Aggregate Supply. A Nonvertical AS Curve. implications for unemployment, rms pricing behavior, the real wage and the markup

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1 A Nonvertical AS Curve nominal wage rigidity nominal price rigidity labor and goods markets implications for unemployment, rms pricing behavior, the real wage and the markup

2 Case 1: Sticky W, Flexible P and Competitive Goods Market Wage is completely xed: W = W Firms are competitive: F 0 (L) = W P Labor is the only variable input in the short run: Y = F (L), F 0 () > 0, F 00 () < 0

3 Case 1: Sticky W, Flexible P and Competitive Goods Market An upward-sloping AS curve. Shifts in AD changes output lead to changes in in ation and output.

4 Case 1: Sticky W, Flexible P and Competitive Goods Market There is unemployment. a countercyclical real wage in response to AD shocks.

5 Case 2: Flexible W, Sticky P and a Competitive Labor Market P = P (π = π) imperfect competition in the goods market P W F 0 (L) A horizontal AS

6 Case 2: Flexible W, Sticky P and a Competitive Labor Market Labor Market: P W F 0 (L)

7 Case 2: Flexible W, Sticky P and a Competitive Labor Market a procyclical real wage in the face of demand uctuation no unemployment. (It shows that there is no necessary connection between nominal rigidity and unemployment.) a countercyclical markup a shock to AD

8 Case 3: Flexible W, Sticky P and Labor Market Imperfections AS curve is at. (Same as Case 2)

9 Case 3: Flexible W, Sticky P and Labor Market Imperfections Labor Market: Assume that rms have some "real-wage function", W P = w(l), w 0 () > 0 There is unemployment. If the real-wage function is atter than the labor supply, unemployment rises when demand falls a procyclical real wage in the face of demand uctuation a countercyclical markup

10 Case 3: Flexible W, Sticky P and Labor Market Imperfections

11 Case 4: Sticky W, Flexible P and Goods Market Imperfections W = W P = µ(l) W F 0 (L)

12 Case 4: Sticky W, Flexible P and Goods Market Imperfections If µ is constant AS curve slopes up There might be unemployment The real wage is countercyclical

13 Case 4: Sticky W, Flexible P and Goods Market Imperfections If µ(l) is as countercyclical as F 0 (L) AS is horizontal. The real wage is acyclical. If µ(l) is more countercyclical than F 0 (L) AS is downward-sloping The real wage is procyclical. Unemployment

14 Conclusions There are di erent assumptions Keynesian theories do not make strong predictions about the behavior of these variables The behavior of these variables can be used to test speci c Keynesian models The absence of a countercyclical real wage, appears to be strong evidence against the view that uctuations are driven by changes in aggregate demand and that Keynes s original model provides a good description of aggregate supply

15 The Phillips Curve Phillips Curve: Phillips (1958): a strong and relatively stable negative relationship between unemployment and in ation UK in the 19th century, USA (until late 1960s)

16 The Phillips Curve: A model rigid wages, exible prices and competitive goods market (Case 1 in section 5.3) Modi cation: W t = AP t 1, A > 0 Y t = F (L t ), F 0 (L t ) = W t P t The two bullets above imply that F 0 (L t ) = AP t P t 1 = A 1+π t

17 Failure of the Phillips Curve: Empirical Side

18 Failure of the Phillips Curve: Empirical Side Sources of empirical failure: disturbances to AS rather than AD (eg. oil shocks in and ) The high in ation of the 1970s changed how prices and wages were set. That caused both high in ation and unemployment in 1981 and 1982.

19 Failure of the Phillips Curve: Theoretical Side Natural Rate Hypothesis of Friedman (1968) and Phelps (1968): In the long run, the behavior of real variables is determined by real forces, not by nominal variables, such as the money supply or in ation. There is some "normal" or "natural" rate of unemployment. It is determined by real forces. Hence, there is no unemployment-in ation trade-o. A shift by policymakers to permanently expansionary policy would, sooner or later, change the way that prices or wages are set. No unemployment-in ation trade-o

20 Failure of the Phillips Curve: Theoretical Side A shift by policymakers to permanently expansionary policy: Without Natural Rate Hypothesis: price increases! real wage decreases! lower level of unemployment With Natural Rate Hypothesis: price increases! real wage decreases! lower level of unemployment. But the real wage, sooner or later, will be set to account for the expansionary policies undertaken. Then, unemployment rate will go back to the "natural" rate.

21 Failure of the Phillips Curve: Theoretical Side A shift by policymakers to permanently expansionary policy: With Natural Rate Hypothesis: price increases! real wage decreases! lower level of unemployment Without Natural Rate Hypothesis: price increases! real wage decreases! lower level of unemployment. But the real wage, sooner or later, will be set to account for the expansionary policies undertaken. Then, unemployment rate will go back to the "natural" rate.

22 The Expectations-Augmented Phillips Curve This version of Phillips curve consists of several crucial parts: "natural" rate of output from the Natural Rate Hypothesis supply shocks complicated adjustment to past and expected future in ation

23 The Expectations-Augmented Phillips Curve "natural" rate of output In the long run, wages and prices are exible. Long-run aggregate supply (or LRAS) curve is vertical. The natural rate of output (or potential or full-employment output) denoted as Y, is determined by the LRAS. In the short run, higher output is assumed to be associated with higher wages and prices.

24 The Expectations-Augmented Phillips Curve SRAS, π t = π t + λ ln Y t ln Y t + ε S t, λ > 0 π t is the core or underlying in ation. The version is called the expectations augmented Phillips curve.

25 The Expectations-Augmented Phillips Curve: Alternative Version 1 Alternative Version 1: (also known as the accelerationist Phillips curve) π t = π t 1 π t = π t 1 + λ ln Y t ln Y t + ε S t, λ > 0 There is only tradeo between output and the change in in ation. For in ation to fall, there must be a period when output is below the natural rate. For in ation to be held steady, we must have Y t = Y t.

26 The Expectations-Augmented Phillips Curve: Alternative Version 1 This version of Phillips Curve is much more successful at tting the macroeconomic history. Take the behavior of unemployment and in ation in the early 1980s for an example: High in ation and high unemployment in the early 1980s is due to: 1. In ation is high in the 1970s. That is to say, π t 1 is high. 2. contractionary shifts in AD

27 The Expectations-Augmented Phillips Curve: Alternative Version 1 Problem with this version of the Phillips Curve Staiger, Stock, and Watson (1997) Since the mid-1990s, in ation has failed to rise even though unemployment has been below the natural rate the Natural Rate Hypothesis

28 The Expectations-Augmented Phillips Curve: Alternative Version 2 π t = π e t + λ ln Y t ln Y t + ε S t

29 The Expectations-Augmented Phillips Curve: Alternative Version 3 π t = φπ e t + (1 φ) π t 1 + λ ln Y t ln Y t + ε S t, 0 φ 1 Allows for inertia in wage and price in ation. Allows for some link between past and future in ation beyond e ects operating through expectations.

30 Conclusions No AS models that are intended to hold generally. The models of AS largely fall into two groups. AS curve or nominal stickiness is built up from speci c assumptions about the microeconomic environment. models that are intended to be useful summaries of AS behavior in speci c situation