Transcript Supply Side - Vincent Hogan

Supply Side
Mankiw Chpt. 10, 14.1
&
Akerlof Book for intuition and
examples
1
Learning Objectives
1. Crucial role for expectations & for time
frame.
–
Specifically the time it take for prices to adjust
completely is the long run.
2. Policy conclusions of IS-LM-BP model hold
only in the short run and not in the long run.
3. The role for stabilization policy depends on
expectations adjustment process
2
Overview of AS-AD
• Simple model of Aggregate Supply and
Aggregate Demand
• Same idea as supply and demand
• AD slopes down:
– As price rises AD falls
• AS slopes up:
– As price rises AS increases
3
AS
P
AD
Y
4
Example: Fiscal Policy
P
B
AS
A
AD1
AD0
Y
• If G increases then AD
shifts to right
• At any P, AD will be
higher because G is
higher
• AB
• P and Y rise
• Why P rise?
– Need to pay higher w
to get higher output
5
IS-LM-BP
P
B
A
AS
AD1
AD0
Y
• Previously we
assumed that P did not
adjust
• Equivalent to
assuming that AS is
flat
• Note for FP to even
move the AD curve
we need fixed e
6
Agenda
1. Need to show that IS-LM-BP reduces to
AD
2. Need to model price setting behaviour
3. Need to show that assumption of price
stickiness is valid in the short run
7
Aggregate Demand
• The AD curve summarizes the whole of the ISLM-BP model
• What happens to IS-LM when P increases?
–
–
–
–
–
Equivalent to reducing money supply
M/P=L(r,Y)
More transactions as P increases
So higher prices lead to lower real money supply
Or higher demand for money
• Focus on IS-LM for simplicity sake but
similar arguments apply to IS-LM-BP
8
LM(P1)
r
LM(P0)
P
B
B
A
A
AD
IS
YB
YA
Y
YB
YA
Y
9
Implications
• Anything we can model in the IS-LM-BP
we can also model in AD
• Think of MP, FP under fixed and floating
exchange rates
• Why use either model?
– Use IS-LM-BP to understand interest rates
– Use AD & AS when need to understand how
supply adjust
10
Aggregate Supply
• Q: What underlies the Aggregate Supply
Curve?
• A: Production and pricing decisions for
firms
• Many Theories
– Mankiw table 10. 2 lists 12 theories
• Mankiw 14 discusses two theories
– Staggered or sticky price adjustment
– Imperfect information
11
Imperfect Information
• I will focus a version of the imperfect
information theory
– Apply to the labour market
• Why?
– Useful for discussion of unemployment later
– Easier to relate to labour price because we all sell it
– Most important single market
• What is said about labour market here will
apply to all other markets all of which suffer
from Imperfect Information
12
Labour Market
W
D(P1)
D(P0)
L
• Firms have a demand
for labour or workers
• Decreases as nominal
wage (W) rises
• Increases as Price of
output rises
– Curve shifts to the right
– At any wage firm will
want more workers
– Curve shifts up
– For any amount of labour
the firm can pay higher
wage
13
• Workers supply labour
S(P1
• Higher nominal wage
will induce more
work(ers)
• Form expectation
S(P0e)
about cost of living
e)
W
– Price expectation (Pe)
• Increased (Pe)
L
– Curve shifts up
– Higher wage for any
level of work
14
Labour market Equilibrium
• Put two curves together
• Lab Mkt eqm
W
S(Pe)
D(P)
– Firms and workers plans
agree
– Wage and employment
– “competitive” labour
market
– No unemployment
• Also agree on price
– P=Pe
L
• Implies agree on real
wages
15
Derive the Aggregate Supply Curve
• We can use the labour market to derive the
AS curve in short run and in the long run
• First the short run:
– Assume that expectations do not change
– Pe = P
– SL will not move
16
• Suppose start at A which represents lab mkt
eqm
– P level rises
– DL increases
– New eqm at B
• Employment increases
• Wage increases
– Goods market
• Output increases
– Upward sloping supply curve
• Note that AS depends on expectations
17
S(Pe)
W
P
AS(Pe)
B
B
A
D(P1)
D(P0)
A
L
Y
18
• Note that all this implies something weird
about workers
– The work more, for less!
• W has increased, but P has increased by
more
– Real wages have declined
– See diagram
• Supply of labour was conditional on prices
being at a certain level
– Pe = P
– But this no longer true
19
• With P>Pe we have lower real wages
• Demand W increase to restore living
standards
– they adjust expectations upwards
– Supply curve shifts up
– Shifts up so that increase in W is same as
increase in P
• New equilibrium is a point C
– Real wage same at C as at A
– Employment same at C as at A
20
S(P1e)
W
C
S(P0e)
P
C
B
A
AS(P1e)
AS(P0e)
B
D(P1)
D(P0)
A
L
Y
21
• As expectations change there is a new AS
curve
• Eqm at C has same output as A
– Reflects the fact that employment is the same
• Net effect is that output and employment
remain the same
• P and W go up by the same amount
22
Summary of AS
• We have a distinction between short run and long
run
• The Short run is for fixed expectations
– AS(Pe)
– SRAS
– Quite flat: Explains why ISLM works as approx
• LR is how long it takes for real wages to adjust
– Expectations adjust
– Workers to act on exp
– ISLM wont work in LR
• In LR Y is unaffected by P
23
LRAS
P
AS(Pe)
Y*
Y
24
LRAS
• What determines Y*?
–
–
–
–
–
Natural rate
Incentives
Technology
“growth”
Not anything that just affects price
25
Agenda
• Look at policy in AS-AD model
– FP & MP
• Supply side policy
• Dealing with shocks
– Automatic adjustment mechanism
– Stabilization policy
– Speed of adjustment
26
Policy in AS-AD Model
• Suppose there is an increase in G
• AD shifts right
– For all P, there is higher AD, because govt component
has risen
– Could derive this from IS-LM-BP
– Note for FP to shift the AD curve we need fixed e
– Same for MP
• For fixed expectations i.e. SR
–
–
–
–
Move along AS
New (temp) eqm at B
Y increases
P increases (but not by much)
27
• P rising implies real wage falling
– P>Pe
• Pe will adjust upwards
– W increase
– SRAS shifts up
• Keep going until output returns to “natural
level”
• How long does transition take?
– Theory: depends. Instantaneous?
– Empirics: about 2 years – see diagram
28
LRAS
AS(Pce)
P
C
AS(PAe)
B
A
AD0
Y*
AD1
Y
29
• Be clear on the reasons why there is no long
run effect
– In order to get more output need to pay more
people higher wages
– Higher wages imply firms need to charge
higher prices
– Higher prices negate the higher wages as far as
workers are concerned
– We go back to original values of real variables
– Only affect nominal variables
• Policy is ineffective!
30
• We can only get an increase in Y in long
run i.e. increase in Y*
–
–
–
–
–
If induce people to work more
Need increase in real wage
Technology
Efficiency
Lower taxes?
• Reganomics
• Supply side economics
• Voodoo economics
31
Reagan Style Tax Cut
• Cut personal taxes
–
–
–
–
–
Idea is that this will improve incentives
People will work more
Shift the LRAS to the right
Increase Y* and reduce P
Note that SRAS shifts also as expectations adjust to the
new lower level
• But cutting taxes will shift the AD curve to right
– SR boom
– LR return to Y* with higher P
• Which happened?
– Both
– Demand effect larger
32
P
LRAS
AS(Pe)
AS(Pe)
AD0
Y*
Y1*
Y
33