Chapter06

CHAPTER 6 AGGREGATE SUPPLY: WAGES, PRICES, AND UNEMPLOYMENT Chapter Outline: · The aggregate supply curve and price adjustments · The old view of the Phillips curve · The inflationary-expectations-augmented Phillips curve · Stagflation · Rational expectations and the role of mistakes · Reasons for slow wage adjustment · The derivation of the AS-curve · Okun's law · Supply shocks and policy responses Changes from the Previous Edition: This chapter has been updated, reorganized and streamlined. Box 6-1 now contains Figure 1, showing a non-linear AS-curve, reflecting that there is a limit to how far GDP can be pushed past its potential value. Former Section 6-7 is now Section 6-3 and Section 6-4 dealing with rational expectations and the role of mistakes has been added. The mathematical equations used in the derivation of the AS-curve in former Section 6-4 (now 6-6) have been reworked, starting with the use of Okun's law. Section 6-5 on the effect of monetary expansion has been eliminated, while a paragraph on favorable supply shock has been added. Figure 6-13, which displays the drastic drop in prices for computers and software over the last decade, is new. Introduction of the Material: Chapter 6 develops a theory of aggregate supply in more detail. It begins by explaining the price adjustment over time so that the dynamic response of the economy to supply shocks or policy changes in the short, medium, and long run can be studied. Figure 6-1 explains the dynamic adjustment from the very short run (where the AS-curve is horizontal) to the long run (where the AS-curve is vertical). The Phillips curve, which shows an empirical inverse relationship between the unemployment rate and increases in the nominal wage rate, is introduced next. This relationship can be expanded into a relationship between inflation and unemployment, which implies that the Phillips curve and the AS-curve can be viewed as two alternative ways to study price adjustments in the economy. The old view of the Phillips curve suggested a clear policy trade-off between the rate of inflation and the unemployment rate. If this relationship held over time, then policy makers could always choose the most desirable combination of unemployment and inflation along this curve. The basis for the Phillips curve is the observation that wages adjust only slowly to changes in the unemployment rate. The data in 6-5 show that the Phillips curve is fairly flat in the short run. However, in periods of low unemployment the curve becomes much steeper. If one relates this to Figure 1 in Box 6-1, it becomes clear that the AS-curve and the Phillips curve are closely connected. A newer view on the Phillips-curve is introduced next. The inflation-expectations-augmented Phillips curve assumes that inflationary expectations are constant in the short-run (along the downward-sloping Phillips curve). But whenever inflationary expectations increase, then the short-run Phillips curve will shift to the right. The adjustment to expected inflation is a further element in the adjustment process from the short run to the long run. Output is at its full-employment level only if expected inflation is equal to actual inflation. This newer view of the Phillips curve can also be used to explain periods of stagflation, that is, high inflation in periods of high unemployment. Stagflation occurs when the economy moves to the right along a Phillips curve that includes a high component of expected inflation. Rational expectations theory is used to show the flaws in this newer view of the Phillips curve. The theory relies on the notion that the Phillips curve shifts up or down in response to available new information about the future. Robert Lucas, however, modified the theory of rational expectations by allowing for mistakes. The Lucas model predicts that monetary policy does not affect unemployment in the long run, but does affect the rate of inflation. Temporary deviations from the full-employment level of output are possible due to forecasting errors, but these deviations do not last very long, as people ultimately recognize their errors. Thus, the timing of the adjustment is consistent with the timing of the price adjustment discussed in Section 6-1. Even though economists widely agree that wages, employment, and output adjust only slowly to changes in aggregate demand, a number of competing theories exist, trying to explain the true reasons for the slow adjustment. The theory of aggregate supply is one of the least settled in macroeconomics, with competing schools of thought each offering their own explanations. Friedman and Phelps first argued that workers have imperfect information or money illusion in the short run and therefore labor markets cannot clear rapidly. In other words, workers do not immediately realize whether a change in their nominal wage is the result of an increase in prices or in the real wage they receive for work they provide. Their short-run behavior is thus based on nominal wages, and a higher level of wages is associated with a higher level of output. Lucas used a similar explanation in a rational expectations context, and his model will be discussed in more detail in Chapter 8. A second argument is that coordination problems exist, that is, different firms within an economy cannot coordinate price changes in response to monetary policy changes. Unsure about the behavior of competitors, individual firms change their prices only reluctantly. The efficiency wage theory, on the other hand, argues that employers pay above market-clearing wages to motivate their workers to work harder and that firms are reluctant to change wages because of the perceived cost involved. In addition, there are long-term relations between firms and workers, that is, wages are usually set in nominal terms and wage contracts are renegotiated only periodically. As prices change over time, real wages fluctuate over the length of the wage contract. The process of adjusting wages and prices continues until the economy eventually gets back to full employment, but during this process output adjusts only slowly to these changes. Finally, the so-called insider-outsider model argues that firms negotiate only with their employees and not with the unemployed. Since a turnover in the labor force is costly to firms, they are willing to offer above market-clearing wages to the currently employed rather than hiring the unemployed who may be willing to work for lower wages. It is important to realize that these various explanations are not mutually exclusive and all point in the same direction: in the short run the AS-curve is flat, while in the long run it is vertical. However, the most interesting price adjustments occur in the medium run, that is, when the AS-curve is upward sloping. Chapter 6 derives the upward-sloping AS-curve in four steps. First, Okun's law is used to show the connection between output and unemployment. Second, a price-cost relation that assumes that firms set prices as a mark-up on labor costs is introduced. Third, the Phillips curve relationship is used, which implies that changes in the rate of unemployment in one period will affect nominal wages in the subsequent period. Finally, the Phillips curve relationship is translated into a relationship between the price level and output. The incorporation of material prices in this analysis allows us to deal with supply shocks, such as a change in oil prices. An increase in material prices will shift the upward-sloping AS-curve to the left because each unit of output has become more expensive for the firm to produce. Supply shocks cause a simultaneous increase in the rate of inflation and unemployment, which poses a difficult problem for policy makers. They can accommodate supply shocks by expansionary demand-side policies, but this will accelerate inflation. On the other hand they can offset the price increase by implementing restrictive demand-side policies, but this will cause output to fall further. A favorable supply shock, such as the technological improvements made in the computer industry, shifts the upward-sloping AS-curve to the right, leading to lower prices combined with increased output. This is what the U.S. experienced in the late 1990s. Note that the analysis in the textbook is simplified by the assumption that a change in material prices does not affect the level of full-employment (potential) output. But even if the level of potential output were affected, the analysis would not change significantly. For example, if technological innovation also increases potential GDP, and therefore shifts the vertical AS-curve to the right, then the central bank should let money supply increase at a rate fast enough to shift the AD-curve in tandem with the AS-curve. This could ensure a period of high growth combined with stable and low inflation. Suggestions for Lecturing: A discussion of the old and new view of the Phillips curve serves to show students that economic theories undergo constant changes. Theories are adjusted as new evidence comes to light. Students should know that the idea of a permanent trade-off between inflation and unemployment must be wrong, since the long-run AS-curve is vertical. Thus, the role of price expectations has to be discussed and the inflation-expectations-augmented Phillips curve can be used to show the analogies between the Phillips curve and the AS-curve. The AS-curve shows a relationship between the price level and the level of output. The Phillips curve shows a relationship between the rate of inflation and the unemployment rate, given certain inflationary expectations. Okun’s law states that there is an inverse relationship between changes in the unemployment rate and changes in output, which explains why the AS-curve is upward sloping but the Phillips curve is downward sloping. The Phillips curve shifts whenever inflationary expectations change. If we assume that workers change their wage demands whenever inflationary expectations change, we can conclude that a shift in the Phillips curve corresponds to a shift in the AS-curve, since higher wages mean higher cost of production. Another way to describe the relationship between the Phillips curve and the AS-curve is to point out the following: A shift in the AD-curve (which can be seen as a movement along the upward sloping AS-curve to the new macroeconomic equilibrium) corresponds to a movement along the Phillips curve. However, a shift in the upward sloping AS-curve (due to a change in the cost of production) corresponds to a shift of the Phillips curve. A discussion of the Phillips curve should also include a discussion of stagflation, that is, the simultaneous occurrence of high inflation and high unemployment. The supply shocks of the 1970s disproved the simple Phillips curve relationship that predicted a trade-off between unemployment and inflation, and economists had to come up with an explanation of the simultaneous rise in unemployment and inflation. This was accomplished by incorporating inflationary expectations into the Phillips curve framework. Along the Phillips curve, inflationary expectations are constant. But when inflationary expectations change, the Phillips curve will shift. Inflationary expectations adjust over time to reflect recent levels of inflation, and when expected inflation is equal to actual inflation, the economy is at full employment. Therefore stagflation means that we are on a Phillips curve with high inflationary expectations to the right of the natural rate of unemployment. Unfortunately, even this inflation-expectations-augmented Phillips curve has its shortcomings, since it assumes that people are wrong in their inflation forecasts. But if people are rational, why doesn’t everyone adjust quickly to new expectations about the inflation rate? If people knew that in the long run monetary policy only affects inflation but not output or employment, wouldn’t we always stay at the full-employment level of output? Lucas argued that a good macroeconomic model should not be based on the assumption that people make easily avoidable mistakes. Therefore, a predictable change in monetary policy should have no effect on unemployment. However, empirical data show that even anticipated monetary policy has real effects on output and employment. Why is this not predicted by the rational expectations hypothesis? One possible answer is that wages and prices simply cannot adjust quickly. Instructors should spend time discussing the different reasons for the slow adjustment of wages that are provided in the text and ask students which explanation they find most convincing. This will create a very useful classroom discussion, and students will realize that these different explanations are by no means mutually exclusive. After such a discussion, it may nonetheless be useful to let students pick one reason for the stickiness of wages (such as the existence of wage contracts) to use in any further analysis of the effects of policy changes. This will avoid the need to repeatedly discuss competing theories for the slow wage adjustment. It should also be pointed out that, even though the theory of aggregate supply is by no means settled, all economists agree that wages do indeed adjust only slowly to any change in aggregate demand. Therefore the framework that employs a vertical long-run AS-curve but an upward sloping medium-run AS-curve is still very useful. Whenever students have to analyze the effects of a disturbance or policy change, they should always ask themselves the following two questions: · Which curve is affected, the AD-curve or the AS-curve? · Will the disturbance lead to an increase or decrease in output (national income)? The answers will be of great help in assessing whether their analysis is correct. A simple rule will help to provide an answer to the first question: If the cost of production is affected, then the AS-curve will shift; all other disturbances will shift the AD-curve. (Exceptions to this rule are supply-side policies, which will be discussed elsewhere.) The answer to the second question will tell students whether the AD-curve or the AS-curve will shift to the right or left. Two more points should be kept in mind in such an analysis. First, after an initial equilibrium has been established at the intersection of the AD-curve with the upward sloping AS-curve, the long-run adjustment will always involve an adjustment of wages, that is, a change in the cost of production. This adjustment will take place through continuous shifts of the upward sloping AS-curve towards the full-employment level of output (the long-run vertical AS-curve) at Y*. Second, the long-run outcome is always equal to the outcome of the classical case, since wages are assumed to be completely flexible in the long run. Most students shy away from the mathematical derivations presented in this chapter. They prefer not having to go through all of the steps that are needed to derive Equation (10). Although the mathematical derivation of this equation, which describes the upward-sloping aggregate supply curve, is not extremely difficult, instructors may choose not to devote class time to it, leaving it up to the more motivated students to do it on their own. But instructors should give students at least a heuristic explanation of the reasons for an upward-sloping aggregate supply curve, which assumes less than fully flexible wages. A positive price-output relationship implies that firms are willing to supply more output as prices go up. Increased output implies reduced unemployment (Okun’s law) and therefore increased labor costs. This means that the cost of production will increase, shifting the upward-sloping AS-curve to the left. This adjustment process stops when a new long-run equilibrium is reached at the full-employment level of output. It is also important to clearly state the following properties of the aggregate supply curve: · The AS-curve becomes steeper as wages adjust to changes in unemployment more rapidly; if wages become completely flexible, the AS-curve becomes vertical. · The position of the upward-sloping AS-curve depends on the price level that existed in the previous time period. · As long as output is above (below) the full-employment level there will be upward (downward) pressure on wages and prices and the upward-sloping AS-curve will begin shifting to the left (right). · After a demand-side disturbance, the adjustment to a new long-run macro-equilibrium is achieved through a series of shifts in the upward-sloping AS-curve up to the point at which the new AD-curve intersects the vertical AS-curve at the full-employment level of output. · A negative (positive) supply shock will shift the upward-sloping AS-curve temporarily to the left (right). But if there is no policy response to it, then the long-run adjustment will eventually get us back to the original position (assuming that potential output is not affected). Since the theory of aggregate supply is one of the most controversial in macroeconomics, instructors may find it worthwhile to spend extra time presenting the material. Mastery of the key concepts in this chapter will make the material in the following chapters easier to comprehend. Assigning exercises in which the effects of policy changes or supply shocks have to be analyzed is a good way to help students understand the material. Additional Readings: Akerlof, G. and Yellen, J., “A Near-Rational Model of the Business Cycle, with Wage and Price Inertia,” Quarterly Journal of Economics, Supplement, 1985. Blanchard, O. and Katz, L., “What We Know and Do Not Know About the Natural Rate of Unemployment,” Journal of Economic Perspectives, Winter, 1997. Blinder, A. and Choi, D., “A Shred of Evidence on Theories of Wage Stickiness,” Quarterly Journal of Economics, November, 1990. Bridgman, B. and Trehan, B., “What Do Wages Tell Us about Future Inflation?” Economic Letter, FRB of San Francisco, January 19, 1996. Chang, Roberto, “Is Low Unemployment Inflationary?” Economic Review, FRB of Atlanta, First Quarter, 1997. The Economist, “Why Wages Do Not Fall in Recessions,” February 26, 2000. Espinosa-Vega, M. and Russell, S., “History and Theory of the NAIRU: A Critical Review,” Economic Review, FRB of Atlanta, Second Quarter, 1997. Fox, Justin, “What in the World Happened to Economics,” Fortune, March 15, 1999. Friedman, Milton, “The Role of Monetary Policy,” American Economic Review, March, 1968. Galbraith, James, “Time to Ditch the NAIRU,” Journal of Economic Perspectives, Winter, 1997. Koenig, Evan, “Is the Fed Slave to a Defunct Economist?” Southwest Economy, FRB of Dallas, September/October, 1997 Lindbeck, Assar, “Macroeconomic Theory and the Labor Market,” European Economic Review, vol. 36, 1992. Lucas, Robert, E., “Some International Evidence on Output-Inflation Tradeoffs,” American Economic Review, June, 1973. Phelps, Edmund, “A Review of Unemployment,” Journal of Economic Literature, September, 1992. Phelps, Edmund, “Phillips Curves, Expectations of Inflation, and Optimal Unemployment Over Time,” Economica, March, 1967. Phillips, A.W., “The Relation between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861-1957,” Economica, November, 1958. Stevenson, Richard, “Joblessness Is Down. Prices Aren’t Up. Go Figure,” The New York Times, April 11, 1999. Stiglitz, Joseph, “Reflections on the Natural Rate Hypothesis,” Journal of Economic Perspectives, Winter, 1997. Taylor, John, “Aggregate Dynamics and Staggered Contracts,” Journal of Political Economy, February, 1980. Walsh, Carl, “Nobel Views on Inflation and Unemployment,” Weekly Letter, FRB of San Francisco, January 10, 1997. Learning Objectives: · Students should be able to explain why the AS-curve is positively sloped when wages are not fully flexible and vertical in the long run. · Students should be able to explain the concept of the natural rate of unemployment. · Students should understand the implications of the inflation-expectations-augmented Phillips curve. · Students should be able to explain the concept of stagflation. · Students should be able to discuss Lucas’ critique of the inflation-expectations-augmented Phillips curve and be able explain how rational expectations can be modified to allow for the role of mistakes. · Students should be able to explain the reasons for wage rigidity in the short run and know what such rigidity implies for stabilization policy. · Students should be able to explain the short-run and long run adjustment process following an economic disturbance. · Students should be able to explain the four steps used to derive the aggregate supply curve. · Students should be able to state the effects of adverse and favorable supply shocks and suggest appropriate policy responses. Solutions to the Problems in the Textbook: Conceptual Problems: 1. The aggregate supply curve and the Phillips curve describe very similar relationships and both curves can be used to analyze the same phenomena. The AS-curve shows a relationship between the price level and the level of output. The Phillips curve shows a relationship between the rate of inflation and the unemployment rate, given certain inflationary expectations. For example, a movement along the AS-curve depicts an increase in the price level that is associated with an increase in the level of output. As output increases, the rate of unemployment decreases (see Okun’s law). Therefore, with a larger increase in the price level (a higher level of inflation) there will be a decrease in unemployment, creating a downward-sloping Phillips curve. This downward sloping Phillips curve shifts whenever inflationary expectations change. If one assumes that workers will change their wage demands whenever their inflationary expectations change, one can conclude that a shift in the Phillips curve corresponds to a shift in the upward sloping AS-curve, since higher wages mean higher cost of production. 2. In the short run, when wages and prices are assumed to be fixed, there can be no inflation and thus the Phillips curve makes no sense over this very brief time frame. But in the medium run (in this chapter also often referred to as the short run), the Phillips curve is downward sloping as inflationary expectations are assumed to be constant. In the long run, the Phillips curve is vertical at the natural rate of unemployment, which corresponds to the vertical long-run AS-curve at the full-employment level of output. 3. A variety of explanations are given in this chapter for the stickiness of wages in the short or intermediate run. One is that workers have imperfect information and nobody knows the actual price level. People don’t know whether a change in their nominal wage is the result of an increase in prices or in the real wage they receive for the work they provide. Due to this uncertainty, labor markets will not clear immediately. Another argument relies on coordination problems, that is, different firms within an economy cannot coordinate price changes in response to monetary policy changes. Individual firms change their prices only reluctantly, since they are afraid of losing market share. The efficiency wage theory argues that employers pay above market-clearing wages to motivate their workers to work harder. Firms are also reluctant to change wages because of the perceived menu costs involved. There are long-term relations between firms and workers and wages are usually set in nominal terms by wage contracts, which are renegotiated only periodically. Thus real wages fluctuate over time as the price level changes. Finally, the insider-outsider model argues that firms negotiate only with their own employees but not with unemployed workers. Since a turnover in the labor force is costly to firms, they are willing to offer above market-clearing wages to the currently employed rather than hiring the unemployed who may be willing to work for lower wages. These different views are not necessarily mutually exclusive and it is up to students to decide which of the arguments presented here they find most plausible. The explanations differ mainly in their assumption of how fast markets clear and whether employment variations are voluntary. 4.a. Stagflation is defined as a period of high unemployment accompanied by high inflation. 4.b. Stagflation can occur in time periods when people have high inflationary expectations. If the economy goes into a recession, the actual rate of inflation will fall below the expected rate of inflation. However, the actual inflation rate may still be very high while the rate of unemployment is increasing. For example, the Fed may have let money supply grow much too fast in the past, so everyone expects a high inflation rate. If a supply shock occurs, we will see an increase in the rate of unemployment while inflationary expectations and actual inflation remain very high. This scenario occurred during the 1970s. Once we have reached such a situation, it becomes necessary to design policies that will reduce inflationary expectations to shift the Phillips curve back to the left. 5. Assume a disturbance occurs and the AD-curve shifts to the right. Unemployment decreases and inflation increases, and we move along the downward sloping Phillips curve to the left. However, as soon as people realize that actual inflation is higher than their inflationary expectations, they adjust their inflationary expectations upward and the downward-sloping Phillips curve shifts to the right, eventually returning unemployment back to its natural rate. In other words, the economy adjusts back at the full-employment level of income. If an adverse supply shock occurs (the upward-sloping AS-curve shifts to the left), unemployment and inflation increase simultaneously. This will correspond to a shift of the downward-sloping Phillips curve to the right. However, when people realize that actual inflation is less than expected inflation, then the downward-sloping Phillips curve starts to shift back and the economy adjusts back to the natural rate of unemployment in the long run. 6. The expectations-augmented Phillips curve predicts that inflation will rise above the expected level when unemployment drops below its natural rate. However, if people know that this is going to happen, why don’t they immediately adjust to it? And if people immediately adjusted to it, wouldn’t this imply that anticipated monetary policy would be ineffective to cause any deviation from the full-employment level of output? In reality, however, even if people have rational expectations, they may not be able to adjust immediately. One reason is that wage contracts often set wages for an extended time period. Similarly, prices cannot always be changed right away and the costs of changing prices may outweigh the benefits. A further argument is that even rational people make forecasting mistakes and learn only slowly. In other words, the location of the expectations-augmented Phillips curve is determined by the level of expected inflation, which is set by recent historical experience. A shift in this curve caused by changing inflationary expectations occurs only gradually. The rational expectations model, on the other hand, assumes that the Phillips curve shifts almost instantaneously as new information about the near future becomes available. Technical Problems: 1. A reduction in the supply of money leads to excess demand for money and increased interest rates, reducing the level of private spending (especially investment). Therefore the AD-curve shifts to the left. This causes an excess supply of goods and services at the original price level so the price level starts to decrease. Since the AS-curve is upward sloping, a new short-run macro-equilibrium is reached at a lower level of output (and thus a higher level of unemployment) and a lower price level. P AD1 AS1 AS2 AD2 P1 1 P2 2 P2 3 0 Y1 Y* Y However, the higher level of unemployment eventually puts downward pressure on wages, reducing the cost of production and shifting the upward-sloping AS-curve to the right. Alternatively, since this equilibrium output level is below the full-employment level, prices will continue to fall, and the upward-sloping AS-curve will shift to the right. As long as output is below the full-employment level Y*, the upward-sloping AS-curve will continue to shift to the right, which means that the price level will continue to decline. Eventually a new long-run equilibrium will be reached at the full-employment level of output (Y*) and a lower price level. 2. According to the rational expectations theory, an announced change in monetary policy would immediately change people’s perception in regard to the expected inflation rate. If people could adjust immediately to this change in inflationary expectations, then the rate of unemployment or the output level would remain the same. In other words, we would immediately move from point 1 to point 3 in the diagram used to explain the previous question and the Fed would be unable to affect the unemployment rate. In reality, however, even if people have rational expectations and can anticipate the effects of a policy change correctly, they may not be able to immediately adjust due to wage contracts, etc. Thus, there will always be some deviation from the full-employment output level Y*. 3.a. A favorable supply shock, such as a decline in material prices, shifts the upward-sloping AS-curve to the right, leading to excess supply at the existing price level. A new short-run equilibrium is reached at a higher level of output and a lower price level. But since output is now above the full-employment level Y*, there is upward pressure on wages and prices and the upward-sloping AS-curve shifts back to the right. A new long-run equilibrium is reached back at the original position (Y*), and the original price level (assuming that the change in material prices did not affect the full-employment level of output). Since nominal wages (W) will have risen but the price level (P) will not have changed, real wages (W/P) will have increased. P AD AS1 AS2 P1 P2 0 Y* Y1 Y 3.b. Lower material prices lower the cost of production, shifting the upward-sloping AS-curve shifts to the right, and leading to an increase in output and a lower price level. Since unemployment is now below its natural rate, there is a shortage of labor, providing upward pressure on wages. This will increase the cost of production again, eventually shifting the upward-sloping AS-curve back to the original long-run equilibrium (assuming that potential GDP has not been affected). Additional Problems: 1. Explain the long-run effect of an increase in nominal money supply on the amount of real money balances available in the economy. In the very short run, the price level is fixed, so if nominal money supply (M) increases, a higher level of real money balances is available, causing interest rates to fall and the level of investment spending to increase. This leads to an increase in aggregate demand. The shift to the right of the AD-curve causes the price level (P) to increase, leading to a reduction in real money balances (M/P). In the medium run (an upward-sloping AS-curve), we reach a new equilibrium at a higher output level and a higher price level. Since prices have gone up proportionally less than nominal money supply, real money balances have increased. However, to reach a new long-run equilibrium, prices have to increase further, and as a result, the level of real money balances will decrease further. When the new long-run equilibrium at Y* is finally reached, the price level will have fallen proportionally to nominal money supply and the level of real money balances will be back at its original level. 2. Assume the economy is in a recession. Describe an adjustment process that will ensure that the economy eventually will return to full employment. How can the government speed up this process? If the economy is in a recession, there will be downward pressure on wages and prices, which will bring the economy back to the full-employment output level. The upward-sloping AS-curve will shift to the right due to lower production costs. However, this process may take a fairly long time. The government can shorten this adjustment process with the help of expansionary fiscal or monetary policies to stimulate aggregate demand. The resulting shift to the right of the AD-curve implies that the final long-run equilibrium will be at a higher price level. In other words, the reduction in unemployment can only be achieved at the cost of higher inflation. 3. "The stickiness of wages implies that policy makers can achieve low unemployment only if they are willing to put up with high inflation." Comment on this statement. There are several explanations of why wages and prices adjust only slowly. One is that workers have imperfect information, so they do not realize that lower prices mean higher real wages. Another is that firms are reluctant to change prices and wages since they are unsure about the behavior of their competitors and want to avoid the perceived cost of making these changes. Finally, wage contracts tend to be long-term and staggered, so it takes time to adjust wages to price changes. Some firms may pay their workers above market-clearing wages to keep them happy and productive. For these reasons, wages and prices tend to be rigid in the short run. Thus it takes time for the economy to adjust back to full-employment. If there were a stable Phillips-curve relationship, a low rate of unemployment could only be achieved by allowing inflation to increase. However, such a stable relationship does not exist. Wages tend to be rigid in the short run, so expansionary policies lower unemployment and increase inflation in the short run. In the long run, however, the economy will adjust back to the natural rate of unemployment, so expansionary policies simply lead to a higher price level. 4. "If we assume that people have rational expectations, then fiscal policy is always irrelevant. But monetary policy can still be used to affect the rate of inflation and unemployment." Comment on this statement. Individuals and firms with rational expectations consistently make optimal decisions based on all information available. As long as a policy change is anticipated, people are able to assess its long‑run outcome and will try to immediately adjust. Since fiscal policy doesn't affect inflation or unemployment in the long run, it is also ineffective in the short run if wages and prices are assumed to be flexible. An anticipated change in monetary growth, on the other hand, will be reflected in a change in the inflation rate. If wages are flexible, workers will adjust their wage demands immediately and no significant change in the unemployment rate will occur. However, even if people have rational expectations, wages tend to be fairly rigid in the short run due to wage contracts. Therefore, it will take time for the economy to adjust back to a long-run equilibrium. This implies that both fiscal and monetary policy can affect the rate of inflation and unemployment to some degree in the short run. 5. "Inflation cannot accelerate in a recession, when the rate of unemployment is above its natural rate." Comment on this statement. Inflation can accelerate even in a recession, that is, when the unemployment is high, if a supply shock occurs. An oil price increase will increase the cost of production, so the upward-sloping AS-curve will shift to the left. This will increase the inflation rate and the rate of unemployment simultaneously, as firms increase their product prices and cut their production. If the Fed tries to accommodate the supply shock with expansionary monetary policy in an effort to stimulate the economy, then inflation will accelerate even more, as the AD-curve shifts to the right. 6. Comment on the following statement: "The coordination approach to the Phillips curve focuses on the problems that the administration has in coordinating its fiscal policies with the monetary policies of the Fed." The coordination approach has nothing to do with fiscal or monetary policy but is simply one explanation of why wages adjust slowly. This view asserts that firms generally are unable to coordinate wage and price changes in response to a monetary policy change. For example, any firm that cuts workers' wages in response to monetary contraction while other firms don't, will anger its employees who may then choose to leave. Firms are also reluctant to change their prices since they are unsure about their competitors' behavior. Thus wages and prices change only slowly in response to a change in aggregate demand. This implies an upward-sloping (short-run) AS-curve. 7. Comment on the following statement: "The unemployment rate is zero at the full-employment level of output." With a higher price level real wages decline, increasing the quantity of labor demanded. Therefore the nominal wage rate is bid up until the real wage rate is restored to its unique equilibrium level. Similarly, if prices fall, real wages increase, leading to unemployment. The nominal wage rate falls to bring the real wage rate back to its equilibrium level. So the nominal wage rate changes in proportion to the price level to maintain a real wage rate that clears the labor market. At this wage rate, the full-employment level of output is produced. However, at the full-employment output level the unemployment rate is not zero. Due to frictions in the labor market, there is always a positive unemployment rate, as workers switch between jobs. This is called the natural rate of unemployment. 8. Briefly state the reason for the slow adjustment of wages to changes in aggregate demand. The reasons for the slow adjustment of nominal wages can be explained in several ways. One explanation is that workers have imperfect information, that is, they do not immediately realize whether a change in their nominal wage is the result of an increase in prices or in the real wage they receive for the work they provide. Another explanation is that coordination problems exist, that is, different firms within an economy are unsure about the behavior of their competitors and thus they only reluctantly change wages or prices. The efficiency wage theory, on the other hand, argues that firms pay above market-clearing wages to motivate their workers to work harder. Firms are also reluctant to change wages due to the perceived cost of doing so. Another argument is that wage contracts tend to be long-term, so real wages tend to fluctuate over the length of the contract and output adjusts only slowly to price changes. Finally, the insider-outsider model argues that firms negotiate only with their employees but not the unemployed. Since a turnover of the labor force is costly to firms, they are willing to offer above market-clearing wages to the currently employed rather than hiring the unemployed who may be willing to work for less. These various explanations are not mutually exclusive, and they all imply that the AS-curve is positively sloped, that is, that a change in aggregate demand will affect both output and prices in the short run. 9. True or false? Why? "There is no frictional unemployment at the natural rate of unemployment." False. The natural rate of unemployment is the rate at which the labor market is in equilibrium. But there is always some unemployment due to new entrants into the labor force, people between jobs, and the like. This rate of unemployment is considered normal, due to frictions in the labor market, and is often called frictional unemployment. 10. "If everyone in this economy had rational expectations, then wages would be flexible and unemployment could not occur." Comment on this statement. The new Keynesian models argue that even if people have rational expectations, socially undesirable outcomes may still occur due to imperfect competition and the existence of wage contracts. Prices may not change freely, since firms in imperfectly competitive markets are reluctant to change them, due to the menu costs involved. Nominal wages are set by contracts over a period of time, so the economy may adjust only slowly to a decrease in aggregate demand. Thus a rate of unemployment higher than the natural rate can exist over an extended period of time. 11. True or false? Why? "If nominal wages were more flexible, expansionary policies would be more effective in reducing the rate of unemployment." False. In Chapter 5 we learned that in the classical case (where nominal wages are completely flexible) the AS-curve is vertical, whereas in the Keynesian case (where wages do not change, even if unemployment persists) the AS-curve is horizontal. From this we can conclude that more flexible nominal wages imply a steeper upward-sloping AS-curve. Any type of expansionary demand-side policy will shift the AD-curve to the right and this will cause the level of output and prices to increase (at least in the short-run). A steeper upward-sloping AS-curve results in a larger price increase and a smaller increase in output. But a smaller increase in the level of output results in a smaller reduction in unemployment. In either case, the economy will settle back at the full-employment level of output in the long run. In the long run, the rate of unemployment always goes back to its natural level. 12. Explain the short-run and long-run effects of expansionary an increase in the level of government spending on output, unemployment, interest rates, prices, and real money balances. An increase in government spending increases aggregate demand, shifting the AD-curve to the right. Because there is excess demand, the price level increases, which reduces the level of real money balances. Therefore interest rates increase, leading to some crowding out of investment. Due to this real balance effect, the increase in output is less than the shift in the AD-curve. Assuming an upward-sloping AS-curve, a new equilibrium is reached at a higher price level, a higher level of output, a lower unemployment rate and a higher interest rate. Since output is now above the full-employment level, wages and prices will continue to rise and the upward-sloping AS-curve will start shifting to the left. This process will continue until a new long-run equilibrium is reached at the full-employment level of income Y*, that is, until unemployment is back at its natural rate. At this point the price level, nominal wages, and interest rates will be higher than previously and real money balances will be lower. 13. Briefly explain why there seems to be so much interest in finding ways to shift the upward-sloping aggregate supply curve to the right. Shifting the upward-sloping AS-curve to the right seems to be the only way to offset the effects of an adverse supply shock without any negative side effects. An adverse supply shock, such as an increase in oil prices, causes a simultaneous increase in unemployment and inflation, and policy makers have only two options for demand-management policies. Expansionary fiscal or monetary policy will help to achieve full employment faster but will raise the price level, while restrictive fiscal or monetary policy will reduce inflationary pressure but increase unemployment. Therefore, any policy that would shift the upward sloping AS-curve back to the right seems preferable, since it might bring the economy back to the original equilibrium by simultaneously lowering inflation and unemployment. 14. Use an AD-AS framework to show the effect of monetary restriction on the level of output, prices and the interest rate in the medium and the long run. A decrease in nominal money supply will increase interest rates, leading to a decrease in investment spending. This will shift the AD-curve to the left, creating an excess supply of goods and services. Therefore price level will decrease and real money balances will increase. A new equilibrium will be achieved at the intersection of the new AD-curve and the upward-sloping AS-curve at an output level that is below the full-employment level. In the long run, higher unemployment will cause downward pressure on wages. As the cost of production decreases, the upward-sloping AS-curve will keep shifting to the right until a new long-run equilibrium is established at the full-employment level of output, that is, where the new AD-curve intersects the long-run vertical AS-curve at Y*. At this point, real output, the real interest rate, real money balances, and the real wage rate will be back at their original level. Nominal money supply, the price level and the nominal wage rate will all have decreased proportionally. A simplified adjustment can be shown as follows: 1-->2: Ms down ==> i up ==> I down ==> Y down ==> the AD-curve shifts left ==> excess supply ==> P down ==> real ms up ==> i down ==> I up ==> Y up (The first line describes a policy change, that is, a shift in the AD-curve; the second line describes the price adjustment, that is, a movement along the AD-curve.) Short-run effect: Y down, i up, P down 2-->3: Since Y < Y* ==> downwards pressure on nominal wages ==> cost of production down ==> the short run AS-curve shifts right ==> excess supply of goods ==> P down ==> real ms up ==> i down ==> I up ==> Y up (This process continues until Y = Y*) Long-run effect: Y stays at Y*, i remains the same, P up. Note: Even though only one shift of the short-run AS-curve to the new long-run equilibrium is shown here, this shift is actually a combination of many shifts. P AD1 AS1 AD2 AS2 P1 P2 P3 0 Y2 Y* Y 15. Briefly discuss the importance of Okun’s law in evaluating the cost of unemployment. Okun’s law states that a reduction in the unemployment rate of 1 percent will increase the level of output by about 2 percent. This relationship allows us to measure the cost to society (in terms of lost production) of a given rate of unemployment. 16. True or false? Why? "If monetary policy accommodates an adverse supply shock, it will worsen any inflationary effects." True. An adverse supply shock shifts the upward-sloping AS-curve to the left. There is excess demand for goods and services at the original price level and prices start to rise, leading to lower real money balances, higher interest rates, and lower output. If no policy is implemented, then unemployment will force the nominal wage down to restore equilibrium at the original position. If the government views this adjustment process as too slow, it can respond by implementing expansionary policies. Accommodating the supply shock in this way shifts the AD-curve to the right and a new equilibrium can be reached at full-employment but at a higher price level. It is unlikely, though, that the economy will remain there for long since workers will realize that their purchasing power has been diminished by higher prices and will demand a wage increase. If they are successful, the cost of production will increase and the upward-sloping AS-curve will shift to the left again. In other words, we will enter a wage-price spiral. P AD2 AS2 AD1 AS1 P3 P2 P1 0 Y2 Y* Y 17. Assume oil prices decline. What kind of monetary policy should the Fed undertake if its goal is to stabilize the level of output while keeping inflation low? Show with the help of an AD-AS diagram and briefly explain the adjustment process. 1-->2: As oil prices decline, the cost of production decreases and the upward-sloping AS-curve shifts to the right, causing excess supply of goods. Thus the price level decreases, real money balances increase, and the interest rate declines. 2-->3: A decrease in money supply will increase the interest rate, decrease private spending, and shift the AD-curve to the left. This means that prices will decrease even further and the level of output will decline. (We assume, for simplicity, that it goes back to the full-employment level Y*, so no long-run adjustment is needed.) Overall, the level of output has remained at its full-employment level but the level of prices and the interest rate have decreased. P AD1 AS1 AD2 AS2 P1 1 P2 2 3 0 Y* Y2 Y 18. Comment on the following statement: "A favorable oil shock causes lower inflation and lower unemployment." A decrease in material prices (or any other favorable supply shock) shifts the upward-sloping AS-curve to the right, and prices begin to decrease. The new equilibrium is at a lower price level and a higher level of output (a lower level of unemployment). Since output is now above the full-employment level, there will be upward pressure on nominal wages and prices, and the upward-sloping AS-curve will start shifting back to its original position (assuming that potential output was not affected). In the long run, unemployment will be back at its natural rate but the price level will have decreased (and thus real wages increased). 19. “Falling oil prices will lead to increased employment, higher wage rates and increased real money balances.” Comment on this statement with the help of an AD-AS diagram and explain the short-run and long-run adjustment processes. A decline in material prices shifts the upward-sloping AS-curve to the right, leading to excess supply at the existing price level. A new equilibrium is reached at a higher level of output and a lower price level. But since output is now above the full-employment level Y*, there is upward pressure on wages and prices and the upward-sloping AS-curve starts shifting back to the right. A new long-run equilibrium is reached back at the original position (Y*), and the original price level (assuming that the change in material prices did not affect the full-employment level of output). Since nominal wages (W) will have risen but the price level (P) will not have changed, real wages (W/P) will have increased. P AD1 AS1 AS2 P1 P2 0 Y* Y2 Y PAGE 69