Macroeconomics
Chamberlin and Yueh
Chapter 8
Lecture slides
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Aggregate Demand and Aggregate
Supply
• The aggregate demand schedule
• The aggregate supply schedule
– Long run aggregate supply
– Short run aggregate supply
• Equilibrium in the AD-AS Model
• Comparative statics in the AD-AS model
– Aggregate demand shocks
– Aggregate supply shocks
• Hysteresis and the Medium Run
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Learning Objectives
• Understand the relation between prices and aggregate
demand
• To determine the non-accelerating inflation rate of
unemployment (NAIRU) and the long run aggregate supply
for an economy
• To identify the factors that lead to shifts in the long run
aggregate supply curve
• To acknowledge that in the short run output can deviate
from its long run equilibrium level by moving along a short
run aggregate supply curve.
• Understanding the difference between adaptive and rational
expectations formation.
• Construct the AD-AS model and use it in comparative
statics exercises.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
AD-AS Model
• The Aggregate Demand and Aggregate Supply (AD-AS)
model simultaneously determines output and prices.
• This model simply aggregates across all goods and services,
in which case, we are determining the average price level
and the total level of output in the economy. The model is
useful to policy makers who have in recent decades become
increasingly concerned with how prices are determined, as
well as output.
• The AD-AS model shares many common features with the
IS-LM model, particularly the Neoclassical version, but is
more rigorous.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The aggregate demand schedule
• The AD schedule plots the relationship between the price
level and aggregate demand. Its construction comes
directly from the IS-LM model – all we have to do is think
about what happens to planned expenditures when prices
fall.
• When the IS-LM model is in equilibrium, planned
expenditures are equal to actual output, so all we need to do
is identify the effect of falling prices on the equilibrium
level of output.
• The combinations of prices and output can be plotted to
form the downward sloping Aggregate Demand (AD)
schedule.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The aggregate demand schedule
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The AD curve
• The AD curve just tells us what the level of aggregate
demand or planned expenditures is at each price level.
• Changes in the price level will relate to movements along
the curve.
• However, if aggregate demand were to change due to a
factor other than prices, the AD curve would shift. Shifts in
the AD curve result from anything that shifts the IS or LM
curve, other than a change in the price level.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Shifts in the AD curve
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The aggregate supply schedule
• The Aggregate Supply (AS) schedule plots the
relationship between the output of an economy and
the price level. In essence, it sums all the output
decisions by productive agents in the domestic
economy.
• An important distinction, though, exists between
aggregate supply in the short and the long run.
Output in the short run can deviate from its long
run level if markets are in disequilibrium for a
period of time because wages and prices adjust
slowly towards equilibrium values.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Long run aggregate supply
• In the long run, the supply decisions of firms are
independent of prices. Prices are considered to be a
nominal factor, whereas production decisions will be based
on real concerns. We will see that these might include
productivity, labour force participation, product market
conditions, or factors determining the bargaining power of
labour.
• Long run aggregate supply is fixed at the long run
equilibrium level of output, which in turn corresponds to the
level of output consistent with equilibrium in the labour
market. This level of output is often referred to as the
natural level of output.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Long run aggregate supply
• Establishing the equilibrium level of output
therefore requires us to investigate the equilibrium
in the labour market.
• More specifically, we will be concerned with the
equilibrium rate of unemployment, which is often
referred to as the non-accelerating inflation rate
of unemployment or the NAIRU. At this rate,
there is no pressure on wages to change. And, as
prices are simply a mark up on wage costs, it must
also be the case that there is no pressure on prices
to change either.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The equilibrium rate of unemployment
or NAIRU
• This refers to the rate of unemployment where the
labour market is in equilibrium.
• This equilibrium is considered to be the outcome of
bargaining between labour (sometimes organised
bodies, such as trade unions) and firms.
• Bargaining works by assuming that workers are
concerned with setting wages and firms with
setting prices.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The wage setting curve
• This schedule determines the nominal wage (W)
desired by labour, and can be written as:
W
 Z  u
e
P
• There are three factors which determine the wage
(W) that workers will push for:
– Pe are expectations of the price level. If workers
anticipate higher prices, then the purchasing power of
their wages will be reduced. Therefore, they would push
for higher nominal wages so as to maintain the value of
their real wages (purchasing power of wages).
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The wage setting curve
– u is the unemployment rate and exerts a negative force
on wage demands. The reserve army of the unemployed
are taken to be the surplus labour that is available to
employers. The larger this pool becomes, the more
moderate wage demands will be. Workers know that if
they push for too higher wages they may be substituted
for cheaper unemployed labour. Also, when
unemployment is high, workers anticipate that finding
new employment when unemployed will be much
trickier. This forms a powerful incentive to avoid
becoming unemployed in the first place by moderating
wage demands. The converse is also true. At low levels
of unemployment, workers would be more confident in
pushing for higher wages.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The wage setting curve
– Z is really a catch all variable which consists of a
number of items that may influence wage demands.
• The first are those factors which influence the bargaining power
of workers. Trade unions bargaining collectively or
employment laws giving rights to workers would be examples.
• The second consists of items which raise the opportunity cost of
working. For example, if unemployment benefits were
relatively generous, then the costs of unemployment would be
correspondingly lower which would lead to more ambitious
wage demands.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The wage setting curve
• For simplicity, it is assumed that workers form correct
expectations concerning the price level, then Pe=P. The
wage setting relationship can be expressed in terms of the
real wage:
W
w
 Z  u
P
• The bargained real wage falls as unemployment rises.
Changes in Z would lead to shifts in the entire function,
meaning that at each level of unemployment workers would
target a different real wage.
• The wage setting relationship is also known as the
bargained real wage (BRW), as it is the real wage that
unions demand in their bargaining with employers (firms).
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The wage setting curve
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Price-setting relationship
• Firms are simply assumed to set prices as a mark up on wage costs.
Although in the real world, firms will face other costs such as rents and
interest payments on capital, these can be ignored in this simple model:
W
P  1   
LP
• where μ is the mark up and LP is labour productivity.
• Costs are given by the ratio of wages (W) to labour productivity (LP).
Firm costs will rise if either wages rise, or labour productivity falls. If
both move in the same proportion, then costs will remain unchanged.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Price-setting relationship
• The mark up μ is largely determined by product market
conditions, which primarily refer to the degree of
competition in the market.
• Where markets are relatively competitive, the mark up
would be expected to be low, and under perfectly
competitive conditions it would be expected to be zero
(which means that firms set prices equal to marginal costs
and only make normal profits). When firms can exert
significant market power, the mark up would of course rise
and firms would take more of a profit margin on their sales.
One factor which might be crucial in determining the size of
the mark up could be the level of competition policy in
existence and how strongly it is enforced.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Price-setting relationship
• The price-setting relationship above can be
rearranged so it is also expressed in terms of the
real wage:
W
LP
w

P 1   
• The price setting function has been drawn as a
horizontal line indicating that price-setting is
independent of the level of unemployment. This
makes the model easier to use, but is in itself is a
debatable proposition. Some discussion justifying
this assumption is presented in Global Applications
8.1.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Price-setting relationship
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Price-setting relationship
• The price setting relationship is also known as the feasible
real wage (FRW), as it states the real wage that firms can
afford to pay workers given the productivity of labour and
product market conditions. If there is movement in either
of these two fields, then the feasible real wage will change
and the price-setting schedule will shift.
• An increase in labour productivity would increase the
feasible real wage and hence the price-setting schedule will
shift upwards.
• An increase in the mark up would lower the price-setting
schedule.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Equilibrium
• The equilibrium rate of unemployment or the
NAIRUû  is where the price-setting and wagesetting curves intersect. This is simply where the
bargained and feasible real wages are consistent
with one another.
• The dynamics of this model will always move
toward the equilibrium level of unemployment.
Any level of unemployment away from this would
induce changes in either or both wages and prices,
so that the real wage and unemployment are
restored to their equilibrium values.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Equilibrium
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
From the equilibrium rate of unemployment to equilibrium
level of output: Deriving the long run aggregate supply curve
(LRAS)
• The relationship between output and employment (N) is
given by a production function: Y=F(N).
• This simply defines the aggregate level of output for each
level of employment, but can also be written in terms of the
unemployment rate. The total labour force (L) consists of
employed (N) and unemployed workers (U): L=N+U.
• The unemployment rate is the proportion of the labour force
that is unemployed: u=U/L.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Deriving the LRAS
• Therefore, the proportion of the labour force that is
employed and unemployed should just add up to one:
1=N/L+U/L, 1=N/L+u.
• This can be rearranged to give employment as a function of
the unemployment rate: N/L=1-u, N=L(1-u).
• The level of employment is equal to the proportion of the
labour force (L) that is not unemployed. If the
unemployment rate is u, then this proportion will be equal
to 1-u.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Deriving the LRAS
• Finally, to find the equilibrium level of
output, all we need to do is substitute this
relationship between employment and
unemployment back into the production
function:
Yˆ  F L1  uˆ 
• Shifts in the long run aggregate supply
schedule will result from anything that acts
to alter the equilibrium level of output.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Deriving the LRAS
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
LRAS and NAIRU
• This should make it clear why the equilibrium level
of unemployment is referred to as the NAIRU.
• It is the rate of unemployment where there is no
pressure on prices to change.
• The equilibrium level of output, which then defines
the position of the long run aggregate supply curve,
is just the level of output at the NAIRU.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
LRAS
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Shifts in LRAS
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Shifts in LRAS
• These shifts in long run AS can come from four sources:
• Labour productivity, LP: As labour productivity improves,
the equilibrium rate of unemployment falls and equilibrium
employment and output both rise. As a result, the long run
AS schedule will shift to the right. As a consequence of
higher productivity, the price setting schedule shifts
upwards. The equilibrium rate of unemployment falls, the
equilibrium level of output rises, and the long run aggregate
supply curve shifts to the right.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Increase in labour productivity
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Shifts in LRAS
• μ: An increase in the mark up increases the natural rate of
unemployment and leads to a leftward shift in the aggregate
supply schedule. An increase in the mark up would produce
a downward shift in the price-setting curve and ultimately a
shift in the long run aggregate supply curve. When firms
increase their margins, they are increasing the average price
level in the economy. At higher prices, aggregate demand
will be lower, and therefore lower output and employment
is sustainable. (See above figure).
• Z: If the wage setting schedule shifts upwards because
unemployment benefits have risen, trade unions have
greater power, etc., the natural rate of unemployment rises
and the long run AS schedule will shift to the left.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Increase in trade union power
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Shifts in LRAS
• L: As the labour force increases, there are more
available labour resources with which to produce
output so the long run AS schedule shifts to the
right. When the labour force increases, it implies
that at every rate of unemployment below 100%,
the level of employment will be higher. This is
why the function which relates the level of
employment to the rate of unemployment will shift
upwards with an increase in the labour supply.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Increase in labour force
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Supply side policies
• Shifting the long run aggregate supply function to the right
is an important goal in policy making, as the equilibrium
level of output increases. From this analysis, it is clear that
there are a range of policies that the government may
undertake to achieve this.
–
–
–
–
Policies to improve productivity (higher LP).
Policies to improve labour market flexibility/competition (lower Z).
Policies to induce higher labour market participation (higher L).
Policies to improve product market competition (lower mark up).
• Taken collectively, attempts to shift the long run aggregate
supply curve are known as supply side policies.
• Global Applications 2.2 Mrs. Thatcher’s supply side
revolution
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Short run aggregate supply
• In the long run, the willingness of firms to produce does not
depend on the price level, and therefore the aggregate
supply function is vertical.
• Aggregate supply in the short run, though, is different. In
this case, it is argued that the schedule is upward-sloping, so
supply rises with prices. This is how we would expect a
conventional supply curve to look.
• To accept an aggregate supply function which slopes
upwards with prices means that we must justify why output
can or might deviate from its equilibrium level. Also, as
output is always expected to eventually return to its
equilibrium level, we have to reason why these deviations
are only temporary.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Short run aggregate supply
• There are two reasons for the slope of the SRAS:
• If wages and prices move slowly, then output will be away
from the equilibrium level for some time. Accounting for
wage and price rigidities is important.
• Also important is the role that is played by expectations.
When deriving the long run equilibrium level of output, we
assumed that price expectations were made correctly. In the
short run, though, actual prices can deviate from expected
prices. This too accounts for why aggregate supply may
differ in the short and long run. We will also observe that
the way expectations are formed will play a critical role in
the dynamics that link the short and long run.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Short run aggregate supply
• One of the key features of the short run aggregate supply
function is that output and prices are positively related. As
output increases, then prices will also rise.
• To understand what factors might be responsible for this
relationship, we need to consider how prices are actually
determined – a process which we have already argued is
summarised by the price-setting behaviour of firms.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Short run aggregate supply
• From the price-setting
relationship, prices are a mark up
on wage costs:
• The level of wages is derived
from the wage setting
relationship:
• If we substitute the wage setting
equation into the price setting
equation, we have an equation of
prices determination in the
economy:
W
P  1   
LP
W  Pe Z  u 
P e Z  u 
P  1   
LP
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Short run aggregate supply
• The price-setting equation consists of a number of
variables. These factors can in turn be split into long run
and short run determinants of the price level.
• We have already seen that changes in labour productivity,
labour supply factors, and the mark up will lead to shifts in
the long run aggregate supply curve. For this reason, we
can ignore these as determining prices in the short run
because any change in these variables will lead to a change
in the equilibrium level of output.
• The two remaining variables are the level of unemployment
(which is strongly linked to output) and the level of price
expectations.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Unemployment/Output
• From the above price-setting equation, we can see that
prices are negatively related to unemployment.
• For unemployment to rise back to the equilibrium level, two
things must happen. Firstly, there needs to be an increase in
the nominal wage – by making labour more expensive,
labour will start to price itself out of jobs.
• The second movement requires an increase in prices. If
wages are rising, then firms should see their costs rising and
wish to raise prices. At higher prices, aggregate demand
will be lower and therefore higher unemployment is
sustainable.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Unemployment/Output
• It should not require much convincing
to accept that unemployment and output
are inversely related, so a rise in output
must be associated with a fall in
unemployment.
• This inverse relationship is known as
Okun’s Law.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Relationship: Y  u  W  P 
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Unemployment/Output
• This mechanism explains why prices will rise with
output, but it doesn’t explain why output may
deviate from its equilibrium level.
• Up to now, we have assumed that markets clear
quite quickly, so movements in wages and prices
will quickly restore equilibrium values of output
and unemployment.
• This would account for a vertical aggregate supply
curve.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Market clearing: A vs. B
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Will markets clear?
• The conventional wisdom is that in the long run markets
will clear (so the long run aggregate supply is vertical), but
in the short run, wages and prices will only adjust gradually
(so in the short run we can justify a position off the long run
aggregate supply curve).
• In the short run, an increase in output above the equilibrium
level would only be partially corrected by movements in
wages and prices. Therefore, prices will be expected to
increase to say an intermediate level. Because prices
partially adjust, output will remain above the equilibrium
level, but would be lower than where there was no
movement in prices. Therefore, output too will stay at an
intermediate level. This output-price combination would
then be expected to lie on a short run aggregate supply
curve (SRAS).
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
SRAS
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
SRAS
• There are two remaining unanswered questions.
• The first is why markets do not immediately clear to correct
any disequilibrium position in output or unemployment?
The short run aggregate supply curve therefore requires us
to rationalise rigidities in wages and prices.
• The second remaining question relates to expectations. A
position on the short run aggregate supply curve away from
the equilibrium level of output implies that actual prices
must differ from expected prices.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Changes in Price Expectations
• The price setting relationship above shows that prices will
respond positively with respect to the level of price
expectations. This is easily understood from the nature of
the wage bargaining process.
• Workers are typically concerned with the real value of their
wages. However, they can only set its nominal value and
only form an expectation as to what actual prices will be. If
they expect prices in the future to be higher, then in order to
preserve the real value of wages, they will push for higher
nominal wages. These in turn represent a cost to firms, who
will respond by increasing prices.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Changes in Price Expectations
• Therefore, there is a clear relationship between expected
and actual prices:
P  W  P 
e
• An increase in price expectations will lead to an upward
shift in the short run aggregate supply curve.
• This is because higher expectations lead to higher prices
regardless of the level of output.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Increase in price expectations
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
How are price expectations formed?
• Adaptive vs. Rational Expectations
• Adaptive Expectations
• In forming expectations adaptively, it is stated that current expectations
are derived from past observations or experiences.
• In this way, price expectations are formed by a backward looking rule
such as:
e
e
t
t 1
t 1
P  P  1    P
• where 0<λ<1.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Adaptive Expectations
• In each period, the expected price is a weighted average of
the actual and expected prices from the previous period.
• If actual prices exceeded expectations, then the next
period’s expectation will be revised upwards. Each time
expectations are adjusted, the short run aggregate supply
curve will shift. It is only when actual and expected prices
are equal that no further changes to expectations will be
required.
• Therefore, over time, expectations will eventually converge
to the correct price level. The speed at which expectations
are updated is given by the parameter λ.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Adaptive Expectations
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Rational Expectations
• These are expectations that are formed using all available information:
Pt e  EPt I t 
where It is the set of information available at time t.
• As new information comes to light, expectations will adjust
immediately to incorporate it.
• Therefore, instead of seeing the gradual adjustment under adaptive
expectations, there would be a single immediate adjustment following
new information about higher prices.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Rational Expectations
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Rational vs. Adaptive Expectations
• There is some debate over which form of expectations formation is the
most realistic/conclusive.
• Rational expectations are considered by many to be the most plausible.
• The main criticism with the adaptive framework is that expectations are
simply backward looking and therefore would ignore important and
relevant information which should be incorporated. Therefore, past
mistakes would continue to be made even though individuals have the
information to correct them.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Rational vs. Adaptive Expectations
• The case for adaptive expectations becomes stronger when
people have less than full and perfect information.
• However, would the nature of expectations formation
change if changes in equilibrium prices were much harder
to ascertain? It is for this reason that increased attention is
now being played to adaptive rules. This is because
economic theory is now turning more and more towards
learning behaviour. Accepting that individuals can only
hold imperfect or incomplete information about the world,
then it is easy to hypothesize that they will attempt to learn
over time in order to improve their decision making.
Therefore, the adaptive rule can be thought of as some kind
of learning mechanism.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Equilibrium in the AD-AS Model
• The long run equilibrium in the AD-AS model is simply
where the aggregate demand and both the long run and
short run aggregate supply curves all intersect. This means
that output is at its equilibrium level, and also that actual
and expected prices are equal at the market clearing level.
• However, in the short run the economy can deviate from the
equilibrium level of output by moving to a position along a
short run aggregate supply curve. This would imply a
disequilibrium in either the goods or the labour market and
a gap between actual and expected prices. Such a position
can be sustained as long as these two conditions continue to
hold.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Equilibrium in the AD-AS Model
• In the long run, though, a disequilibrium in the labour or
goods market would be expected to lead to adjustments in
wages and prices, and price expectations would be updated.
Both of these movements act to reassert the long run
equilibrium position.
• However, because markets tend not to clear instantaneously
and expectations may be updated adaptively, it may take
some time for the economy to move back to the long run
aggregate supply curve. This implies that the short run may
actually be a significant period of time.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Equilibrium in the AD-AS Model
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Comparative statics in the AD-AS model
• Having fully established the AD-AS model, it can be now
be used to perform a number of comparative statics
exercises.
• Shifts in the aggregate demand curve results from anything
that would shift the IS or the LM curve other than a change
in prices. An outward shift in the AD curve could result
from any or more of the following:
–
–
–
–
An increase in government spending
A cut in taxes
A fall in interest rates or an increase in the money supply
More optimistic expectations of the future leading to higher
consumption and/or investment
– Added wealth effects on consumption
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Comparative statics in the AD-AS model
• Shifts in the long run aggregate supply curve result
from changes in the equilibrium level of output, of
which there appear to be two main causes.
– Productivity shocks
– Supply side policies
• When analysing the effects of demand and supply
shocks using the AD-AS model, it is common
practise to assume some price rigidities and
adaptive expectations. It is reasonable to argue that
markets do not clear instantaneously.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Positive aggregate demand shock
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Positive aggregate demand shock
• The transition from the short to the long run
sees prices rise for as long as the economy
operates above the equilibrium level of
output.
• The length of time it takes the economy to
move from point b to point c will depend on
how quickly expectations are updated, and
on how flexible wages and prices are.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Contraction in aggregate demand
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Contraction in aggregate demand
• The path the economy takes is the opposite of that
described above.
• Output will fall below the equilibrium level, but
will eventually be restored over time by falling
prices.
• The economy follows a path marked abcd,
and the only long run effect is a lower price level.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Negative aggregate supply shock
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Negative aggregate supply shock
• The new equilibrium results in lower output
and higher prices.
• However, during the T periods it takes for
the economy to reach the new equilibrium, it
experiences both falling output and rising
prices.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Positive productivity shock
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Positive productivity shock
• A higher established level of equilibrium
income produces a rightward shift in the
long run aggregate supply curve.
• The economy will then experience a process
of falling prices and rising output.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
AD and AS Shocks
• Under demand shocks, it is expected that output and prices
will move in the same direction. Under a supply shock,
they move in the opposite direction to each other. Supply
side shocks may arise from productivity shocks.
• A negative productivity shock, by shifting the long run
aggregate supply curve inwards, would see a period of
falling output and rising prices.
• A positive productivity shock would have the opposite
effect, where output increases and prices fall.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Hysteresis and the Medium Run
• So far it has been established that aggregate demand shocks
have temporary effects on output, whereas aggregate supply
shocks have permanent effects.
• Hysteresis describes a situation where demand shocks may
leave permanent effects on output.
• This works because the initial change in output induced by
a change in aggregate demand may then lead to a change in
the equilibrium level of output.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Hysteresis and the Medium Run
• Example 1: Suppose output rises following an increase in
aggregate demand. This means that previously unemployed
workers may now be employed. This could result in them
picking up on-the-job skills and experiences which raise
labour productivity, in which case, the long run AS curve
should shift to the right and the increase in output will
become permanent.
• Example 2: The economy falls into recession, and aggregate
demand falls and unemployment rises. Faced with a lack of
jobs, workers (especially the long-term unemployed) may
become increasingly despondent and leave the labour force.
Workers’ skills become obsolete and they lose human
capital. Therefore, L will fall and the long run aggregate
supply schedule will shift left making the fall in output
permanent.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Summary
• The aggregate demand and aggregate supply model can be
used to explain how the levels of output and prices are
determined in an economy.
• The aggregate demand curve identifies the total amount of
planned expenditure at each price level. It is a downward
sloping function, as at higher prices the real money stock is
lower, interest rates are higher, and therefore planned
expenditures will be lower.
• Aggregate supply in the long run is fixed at the equilibrium
level of output. This represents the level of output where
there is no pressure on prices to change. At output levels
above the equilibrium level, prices will rise, and at output
levels below the equilibrium level, prices will fall.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Summary
• The equilibrium level of output is derived from the
equilibrium rate of unemployment, also called the nonaccelerating rate of inflation unemployment (NAIRU). This
is established from a labour-firm bargaining model, where
firms set prices and workers set wages. The equilibrium
level of real wages and the NAIRU is determined where the
wage and price-setting curves intersect.
• Anything which causes either the wage or price setting
curves to shift will establish a new NAIRU level of
equilibrium unemployment and therefore long run
aggregate supply curve. Relevant factors might include the
level of productivity, the labour supply, and the degree of
competition in the goods market.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Summary
• In the short run, aggregate supply can deviate from the
equilibrium level of output if markets do not clear and a gap
emerges between actual and expected prices. Therefore, in
the short run it is possible to justify an upward sloping
aggregate supply curve. However, any deviation of output
from the equilibrium level can only be temporary. In the
long run, prices will adjust to clear markets, and
expectations will be updated.
• The long run equilibrium of the economy is established at
the equilibrium level of output, and at a price level where
actual and expected prices coincide.
• The AD-AS model can be used to analyse the effects of
aggregate demand and aggregate supply shocks on the level
of output and prices in an economy.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Summary
• Conventionally, aggregate demand shocks only have
temporary effects on output. This is because markets clear
slowly and expectations are adjusted adaptively. The more
rigidity in wages and prices, and the more adaptively
expectations are formed, the longer it takes for output to
return to the equilibrium level.
• Aggregate supply shocks have permanent effects on both
output and prices. Because an improvement in aggregate
supply generates both permanently higher output and lower
prices, governments are very serious in the use of supply
side policies.
• Hysteresis is a powerful concept which explains why
aggregate demand shocks can have very long lasting effects
on the economy.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning