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Objectives

After working through this topic you should be able to:

· Understand the meaning and derivation of the aggregate demand

curve

· Explain the factors that can cause the AD curve to shift

· Identify the microeconomic foundations of the aggregate supply curve

· Explain the importance of price expectations as a determinant of the

supply of labour

· Distinguish between complete money illusion, imperfect foresight and

perfect foresight as three cases of price expectations

Key Concepts

real money supply money wage rate

aggregate demand curve real wage rate

aggregate supply curve expected price level

aggregate production function coefficient of adjustment

labour market complete money illusion

imperfect foresight perfect foresight

Introduction

In the IS/LM analysis it has been assumed that the general price level

is fixed up to the point of full employment, after which it can rise

without limit. Clearly this is an unacceptable assumption because

since 1950 an axiom of economic life in advanced economies has

been the existence of inflation during both booms and slumps.

Moreover inflation has persisted even though high levels of

unemployment have emerged since the mid 1970’s, i.e. stagflation.

Therefore the general price level has to be explicitly analysed, and

this is the purpose of the aggregate demand and supply framework.

The next two topics discuss in detail the construction and meaning of

the AD/AS model.

In this first topic, we begin by showing how the aggregate demand

curve is derived and discuss the factors which can cause it to shift.

The microeconomic foundations of the aggregate supply curve are

then explained in detail focusing on the aggregate labour market,

worker’s expectations of the price level and the aggregate production

function. The actual derivation of the three different aggregate supply

curves is explored in following topic.

The first step in constructing the AD/AS model is to look at the

meaning and derivation of the aggregate demand curve. As you will

see, the AD curve is easily derived form the basic IS/LM model for

either a closed or open economy. For ease of exposition, it will be

assumed that we are dealing with a closed economy

· The aggregate demand curve can be defined as the schedule which

shows the combinations of the general price level and total

output where the goods and money (assets) markets are in

equilibrium i.e. where the IS and LM curves intersect.

To derive an aggregate demand curve a number of variables are held

constant. These variables include:

1. the marginal propensity to consume

2. the position and slope of the investment demand function

3. the marginal rate of tax

4. the level of Government spending

5. the nominal money supply

6. the position and slope of the demand for money schedule

With these ceteris paribus assumptions in place, the general price

level is varied to chart the impact on the goods/money markets, and

hence the level of aggregate demand. Figure 9-1 below illustrates the

process.

LM0

Interest LM1

rate

E

r0

E1

r1

IS0

Y0 Y1 Real GDP(Y)

Price

level

(P)

P0

P1

AD

Y0 Y1 Real GDP(Y)

interest rates (r) on the vertical axis, and income/output (Y) on the

horizontal axis. In the bottom panel an aggregate demand curve can

be derived with the general price level (P) on the vertical axis and

total output (Y) on the horizontal axis.

Initially the economy is in equilibrium where the curves IS 0 and LM0

intersect at point E. More specifically the LM curve is defined for a

given nominal money supply (MS0) and general price level (P0). Point

E also defines an equilibrium rate of interest (r 0) and level of output

(Y0). The price level (P0) and the level of output (Y 0) can then be

charted on the bottom diagram as a point where the goods and

money markets are in equilibrium.

Say the price level falls by 10% to P 1. With a given nominal money

supply, the real money supply will increase i.e. M0/P1 > M0/P0. In the

top panel the LM curve shifts to the right i.e. LM1. This causes the

rate of interest to fall (to r1) stimulating investment spending.

Moreover larger real balances (i.e. wealth) will tend to increase the

propensity to consume. Consequently a new equilibrium will emerge

at point E1 with a higher level of output Y1.

P1 and Y1 can be charted on the bottom diagram and, when combined

with point P0/Y0, an aggregate demand curve is derived. The

aggregate demand curve is always downward sloping. The steepness

or flatness of the aggregate demand curve depends primarily on the

interest elasticity of both the money demand function and the

investment demand function. For further information on this issue see

Dornbusch and Fischer.

Activity 1

Use a diagram like Figure 9-1 to derive the AD curve for an open

economy. Explain carefully why the schedule would be downward

sloping. Would it have a flatter or steeper slope than the closed

economy AD curve in Figure 9-1?. (Hint; remember the effect of a

fall in the domestic price level, ceteris paribus, on the real

exchange rate.)

Shifting the Aggregate Demand Curve

If any of the ceteris paribus assumptions (see above) are relaxed then

the aggregate demand function will shift. However in this section it is

useful to show how changes in fiscal and/or monetary policy will

cause the curve to shift.

Fiscal Policy

First consider the impact of a fiscal expansion, assuming the general

price level is given - see Figure 9-2 below. The fiscal expansion can

be generated by increased government spending and/or cuts in the

marginal rate of taxation. In the top panel the economy starts with

price level P0 and curves IS0 and LM0, generating an equilibrium with

interest rate r0 and output Y0 at point E. In the bottom diagram it can

be shown that this is compatible with aggregate demand curve AD0.

Holding the price level constant consider the impact of a fiscal

expansion. This is represented in the top panel by a rightward shift in

the IS curve. The rate of interest rises to r 1 and output increases to Y1

- point E1. In other words at the original price level P0 a higher level

of output Y1 is consistent with equilibrium in the goods/money

markets. Charting this down to the bottom panel it is clear that the

aggregate demand curve has shifted to the right, consistent with AD1.

It follows that if there is a fiscal contraction the aggregate demand

curve shifts to the left.

LM0

Interest

rate

E1

r1

E

r0

IS1

IS0

Y0 Y1 Real GDP(Y)

Price

level

(P)

P0

AD1

AD0

Y0 Y1 Real GDP(Y)

· Fiscal Expansion shift the aggregate demand curve to the RIGHT

· Fiscal Contraction shifts the aggregate demand curve to the LEFT

Monetary Policy

Consider the effect of a monetary expansion assuming the price

level is constant - see Figure 9-3 below.

Once again the economy starts with price level P 0 and curves IS0

and LM0. The LM curve is defined by the real money supply (i.e.

the nominal money supply Ms0 deflated by the price level P0).

Interest rate r0 and output Y0 are consistent with equilibrium in the

goods/money markets shown by point E. Bringing this down to

the bottom panel it can be shown that point P 0,Y0 is consistent

with aggregate demand curve AD0.

LM0

Interest LM1

rate

E

r0

r1

E1

IS0

Y0 Y1 Real GDP(Y)

Price

level

(P)

P0

AD1

AD0

Y0 Y1 Real GDP(Y)

Ms1, assuming the price level is constant at P 0. The real money

supply increases thereby shifting the LM curve to the left i.e. LM1

in the top diagram. A new goods/money market equilibrium occurs

with interest rate r1 and output Y1. Charting P0, Y1 on the bottom

panel it is obvious that the aggregate demand curve has shifted to

the right i.e. AD1. It follows that if the nominal money supply is

reduced, ceteris paribus, the aggregate demand curve shifts to the

left.

Again, we can summarise these results as follows:

· Monetary Expansion shifts the aggregate demand curve to the

RIGHT

· Monetary Contraction shifts the aggregate demand curve to the

LEFT.

Activity 2

Briefly outline the factors which would cause the aggregate

demand curve to shift.

For many years the aggregate supply side of macroeconomics was

left rather up in the air. To a large degree this was due to the

dominance of the IS/LM framework which had very little to say

about the supply side of the economy. The aggregate demand/supply

model seeks to rectify this omission.

It is useful to begin by defining the aggregate supply curve.

· The aggregate supply curve shows the combinations of the

general price level and total output where, for a given state of

technical knowledge, the demand for labour equals supply of

labour, and, in this sense, there is a labour market equilibrium.

Before going on to illustrate how an aggregate supply curve is

derived it is useful to review its microeconomic foundations. These

‘microfoundations’ encompass three pieces of theory; first, the

aggregate production function; second, the analysis of the labour

market; and third, the formation of price expectations by the

workforce.

The aggregate production function specifies the relationship between

the aggregate volume of factor inputs i.e. labour (N) and capital (K),

and the aggregate volume of outputs (Y).

Hence:

Y f N , K

the units of N employed. If this is done a microeconomic law applies,

namely the law of diminishing productivity of a variable factor. An

aggregate production function derived in this way is illustrated in

Figure 9-4 below.

Y

Y = f (N, K )

On the vertical axis are units of output (Y), on the horizontal axis are

units of labour (N). As more N is applied to a given capital stock the

total level of output increases but at a diminishing rate, hence the

slope (= the marginal product o labour) gets flatter.

Activity 3

Use a diagram to illustrate and explain the effect on the aggregate

production function of an increase in the given stock of capital, ( K

)

The aggregate production function does not specify the actual

number of workers employed. In the aggregate demand/supply

framework the volume of employment is determined in the labour

market. More specifically the equilibrium volume of employment is a

function of the real wage rate. This position can be illustrated in

Figure 9-5 below.

Real

NS

Wage

(W/P)

W 0/P0

ND

N0 N

On the vertical axis is the real wage rate (i.e. the money wage, W,

deflated by the general price level, P), and on the horizontal axis are

units of labour. The labour demand curve (ND) is negatively related to

the real wage, whilst the labour supply curve (Ns) is a positive

function of the real wage. The labour supply curve has imbedded

within it all forms of imperfections and rigidities which exist in the

real world i.e. imperfect information, trade union restrictions,

government regulations etc. It may therefore be called the ‘real

world’ labour supply curve. Where the two curves intersect identifies

the equilibrium real wage (W0/P0), which in turn determines the

equilibrium volume of employment (N0).

It is possible to illustrate the labour market equilibrium using the

money wage rate instead of the real wage - see Figure 9-6 below.

Money

NS (P0)

Wage

(W)

W0

ND (P0)

N0 N

On the vertical axis is the money wage rate (W), on the horizontal

axis are units of employment (N). The labour demand curve is

downward sloping and specified for a given price level, P 0 [i.e.

ND(P0)]. The labour supply curve (Ns) is upward sloping and also

specified for the price level P0 [i.e. Ns(P0)]. An equilibrium money

wage W0, when combined with price level P0, determines an

equilibrium volume of employment N0 - which is consistent with the

position set out in Figure 9-5 above.

In the money wage framework the labour demand and supply curves

are specified for a given price level. If the price level changes the

curves will shift position (see later).

The real wage and money wage illustrations of labour market

equilibrium are inter changeable. In what follows, however, the

money wage framework will be used because of its greater

transparency.

Activity 4

Explain what happens to the demand for labour curve in Figure 9-6

above, when the aggregate price level increases. (Hint; remember

the microeconomic derivation of the labour demand curve.)

There are two groups that form price expectations: the workforce

and firms. The way both groups form expectations needs to be

considered.

The Workforce

To decide how much labour to supply the labour force must estimate

the real wage rate. This may be represented in equational form as,

W

Ns f E

P

where Ns is labour supply, W is the money wage and P E is the

expected price level.

It should be easy for workers to estimate the money wage rate on

offer (especially for those in employment). Determining the expected

price level, especially when it is not stable, is the difficult part. For

ease of exposition it may be assumed that workers estimate the future

price level by reference to the actual price level. In equational terms

this is represented in the following way:

Pt E 1 p Pt (0 p 1)

PE

where t 1 is the expected price level in the next time period, Pt is the

actual price level in the present time period and p' is called the

coefficient of adjustment.

The value of the coefficient of adjustment specifies how well workers

anticipate changes in the future price level when the actual price level

varies.

Case 1: p' = 0

When the value of p' is zero workers do not adjust their price

expectations when the actual price level varies. If, therefore, the

actual price level (Pt) increases by 10%, workers will not anticipate

Pt E 1

any increase in the future price level ( ). This unanticipated

increase in the price level means that for workers the actual price

PE

level and the expected price level are not equal (i.e. t 1 > Pt).

The assumption that p' equals zero is referred to as a condition of

complete money illusion. In this case the labour supply decision by

workers effectively depends only on the level of money wage rates

i.e.

Ns f W

The complete money illusion case is useful in analysing the very short

run periods immediately after a disturbance to the level of aggregate

demand. This assumption will be used when constructing the Extreme

Keynesian Aggregate Supply Curve (see below).

If the value of p' is greater than zero but less than one, workers

partially adjust their price expectations when the actual price level

varies. If, therefore the actual price level (Pt) increases by 10%, and

the value of p' is 0.4, workers will anticipate a 4% increase in the

PE

future price level ( t 1 ). However, the other 6% increase in the price

level will be unanticipated. Once again, from the viewpoint of the

PE

workers, the actual and expected price levels are not equal: (i.e. t 1

> Pt).

The assumption that O < p' < 1 is referred to as a condition of

imperfect foresight. The imperfect foresight assumption is useful

when analysing the short to medium term impact of a change in

aggregate demand. This assumption will be used when constructing

the General Keynesian Aggregate Supply Curve (see below).

Case 3: p' = 1

The last case where p' is unity relates to a situation where workers

have completely adjusted expectations of the future price level for a

change in the actual price level. If the actual price level (Pt) increases

by 10%, workers fully anticipate a 10% increase in the future price

PE

level ( t 1 ). There is no unanticipated inflation, and the actual and

expected price levels are equal.

The assumption that p' equals unity is called perfect foresight, and is

most usefully applied when considering the long run consequences of

a disturbance to aggregate demand. This assumption will be used

when constructing the Classical Aggregate Supply Curve (see below).

Firms

For ease of exposition it is assumed that firms have perfect foresight

i.e. p' = 1. If a firm's actual product price changes it is immediately

aware of this, and, it is reasonable to suppose, the firm is able to fully

adjust its expectation of the future product price. Hence from the

perspective of firms their actual and expected prices are always equal

and they are clear about the ‘true value’ of the real wage they offer.

This assumption will greatly simplify the analysis which follows.

With these microfoundations it is possible to construct an aggregate

supply curve relevant to a number of different situations.

Activity 5

1. Why do workers form price expectations?

increase in the actual price level.

Price expectation % increase in expected price

level

Perfect foresight

Summary

r The aggregate demand and supply (AD/AS) model brings together the IS/LM

analysis of the demand side of the economy with the supply side analysis

based on the labour market and the aggregate production function to

show how the price level and output are simultaneously determined.

r The aggregate demand curve shows the combinations of the price level and

total output where the goods and asset markets are in equilibrium. It is

derived by varying the price level in the IS/LM model.

r Many variables are held constant when drawing an AD curve. Changes in any

of them will cause the AD curve to shift. Most important are changes in

fiscal and monetary policy

r The aggregate supply curve is based on the microeconomic foundations of the

production function, the labour market and price expectations. It shows

the combinations of the price level and total output where, for a given

state of technology, the aggregate labour market is in equilibrium.

r Labour supply depends on the expected real wage; i.e. the money wage

divided by the expected price level in the next period. Workers’

expectation of the future price level are related to changes in the actual

price level according to the coefficient of adjustment, p'.

r Three types of price expectation are possible. Complete money illusion (p' = 0)

where workers do not adjust their expected price level when the actual

price level changes; imperfect foresight (0 < p' < 1) where there is only a

partial adjustment; and perfect foresight (p' = 1) where workers'

expected price level is always equal to the actual price level.

Further Reading

Dornbusch & Fischer: Chapter 7

Burda & Wyplosz: Chapter 12.2

Branson: Chapter 7

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