Aggregate Supply,

Unemployment
and Inflation
Aggregate Supply, Unemployment and Inflation

Aggregate Supply
 AGGREGATE SUPPLY

• Different views on the shape of the AS

curve
 Contrasting views on the aggregate supply curve:
(a) Extreme Keynesian
AS
Price level

National output
 Contrasting views on the aggregate supply curve:
(a) Extreme Keynesian
AS
Price level

AD1
O Y1 YF

National output
 Contrasting views on the aggregate supply curve:
(a) Extreme Keynesian
AS
Price level

AD2

AD1
O Y1 Y2 YF

National output
 Contrasting views on the aggregate supply curve:
(b) Extreme Monetarist / New Classical
AS
Price level

O Y
National output
 Contrasting views on the aggregate supply curve:
(b) Extreme Monetarist / New Classical
AS
Price level

P1

AD1
O Y
National output
 Contrasting views on the aggregate supply curve:
(b) Extreme Monetarist / New Classical
AS
Price level

P2

P1
AD2

AD1
O Y
National output
 Contrasting views on the aggregate supply curve:
(c) Moderate view

AS
Price level

National output
 Contrasting views on the aggregate supply curve:
(c) Moderate view

AS
Price level

P1

AD1
O Y1
National output
 Contrasting views on the aggregate supply curve:
(c) Moderate view

AS
Price level

P2
P1
AD2

AD1
O Y1 Y2
National output
 AGGREGATE SUPPLY

• Different views on the shape of the AS

curve
• Short-run aggregate supply
 AGGREGATE SUPPLY

• Different views on the shape of the AS

curve
• Short-run aggregate supply
– the microeconomic foundations
Short-run response of a profit-maximising firm
to a rise in demand
£
MC

P1

AR1

Q1 Q
MR1
Short-run response of a profit-maximising firm
to a rise in demand
£
MC

P1

AR2
AR1

Q1 MR2 Q
MR1
Short-run response of a profit-maximising firm
to a rise in demand
£
MC

P2
P1

AR2
AR1

Q1 Q2 MR2 Q
MR1
 The short-run aggregate supply curve

AS short run
Price level

P3

P2
P1

AD3
AD2
AD1
Y1 Y2 Y3
National output
 AGGREGATE SUPPLY

• Different views on the shape of the AS

curve
• Short-run aggregate supply
– the microeconomic foundations
• Long-run aggregate supply
 AGGREGATE SUPPLY

• Different views on the shape of the AS

curve
• Short-run aggregate supply
– the microeconomic foundations
• Long-run aggregate supply
– the interdependence of firms
The long-run AS curve when firms are interdependent

AS (long run) AS
2 (short run)
AS1 (short run)

c
Price level

AD2
AD1

National output
 AGGREGATE SUPPLY

• Different views on the shape of the AS

curve
• Short-run aggregate supply
– the microeconomic foundations
• Long-run aggregate supply
– the interdependence of firms
– investment
 Effect of investment on the long-run AS curve

AS1 (short run)

Price level

AD1

National output
 Effect of investment on the long-run AS curve

AS1 (short run)

AS2 (short run)

b AS (long run)
Price level

d
a

AD2
AD1

National output
 AGGREGATE SUPPLY

• Different views on the shape of the AS

curve
• Short-run aggregate supply
– the microeconomic foundations
• Long-run aggregate supply
– the interdependence of firms
– investment
– expectations
 AGGREGATE SUPPLY

• LRAS: monetarist / new classical model

– flexible real wage rates
The aggregate labour market: Monetarist / New Classical analysis

ASL
N
Real wage rate (W / P)

a b
We

ADL
O Qe
Number of workers
The aggregate labour market: Monetarist / New Classical analysis

ASL
N
Real wage rate (W / P)

Assume now
that AD rises

a b
We

ADL
O Qe
Number of workers
The aggregate labour market: Monetarist / New Classical analysis

ASL
N
Real wage rate (W / P)

Prices rise.
Real wage rate
a falls below We
b
We e.g. to W1
W1

ADL
O Qe
Number of workers
The aggregate labour market: Monetarist / New Classical analysis

ASL
N
Real wage rate (W / P)

This gives an
excess demand
for labour of d − c.
a b
We Real wage rate
c d
W1 will rise back to We

ADL
O Qe
Number of workers
 AGGREGATE SUPPLY

• LRAS: monetarist / new classical model

– flexible real wage rates
– no money illusion
 AGGREGATE SUPPLY

• LRAS: monetarist / new classical model

– flexible real wage rates
– no money illusion
– natural level of unemployment
The aggregate labour market: Monetarist / New Classical analysis

ASL
N
Real wage rate (W / P)

a b
We

ADL
O Qe
Number of workers
 AGGREGATE SUPPLY

• LRAS: monetarist / new classical model

– flexible real wage rates
– no money illusion
– natural level of unemployment
– implications for shape of LRAS
• LRAS: Keynesian models
 AGGREGATE SUPPLY

• LRAS: monetarist / new classical model

– flexible real wage rates
– no money illusion
– natural level of unemployment
– implications for shape of LRAS
• LRAS: Keynesian models
– wage and price rigidity
Keynesian analysis of the aggregate labour market: fall in ADL

ASL
N
Real wage rate (W / P)

Assumption:
wage rates are
c a b sticky downwards
We

ADL2 ADL1
O Q2 Qe
Number of workers
 AGGREGATE SUPPLY

• LRAS: monetarist / new classical model

– flexible real wage rates
– no money illusion
– natural level of unemployment
– implications for shape of LRAS
• LRAS: Keynesian models
– wage and price rigidity
– hysteresis
Keynesian analysis of the aggregate labour market: hysteresis
ASL
N
Real wage rate (W / P)

c a b Assume that there

We is now a recovery:
ADL rises back to ADL1.

ADL2 ADL1
O Q2 Qe
Number of workers
Keynesian analysis of the aggregate labour market: hysteresis
ASL2 ASL
N
Real wage rate (W / P)

d e
We 2
c a b There will be a
We movement up
along ASL2

ADL2 ADL1
O Q2 Qe
Number of workers
 AGGREGATE SUPPLY

• LRAS: monetarist / new classical model

– flexible real wage rates
– no money illusion
– natural level of unemployment
– implications for shape of LRAS
• LRAS: Keynesian models
– wage and price rigidity
– hysteresis
– expectations of output changes
 AGGREGATE SUPPLY

• LRAS: monetarist / new classical model

– flexible real wage rates
– no money illusion
– natural level of unemployment
– implications for shape of LRAS
• LRAS: Keynesian models
– wage and price rigidity
– hysteresis
– expectations of output changes
– long-run money illusion
 AGGREGATE SUPPLY

• AS, AD and inflation

– demand-pull inflation
 Demand-pull inflation
Subsequent
supply response
AS1 AS
Price level

d
P3
P2 c
P1 b
P0 a

AD2
AD1
AD
O
National output
 Demand-pull inflation
Subsequent
demand response
AS1 AS

e
P4
Price level

d
P3
P2 c
P1 b
P0 a
AD3
AD2
AD1
AD
O
National output
 Demand-pull inflation

AS2
AS1 AS

P5 f
e
P4
Price level

d Subsequent
P3
supply response
P2 c
P1 b
P0 a
AD3
AD2
AD1
AD
O
National output
 Demand-pull inflation

AS2
g AS1 AS
P6
P5 f
e Subsequent
P4
Price level

d demand response
P3
P2 c
P1 b
P0 a AD4
AD3
AD2
AD1
AD
O
National output
 AGGREGATE SUPPLY

• AS, AD and inflation

– demand-pull inflation

– cost-push inflation
 Cost-push inflation

AS2
AS1
AS
Price level

d
P3
c
P2
b Subsequent
P1 a demand response
P0

AD1
AD
O
National output
 Cost-push inflation
AS3
AS2
AS1
AS

e
P4 Subsequent
Price level

d
P3 supply response
c
P2
b
P1 a
P0

AD1
AD
O
National output
 AGGREGATE SUPPLY

• AS, AD and inflation

– demand-pull inflation

– cost-push inflation

– what causes inflation in practice?

Aggregate Supply, Unemployment and Inflation

Expectations
Augmented Phillips
Curve
EXPECTATIONS AUGMENTED PHILLIPS
CURVE
• Incorporating expectations into a
Phillips equation
• Adaptive expectations

• The accelerationist theory

– attempting to reduce unemployment below
the ‘natural’ level
.
The accelerationist theory of inflation
P (%)
20

16

12

4 b

a
0
0 6 8 . U (%)
I (Pe = 0)
.
The accelerationist theory of inflation
P (%)
20

f
16

e
12

d
8
.
IV (Pe = 12%)
4 b c .
III (Pe = 8%)
.
a II (Pe = 4%)
0
0 6 8 . U (%)
I (Pe = 0)
EXPECTATIONS AUGMENTED PHILLIPS
CURVE
• Incorporating expectations into a
Phillips equation
• Adaptive expectations

• The accelerationist theory

– attempting to reduce unemployment below
the ‘natural’ level
– the long-run Phillips curve
.
P (%) The long-run Phillips curve
20

16

12

0
0 6 8 U (%)
U
EXPECTATIONS AUGMENTED PHILLIPS
CURVE
• Incorporating expectations into a
Phillips equation
• Adaptive expectations

• The accelerationist theory

– attempting to reduce unemployment below
the ‘natural’ level
– the long-run Phillips curve

– effects of deflationary policies

.
The effects of deflation
P (%)
24
22
J
20
k
18
16
.
14 X (Pe = 20%)
12
10
8
6
4
2
0
0 8 1 U (%)
3
.
The effects of deflation
P (%)
24
22
J
20
k
18
16 l
.
14 m X (Pe = 20%)
.
12 XI (Pe = 18%)
.
10
XII (Pe = 16%)
8
6
4
2
0
0 8 1 U (%)
3
.
The effects of deflation
P (%)
24
22
J
20
k
18
16 l

14 m
12
10
8
6
4
2
a
0
0 8 1 U (%)
3
EXPECTATIONS AUGMENTED PHILLIPS
CURVE
• How quickly can inflation be eliminated?
– the ‘short, sharp shock’
– the slow route
• Explanations of stagflation
– clockwise Phillips loops
. Clockwise Phillips loops
P (%)
20

b
a
0 Year 2
0 Un U (%)
Year 0, 1
. Clockwise Phillips loops
P (%)
20

f
e

Year 5
c
Year 4

Year 3
b
a
0 Year 2
0 Un U (%)
Year 0, 1
. Clockwise Phillips loops
P (%)
20

f
e

g
d

h Year 5, 8
c
Year 4, 7
i

Year 3, 8
b J
a Year 2, 9
0
0 Un U (%)
Year 0, 1, 10
EXPECTATIONS AUGMENTED PHILLIPS
CURVE
• How quickly can inflation be eliminated?
– the ‘short, sharp shock’
– the slow route
• Explanations of stagflation
– clockwise Phillips loops
– rightward shifts in the long-run Phillips
curve
EXPECTATIONS AUGMENTED PHILLIPS
CURVE
• How quickly can inflation be eliminated?
– the ‘short, sharp shock’
– the slow route
• Explanations of stagflation
– clockwise Phillips loops
– rightward shifts in the long-run Phillips
curve
• Policy implications of the model
EXPECTATIONS AUGMENTED PHILLIPS
CURVE
• How quickly can inflation be eliminated?
– the ‘short, sharp shock’
– the slow route
• Explanations of stagflation
– clockwise Phillips loops
– rightward shifts in the long-run Phillips
curve
• Policy implications of the model
– shifting the long-run Phillips curve
Inflation (%)
26
Phillips loops in the UK?
75
24

22

20

18 80
76
16 74 77
14
79
12 81

10 90
7 7
3 1 78 82
8 89
7
2
6 91 85
88 84
87 83
4 98 97 95
00 92 86
94
2 01 96
93
02 99
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Unemployment (%)
Inflation (%)
26
Phillips loops in the UK?
75
24

22

20

18 80
76
16 74 77
14
79
12 81

10 90
7 7
3 1 78 82
8 89
7
2
6 91 85
88 84
87 83
4 98 97 95
00 92 86
94
2 01 96
93
02 99
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Unemployment (%)
Inflation (%)
26
Phillips loops in the UK?
75
24

22

20

18 80
76
16 74 77
14
79
12 81

10 90
7 7
3 1 78 82
8 89
7
2
6 91 85
88 84
87 83
4 98 97 95
00 92 86
94
2 01 96
93
02 99
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Unemployment (%)
Inflation (%)
26
Phillips loops in the UK?
75
24

22

20

18 80
76
16 74 77
14
79
12 81

10 90
7 7
3 1 78 82
8 89
7
2
6 91 85
88 84
87 83
4 98 97 95
00 92 86
94
2 01 96
93
02 99
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Unemployment (%)
Inflation (%)
26
Phillips loops in the UK?
75
24

22

20

18 80
76
16 74 77
14
79
12 81

10 90
7 7
3 1 78 82
8 89
7
2
6 91 85
88 84
87 83
4 98 97 95
00 92 86
94
2 01 96
93
02 99
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Unemployment (%)
Inflation (%)
26
Phillips loops in the UK?
75
24

22

20

18 80
76
16 74 77
14
79
12 81

10 90
7 7
3 1 78 82
8 89
7
2
6 91 85
88 84
87 83
4 98 97 95
00 92 86
94
2 01 96
93
02 99
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Unemployment (%)
Aggregate Supply, Unemployment and Inflation

Rational Expectations
and the Phillips Curve
RATIONAL EXPECTATIONS AND THE
PHILLIPS CURVE

• Assumptions
– flexible wages and prices

– rational expectations

• Aggregate supply & the Phillips curve:

when expectations are correct
– short-run vertical AS curve
 The effects of an increase in aggregate demand

SRAS1
(expected price level = P1)
Price level

(a) Adaptive
P2 b
expectations
P1
a

AD2

AD1
O Q1 Q2
National output
 The effects of an increase in aggregate demand

SRAS2
(expected price level = P3 )
SRAS1
(expected price level = P1)
c
Price level

P3
(a) Adaptive
P2 b
expectations
P1
a

AD2

AD1
O Q1 Q2
National output
 The effects of an increase in aggregate demand
LRAS
SRAS2
(expected price level = P3 )
SRAS1
(expected price level = P1)
c
Price level

P3
(a) Adaptive
P2 b
expectations
P1
a

AD2

AD1
O Qn Q2
National output
 The effects of an increase in aggregate demand

SRAS1
(expected price level = P1)
Price level

(b) Rational
expectations
P1
a

AD2

AD1
O Q1
National output
 The effects of an increase in aggregate demand

SRAS2
(expected price level = P3 )
SRAS1
(expected price level = P1)
c
Price level

P3
(b) Rational
expectations
P1
a

AD2

AD1
O Q1
National output
 The effects of an increase in aggregate demand
LRAS = SRAS actual
SRAS2
(expected price level = P3 )
SRAS1
(expected price level = P1)
c
Price level

P3
(b) Rational
expectations
P1
a

AD2

AD1
O Qn
National output
RATIONAL EXPECTATIONS AND THE
PHILLIPS CURVE

• Assumptions
– flexible wages and prices

– rational expectations

• Aggregate supply & the Phillips curve:

when expectations are correct
– short-run vertical AS curve

– short-run vertical Phillips curve

RATIONAL EXPECTATIONS AND THE
PHILLIPS CURVE
• Aggregate supply & the Phillips curve:
when expectations are incorrect
– the goods market
 How a rise in aggregate demand could cause a rise in
national output

LRAS
SRAS2
(expected price level = P2 )

SRAS1
b
Price level

(expected price level = P1)

P3
P2

P1
a

AD3
AD2
AD1
O Qn Q3
National output
 How a rise in aggregate demand could cause a fall in
national output
SRAS2
LRAS (expected price level = P2 )

SRAS1
(expected price level = P1)
P2
Price level

c
P3

P1
a

AD2
AD3
AD1
O Q3 Qn
National output
RATIONAL EXPECTATIONS AND THE
PHILLIPS CURVE
• Aggregate supply & the Phillips curve:
when expectations are incorrect
– the goods market
– the labour market
Effects in the labour market of an underprediction of inflation

ASL1 ((W / P )e = W / P )

ASL2 ((W / P )e > W / P )

Real wage rate (W / P)

Underprediction
of inflation

ADL
O Q1 Q2

Number of workers
RATIONAL EXPECTATIONS AND THE
PHILLIPS CURVE
• Aggregate supply & the Phillips curve:
when expectations are incorrect
– the goods market
– the labour market
– implications for the Phillips curve
• Policy implications of rational
expectations
• Real business cycles
– persistent shifts in aggregate supply
– turning points
 New classical version of short-run Phillips curves

. . . . . .
e e e
P <P P =P P >P
Inflation (%)

O
Unemployment (%)
RATIONAL EXPECTATIONS AND THE
PHILLIPS CURVE
• Aggregate supply & the Phillips curve:
when expectations are incorrect
– the goods market
– the labour market
– implications for the Phillips curve
• Policy implications of rational
expectations
RATIONAL EXPECTATIONS AND THE
PHILLIPS CURVE
• Aggregate supply & the Phillips curve:
when expectations are incorrect
– the goods market
– the labour market
– implications for the Phillips curve
• Policy implications of rational
expectations
• Real business cycles
RATIONAL EXPECTATIONS AND THE
PHILLIPS CURVE
• Aggregate supply & the Phillips curve:
when expectations are incorrect
– the goods market
– the labour market
– implications for the Phillips curve
• Policy implications of rational
expectations
• Real business cycles
– persistent shifts in aggregate supply
RATIONAL EXPECTATIONS AND THE
PHILLIPS CURVE
• Aggregate supply & the Phillips curve:
when expectations are incorrect
– the goods market
– the labour market
– implications for the Phillips curve
• Policy implications of rational
expectations
• Real business cycles
– persistent shifts in aggregate supply
– turning points
Aggregate Supply, Unemployment and Inflation

Modern Keynesian
Views
 MODERN KEYNESIAN VIEWS

• Modern developments of the Keynesian

model
• Growth in equilibrium unemployment
– higher structural unemployment
– hysteresis
• The persistence of demand-deficient
unemployment
– payment of efficiency wages
– insider power
 MODERN KEYNESIAN VIEWS

• Incorporation of expectations

– expansion of aggregate demand

 Keynesian analysis of reflationary policies

.
P2 c
Inflation (%)

b Z

. II
a
P1
I

O U2 U1
Unemployment (%)
 MODERN KEYNESIAN VIEWS

• Incorporation of expectations

– expansion of aggregate demand

– contraction of aggregate demand

Inflation (%) Keynesian analysis of deflationary policies

a
b
I

O U1 U2

Unemployment (%)
Inflation (%) Keynesian analysis of deflationary policies

a
b
I
c L

O U1 U2
Unemployment (%)
 MODERN KEYNESIAN VIEWS

• Incorporation of expectations

– expansion of aggregate demand

– contraction of aggregate demand

• Keynesian criticisms of
non-intervention
Aggregate Supply, Unemployment and Inflation

Common Ground
Among Economists?
COMMON GROUND AMONG ECONOMISTS?

• Short-run effects of changes in

aggregate demand

• Long-run effects of changes in

aggregate demand

• Role of expectations

• Importance of supply-side factors