Transcript Chapter 6 PPT

Chapter 6
Aggregate Supply: Wages,
Prices and Unemployment
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
1
Chapter Organisation
6.1 The AS Curve and the
Price Adjustment Mechanism
6.2 Inflation and Unemployment
6.3 The Wage–Unemployment Relationship:
Why are Wages Sticky?
6.4 From Phillips Curve to the AS Curve
6.5 The Effects of a Monetary Expansion
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
2
Chapter Organisation
6.6 Stagflation, Expected Inflation
and the Inflation-ExpectationsAugmented Phillips Curve
6.7 The Rational Expectations
Revolution
6.8 Supply Shocks
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
3
Chapter Organisation
6.1 The AS Curve and the
Price Adjustment Mechanism
6.2 Inflation and Unemployment
6.3 The Wage–Unemployment Relationship:
Why are Wages Sticky?
6.4 From Phillips Curve to the AS Curve
6.5 The Effects of a Monetary Expansion
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
4
6.1 AS and the Price
Adjustment Mechanism

The AS curve is horizontal in the very short
run

In the long run the AS curve is vertical

There is a spectrum of upward-sloping
intermediate-run AS curves

Equation 6.1 gives the AS curve
Pt 1  Pt 1   Y Y * 
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
5
AS and the Price Adjustment
Mechanism

Where Pt +1 is the price level next period, Pt
is the price level today, Y* is potential
output and  is the speed of price
adjustment
 The equation states that if output is above
potential output then prices will rise next period
and vice versa
 If is large, the AS curve will be steeper and
the AS mechanism will return the economy to
potential output relatively quickly
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
6
Chapter Organisation
6.1 The AS Curve and the
Price Adjustment Mechanism
6.2 Inflation and Unemployment
6.3 The Wage–Unemployment Relationship:
Why are Wages Sticky?
6.4 From Phillips Curve to the AS Curve
6.5 The Effects of a Monetary Expansion
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
7
6.2 Inflation and
Unemployment

The classical model holds that the economy
is always at full employment

Any unemployment is purely frictional

Implied is that wages are determined by
 Productivity
 The impact of money on prices

Unemployment does not affect wages
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
8
Inflation and Unemployment

The classical model has been criticised
because
 The unemployment rate fluctuates more than is
consistent with it all being frictional
unemployment (e.g. 8–10%)
 There appears to be a systematic relationship
between the rate of change of wages and the
unemployment rate
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
9
The Phillips Curve (PC)

The PC shows an inverse relationship
between the rate of unemployment and the
rate of increase in money wages

The higher the rate of unemployment, the
lower the rate of wage inflation
gw   u  u
*

Where gw is the rate of wage inflation and
u* is the NRU

When u > u*, wage inflation is falling
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
10
The Phillips Curve (PC)
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
11
The Phillips Curve (PC)

The PC implies that wages and prices adjust
slowly to changes in AD

Hence, in the short run, we are faced with
a policy trade-off between
 high unemployment and low inflation, or
 high inflation and low unemployment
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
12
Chapter Organisation
6.1 The AS Curve and the
Price Adjustment Mechanism
6.2 Inflation and Unemployment
6.3 The Wage–Unemployment Relationship:
Why are Wages Sticky?
6.4 From Phillips Curve to the AS Curve
6.5 The Effects of a Monetary Expansion
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
13
6.3 Wage–Unemployment
Relationship

Wages are ‘sticky’ when they move slowly
over time

Because ‘sticky’ wages are not fully flexible,
full employment is not ensured

The PC relationship between the level of
employment and the rate of change in
wages is
 Given by Equations 6.2 to 6.5
 Illustrated in Figure 6.6
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
14
The Wage–Unemployment
Relationship
Wt 1  Wt
gw 
Wt
and

gw   u  u * 

Wt 1  Wt 1   u  u * 


Defining
Wt 1
N* N
u 
N*

N* N
 Wt 1   
*
N


gives:



Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
15
The Wage–Unemployment
Relationship
 If employment is above the full-employment
level, the wage next period increases above this
period’s wage
N > N* implies Wt +1 > Wt
 If employment is held above N* next period
then the increase in wages is shown by an
upward shift of the WN curve next period
 If N > N* is maintained then Wt + 2 > Wt +1
 This spiral process works in the reverse as well
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
16
The Wage–Unemployment
Relationship
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
17
The Wage–Unemployment
Relationship
Wt 1

N* N
 Wt 1   
*
N





 The extent that wages respond to employment
depends on the parameter 
 If  is large, unemployment has larger effects
on the wage and the WN curve is steeper
 So changes to AD that alter the unemployment
rate this period will have effects on wages in
subsequent periods
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
18
Wage Stickiness

Imperfect information: market clearing
 Wages are fully flexible but adjust slowly
because information is imperfect
 When wages go up because prices increase,
workers mistakenly believe real wages have
increased and are willing to increase labour
supply
 This increases output and reduces
unemployment until workers realise that real
wages have not gone up
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
19
Wage Stickiness

Coordination problems
 As all firms cannot coordinate their prices, any
firm that increases its price due to a change in
money supply will lose market share
 Hence, firms raise prices slowly as the effects of
a change in money stock is felt through an
increased demand for goods at existing prices
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
20
Wage Stickiness

Efficiency wages and costs of price change
 Efficiency wage theory focuses on wages as a
means of motivating labour
 Firms may want to pay workers above the
market-clearing wage to ensure that employees
work harder
 This may reduce disguised ‘shirking’ by workers
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
21
Wage Stickiness

Contracts and long-term relationships
 Working conditions and wages are renegotiated
periodically, but not frequently, because it is
costly to do so
 Assume half the labour force renegotiate wages
in January and half in June
 Assume an increase in the money stock in
September
 Workers renegotiating wages in January cannot
adjust their salary to long-run equilibrium
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
22
Wage Stickiness
 If they attempted to do so, employers would
simply hire June workers as overtime
 Thus, there is a danger of unemployment for
January workers if the renegotiated wages are
too high
 Wages only adjust partway to equilibrium
 June workers are faced with the same problem
when it is time for their renegotiation
 Thus, there is a process of staggered wage and
price adjustments
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
23
Wage Stickiness

Insider-outsider models
 It is costly for firms to turnover labour due to
firing costs, hiring costs and training costs
 As a result, insiders have an advantage over
outsiders
 It may be beneficial for the firm to reach a deal
with insiders and pay higher wages even if there
are unemployed people who would be willing to
work for less
 Therefore, unions only look after their workers
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
24
Chapter Organisation
6.1 The AS Curve and the
Price Adjustment Mechanism
6.2 Inflation and Unemployment
6.3 The Wage–Unemployment Relationship:
Why are Wages Sticky?
6.4 From Phillips Curve to the AS Curve
6.5 The Effects of a Monetary Expansion
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
25
6.4 From PC to the AS
Curve

To derive the AS curve we need to
1. Translate unemployment to output
2. Link the prices firms charge to their costs
3. Use the PC relationship between wages and
unemployment
4. Put the three components together to derive
an upward-sloping AS curve
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
26
From PC to the AS Curve
Y Y *
*
  u  u 
*
Y

Okun’s law shows the relationship
between unemployment and output
(Equation 6.6)

When  = 0.5 then for every 1% output is
above potential output, unemployment will
fall by ½%
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
27
From PC to the AS Curve

Costs and prices
 Firms will supply output at a price that at least
covers their costs
 Firms set price as a mark-up (z) on labour
costs of production (W/a)
P
1  z W


a
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
28
From PC to the AS Curve

Costs and prices
 The mark-up costs cover the costs of the other
factors of production and the firm’s normal
profits
 If competition is less than perfect there will be
a greater mark-up cost
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
29
From PC to the AS Curve

Employment and wages and the AS curve
 The three components of the AS curve are
Okun’s law (6.7), the price–cost relationship
(6.5) and the Phillips curve (6.3a)
 Substituting 6.7 into 6.3a gives (note incorrect
ratios in 6.8):
1  z 
1  z 
Pt 1 
  Pt 
1   u  u 
 a 
 a 
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
30
From PC to the AS Curve
 Figure 6.3 shows the AS curve implied by
equation 6.1


 Pt 1  Pt 1   u  u * 


Using Okun's law gives:
Pt +1

 Y Y *  
 Pt 1  

*

  Y
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
31
From PC to the AS Curve

Setting  =
Y*
gives the earlier equation 6.1:
 Pt + 1 = Pt [1 +  (Y - Y*)]
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
32
From PC to the AS Curve
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
33
From PC to the AS Curve
 If output is above full-employment level, Y*,
then next period the AS curve will shift up to
AS’
 If Y < Y* then next period the AS will shift
down to AS”
 The AS curve implies that wages are less than
fully flexible
 Prices increase with the level of output
because increased output implies increased
employment (reduced unemployment) and
therefore increased labour costs
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
34
Chapter Organisation
6.1 The AS Curve and the
Price Adjustment Mechanism
6.2 Inflation and Unemployment
6.3 The Wage–Unemployment Relationship:
Why are Wages Sticky?
6.4 From Phillips Curve to the AS Curve
6.5 The Effects of a Monetary Expansion
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
35
6.5 The Effects of a
Monetary Expansion
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
36
The Effects of a Monetary
Expansion

Consider an increase in the nominal
money stock

Short-run effects
 At each price level real balances are higher,
interest rates are lower and hence the demand
for output increases
 AD shifts to AD’
 Firms run down inventories and accordingly
hire more labour and increase output to E’
 At E’ both prices and output have increased
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
37
The Effects of a Monetary
Expansion

Medium-term adjustment
 At E’ prices continue to rise
 Workers demand a higher wage to compensate
and this shifts the AS curve up to AS’
 New equilibrium is at E” where output is lower
than that of the first period and prices have
risen further
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
38
The Effects of a Monetary
Expansion

Long-term adjustment
 As long as output is above the full-employment
level, wages are rising
 The increase in wages means firms experience
cost increases and pass them on, which
continues to shift the AS curve up
 Output declines back to Y* and prices continue
to rise
 At E’” prices increase by the same proportion
as the nominal money stock
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
39
The Effects of a Monetary
Expansion
 Hence, the real money stock (M/P) returns
back to its original level, and so do interest
rates, AD, output and employment
 The increase in the money stock has no real
effects (money is neutral as it only raises
prices)
 The neutrality of money holds in the long run
but not in the short run
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
40
Chapter Organisation
6.6 Stagflation, Expected Inflation
and the Inflation-ExpectationsAugmented Phillips Curve
6.7 The Rational Expectations
Revolution
6.8 Supply Shocks
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
41
6.6 Stagflation, Expected
Inflation and the InflationExpectations-Augmented PC

The simple PC neglects anticipated
inflation

Decisions are made with regard to real
wages, so nominal wages are usually
adjusted for any expected inflation

Hence, unemployment depends not on
the level of unemployment but on the
excess of inflation over what was
expected
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
42
Inflation-ExpectationsAugmented PC

Incorporating anticipated inflation into
our PC equation 6.3 gives Equation 6.10:
g
w

e
   u  u 
*

   e  u  u *

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
43
Inflation-ExpectationsAugmented PC

Note two critical properties of the
inflation-expectations-augmented PC
 That expected inflation is passed on one for
one into actual inflation
 Unemployment is at the natural rate when
actual inflation equals expected inflation

Hence the PC intersects the NRU at the
level of expected inflation

For persistent inflation, the short-run PC
shifts up
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
44
Chapter Organisation
6.6 Stagflation, Expected Inflation
and the Inflation-ExpectationsAugmented Phillips Curve
6.7 The Rational Expectations
Revolution
6.8 Supply Shocks
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
45
6.7 The Rational
Expectations Revolution

The PC relationship depends on people
being wrong about inflation

Rational expectations assumes that
individuals do not make systematic
mistakes
 Hence, if agents knew that the RBA
increased the money supply by 4%
 Then agents would expect 4% inflation
 Unemployment would remain unchanged
 Inflation would rise to 4%
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
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Rational Expectations
 However, if agents did not know the growth
of the money supply, then they must guess
using all the available information
 If actual inflation turns out to be greater than
anticipated inflation, AD would increase and
unemployment would decrease
 As soon as agents are aware of their mistake,
they adjust very rapidly as inflationary
expectations are set to the correct value,
shifting up the AS curve to its long-run
position
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
47
Rational Expectations
 Hence, anticipated policy changes have no
real effects
 Unanticipated policy changes do affect real
variables, but only for a short period, as the
adjustment process is rapid
 Rational expectations are reconsidered in
Chapter 20
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
48
Chapter Organisation
6.6 Stagflation, Expected Inflation
and the Inflation-ExpectationsAugmented Phillips Curve
6.7 The Rational Expectations
Revolution
6.8 Supply Shocks
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
49
6.8 Supply Shocks

Incorporating materials prices into the
analysis
 Previously, labour costs and the mark-up were
the only determinants of output prices
 Materials prices also impact upon the prices
of final goods
 Equation 6.13 shows that for given wages,
profit margins and labour productivity, an
increase in the real price of materials
increases prices and shifts the AS up
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
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Supply Shocks
W 1  z 
P
 vPm
a
where vPm denotes materials input costs.
Pm
Setting Pm 
and 1  vpm gives :
P
1 z W 
P
 
1  vpm  a 
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
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Supply Shocks
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
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Supply Shocks

Assume that there is an increase in the
price of oil
 The AS curve shifts up and the economy
moves to point E’
 Initially, prices have increased and output
decreased
 The unemployment at point E’ forces wages
and thus the price level down
 The economy moves back to point E
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
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Supply Shocks
 Employment is back to full employment
 However, real wages have decreased since
nominal prices have returned to their original
levels while nominal wages have decreased

Accommodation of supply shocks
 The adjustment process is slow, since wages
are relatively slow to adjust
 The government may accommodate the
supply shock by increasing AD
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
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Supply Shocks
 The economy moves to E*
 Price would increase again while nominal
wages are unchanged, implying lower real
wages
 Accommodating policies face the trade-off
between the inflationary impact of a shock
and its recessionary effects
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
55