W = f (P e ; x) o Wage depends on expected price level P e and catch-all variable x capturing factors like UE rate, strength of organised labour, industrial relations laws, social welfare system all determine bargaining power of labour Shift down: reduction in money wage or lower material input prices Shift up: workers revise upwards wage expectations or higher material input prices

6 Vertical LAS Function In LR, conceived that output is at natural level (Y N) at which competitive equilibrium is established in aggregate labour, capital and product markets of economy Position in which prices and money wages are stable because no excess demand or excess supply pressures in product and labour markets o In particular, is associated with an equilibrium real wage rate Natural level of output corresponds with what is called a natural rate of UE o Not actually full employment o Price and wage adjustments push back to natural level Natural Rate of UE 1. Frictional UE o Job-searchers and labour mobility; seasonal UE o Higher frictional UE = sign of healthier labour market that is more mobile 2. Structural UE o Structure of economy, especially labour market seen to be a problem o Skills and location mismatch in aggregate labour market o Technological change and lagging education acquirement o Industrial relations laws & regulations block labour market mobility o Social welfare system Natural rate of UE, denoted as u n, cannot be reduced by lowering real (money) wage or by raising AD Requires supply-side policies which address the structural problems in the economy and, especially, in the labour market Hence, not influenced by demand-management policies unless they deal with long-term structural problems Contestable policy on how to reduce u n: o Laissez-faire approach which stresses labour market deregulation and welfare reform o Interventionist approach in which government adopt measures to improve skills and labour mobility i.e. subsidies SR v LR Equilibrium

7 Intersection of SAS and LAS is the LR equilibrium position (natural level of income) Based on given price expectation of P 1 and some given price of material goods A is a SR equilibrium position where Y is above the natural level o But it is SR equilibrium because it can t be persistent in this model o High level of income/output and UE is below the natural rate o A is associated with higher price level than at P 1 o Real wage is lower than at long-run equilibrium o Workers won t be happy with this situation; they have more bargaining power; revise upwards price expectations and negotiate wages and then SAS will shift up At B, SAS has shifted up o Money wage to increase to come into line with prices to restore real wage to previous price o Increase in demand that took us to A results in higher price level excess demand levels in economy o As wage goes up, move along AD curve CB will raise interest rates, wealth effects (reduction of real wealth less consumption), exports fall o What takes us to LR equilibrium is change in price in inputs (wages + materials) Actual Price Level Vis-à-vis Expected Price Level along SAS Green section: output above the natural level o P above expected price o Tendency for SAS to shift upwards/left because money wages and price of material inputs tend to increase Blue section: output below natural level o P below expected price o Real wage is higher o UE is higher than natural rate o Tendency for SAS to shift down/rightwards and price of inputs to be reduced because of high UE, revise down expectations Adjustment from SR to LR Equilibrium Excess demand at A tendency to push upwards to increase money wages and price of material inputs Must be consistent with some price target of CB

8 Demand growing pressure on productive capacity higher prices and wages in economic system i.e. shift from A to B Excess supply at A, unemployment is below natural rate of unemployment o Real wage will be higher o Wages will tend to decline because bargaining position of workers is worse o Shift down demand function from A to B o Some economists argue that there is less flexibility; this process not particularly reliable Summary of AS-AD Equilibrium Conditions LR Equilibrium: Y = Y N, u = u n, P e = P o Output = natural level o Natural rate of UE o Price = expected price level W/P = W/P*, P = P T i = i n o Real wage = equilibrium real wage o Price = price target Where W/P* is the equilibrium real wage in aggregate labour market SR Equilibrium: Excess demand: Y > Y N (or AD > Y N ), u < u n, P > P e, W/P < W/P*, P > P T i > i n o AD is above natural level o UE is below natural rate o Price above expected price level o Real wage below equilibrium o Price above target price level o Interest rates higher than normal Excess supply: Y < Y N (or AD < Y N ), u > u n, P < P e, W/P > W/P*, P < P T i < i n o AD is less than natural level o UE is greater than natural rate