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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.
E
r0
E1
r1
IS0
Y0 Y1 Real GDP(Y)
Price
level
(P)
P0
P1
AD
Y0 Y1 Real GDP(Y)
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.)
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.
E
r0
IS1
IS0
Y0 Y1 Real GDP(Y)
Price
level
(P)
P0
AD1
AD0
Y0 Y1 Real GDP(Y)
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.
E
r0
r1
E1
IS0
Y0 Y1 Real GDP(Y)
Price
level
(P)
P0
AD1
AD0
Y0 Y1 Real GDP(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
)
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
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.)
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
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).
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?
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