Worth: Mankiw Economics 5e CHAPTER THIRTEEN Aggregate Supply There is ahvays a temporary tradeoff befween inflation and unemploy from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation Milton friedman Most economists analyze short-run fluctuations in aggregate income and the price level using the model of aggregate demand and aggregate supply. In the IS-LM modek hapters, we examined aggregate demand in some detail. The IS-LM model-together with its open-economy cousin the Mundell-Fleming model-shows how changes in monetary and fiscal policy and shocks to the money and goods markets shift the aggregate demand curve. In this chapter, we turn our attention to aggregate supply and develop theories that explain the po- sition and slope of the aggregate supply curve. When we introduced the aggregate supply curve in Chapter 9, we established that aggregate supply behaves differently in the short run than in the long run. In the long run, prices are flexible, and the aggregate supply curve is vertical.When the aggregate supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the output of the economy remains at its natural rate By con- trast, in the short run, prices are sticky, and the aggregate supply curve is not ver tical. In this case, shifts in aggregate demand do cause fluctuations in output. In Chapter 9 we took a simplified view of price stickiness by drawing the short-run aggregate supply curve as a horizontal line, representing the extreme situation in which all prices are fixed. Our task now is to refine this understanding of short- run aggregate supply Unfortunately, one fact makes this task more difficult: economists disagree about how best to explain aggregate supply. As a result, this chapter begins by presenting three prominent models of the short-run aggregate supply curve. Among economists, each of these models has some prominent adherents(as well as some prominent critics), and you can decide for yourself which you find most plausible. Although these models differ in some significant details, they are also elated in an important way: they share a common theme about what makes the User JoENA: Job EFFo1429: 6264_ch13: Pg 347: 25876#/eps at 100sl Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 347:25876#/eps at 100% *25876* Mon, Feb 18, 2002 12:56 AM Most economists analyze short-run fluctuations in aggregate income and the price level using the model of aggregate demand and aggregate supply. In the previous three chapters, we examined aggregate demand in some detail. The IS–LM model—together with its open-economy cousin the Mundell–Fleming model—shows how changes in monetary and fiscal policy and shocks to the money and goods markets shift the aggregate demand curve. In this chapter, we turn our attention to aggregate supply and develop theories that explain the position and slope of the aggregate supply curve. When we introduced the aggregate supply curve in Chapter 9, we established that aggregate supply behaves differently in the short run than in the long run. In the long run, prices are flexible, and the aggregate supply curve is vertical.When the aggregate supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the output of the economy remains at its natural rate. By contrast, in the short run, prices are sticky, and the aggregate supply curve is not vertical. In this case, shifts in aggregate demand do cause fluctuations in output. In Chapter 9 we took a simplified view of price stickiness by drawing the short-run aggregate supply curve as a horizontal line, representing the extreme situation in which all prices are fixed. Our task now is to refine this understanding of shortrun aggregate supply. Unfortunately, one fact makes this task more difficult: economists disagree about how best to explain aggregate supply. As a result, this chapter begins by presenting three prominent models of the short-run aggregate supply curve. Among economists, each of these models has some prominent adherents (as well as some prominent critics), and you can decide for yourself which you find most plausible. Although these models differ in some significant details, they are also related in an important way: they share a common theme about what makes the | 347 Aggregate Supply 13 CHAPTER There is always a temporary tradeoff between inflation and unemployment; there is no permanent tradeoff. The temporary tradeoff comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation. — Milton Friedman THIRTEEN
Worth: Mankiw Economics 5e 348 PART IV Business Cycle Theory: The Economy in the Short Run short-run and long-run aggregate supply curves differ and a common conclusion chat the short-run aggregate supply curve is upward sloping After examining the models, we examine an implication of the short-run gregate supply curve. We show that this curve implies a tradeoff between two measures of economic performance--inflation and unemployment. According to this tradeoff, to reduce the rate of inflation policymakers must temporarily raise unemployment, and to reduce unemployment they must accept higher inflation. As the quotation at the beginning of the chapter suggests, the tradeoff between infation and unemployment is only temporary. One goal of this chapter is to ex- plain why policymakers face such a tradeoff in the short run and, just as impor- tant, why they do not face it in the long run. 13-7 Three Models of Aggregate Supply When classes in physics study balls rolling down inclined planes, they often begin by assuming away the existence of friction. This assumption makes the problem simpler and is useful in many circumstances, but no good engineer would ever take this assumption as a literal description of how the world works. similarly, this book began with classical macroeconomic theory, but it would be a mistake to assume that this model is always true. Our job now is to look more deeply into the“ frictions” of macroeconomics. We do this by examining three prominent models of aggregate supply, roughly in the order of their development. In all the models, some market im- perfection(that is, some type of friction) causes the output of the economy to deviate from the classical benchmark. As a result, the short-run aggregate sup- ply curve is upward sloping, rather than vertical, and shifts in the aggregate demand curve cause the level of output to deviate temporarily from the nat- ural rate. These temporary deviations represent the booms and busts of the business cycle Although each of the three models takes us down a different theoretical route each route ends up in the same place. That final destination is a short-run aggre- gate supply equation of the form >0 where Y is output, Y is the natural rate of output, P is the price level, and pe is the expected price level. This equation states that output deviates from its natural rate when the price level deviates from the expected price level. The parameter o indicates how much output responds to unexpected changes in the price level; 1/a is the slope of the aggregate supply curve. Each of the three models tells a different story about what lies behind this short-run aggregate supply equation. In other words, each highlights a particular reason why unexpected movements in the price level are associated with fluctu ations in aggregate output. User JoENA: Job EFFo1429: 6264_ch13: Pg 348: 27755 #/eps at 100smml Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 348:27755#/eps at 100% *27755* Mon, Feb 18, 2002 12:56 AM short-run and long-run aggregate supply curves differ and a common conclusion that the short-run aggregate supply curve is upward sloping. After examining the models, we examine an implication of the short-run aggregate supply curve. We show that this curve implies a tradeoff between two measures of economic performance—inflation and unemployment.According to this tradeoff, to reduce the rate of inflation policymakers must temporarily raise unemployment, and to reduce unemployment they must accept higher inflation. As the quotation at the beginning of the chapter suggests, the tradeoff between inflation and unemployment is only temporary. One goal of this chapter is to explain why policymakers face such a tradeoff in the short run and, just as important, why they do not face it in the long run. 13-1 Three Models of Aggregate Supply When classes in physics study balls rolling down inclined planes, they often begin by assuming away the existence of friction.This assumption makes the problem simpler and is useful in many circumstances, but no good engineer would ever take this assumption as a literal description of how the world works. Similarly, this book began with classical macroeconomic theory, but it would be a mistake to assume that this model is always true. Our job now is to look more deeply into the “frictions” of macroeconomics. We do this by examining three prominent models of aggregate supply, roughly in the order of their development. In all the models, some market imperfection (that is, some type of friction) causes the output of the economy to deviate from the classical benchmark.As a result, the short-run aggregate supply curve is upward sloping, rather than vertical, and shifts in the aggregate demand curve cause the level of output to deviate temporarily from the natural rate. These temporary deviations represent the booms and busts of the business cycle. Although each of the three models takes us down a different theoretical route, each route ends up in the same place.That final destination is a short-run aggregate supply equation of the form Y =Y − + a(P − Pe ), a > 0 where Y is output, Y − is the natural rate of output, P is the price level, and Pe is the expected price level.This equation states that output deviates from its natural rate when the price level deviates from the expected price level.The parameter a indicates how much output responds to unexpected changes in the price level; 1/a is the slope of the aggregate supply curve. Each of the three models tells a different story about what lies behind this short-run aggregate supply equation. In other words, each highlights a particular reason why unexpected movements in the price level are associated with fluctuations in aggregate output. 348 | PART IV Business Cycle Theory: The Economy in the Short Run
Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 349 The Sticky-Wage Model To explain why the short-run aggregate supply curve is upward sloping, many economists stress the sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term contracts, so wages cannot adjust quickly when economic conditions change. Even in industries not covered by form contracts, implicit agreements between workers and firms may limit wage changes. Wages may also depend on social norms and notions of fairness that evolve slowly. For these reasons, many economists believe that nominal wages are sticky in the short run The sticky-wage model shows what a sticky nominal wage implies for ag- gregate supply To preview the model, consider what happens to the amount of tput produced when the price level rises: 1. When the nominal wage is stuck, a rise in the price level lowers the real wage, naking labor cheaper 2. The lower real wage induces firms to hire more labor 3. The additional labor hired produces more output This positive relationship between the price level and the amount of output means that the aggregate supply curve slopes upward during the time when the nominal wage cannot adjust To develop this story of aggregate supply more formally, assume that workers and firms bargain over and agree on the nominal wage before they know what the price level will be when their agreement takes effect. The bargaining par- ties--the workers and the firms--have in mind a target real wage. The target may be the real wage that equilibrates labor supply and demand. More likely, the tar- get real wage is higher than the equilibrium real wage: as discussed in Chapter 6, union power and efficiency-wage considerations tend to keep real wages above the level that brings supply and demand into balance The workers and firms set the nominal wage W based on the target real wage wo and on their expectation of the price level Pe. The nominal wage they set is Nominal Wage Target Real Wage X Expected Price Level After the nominal wage has been set and before labor has been hired firms learn the actual price level P. The real wage turns out to be W/P (P/P Real Wage Target Real Wage x Expected Price Level Actual Price level This equation shows that the real wage deviates from its target if the actual price level differs from the expected price level. When the actual price level is greater than expected, the real wage is less than its target; when the actual price level is less than expected the real wage is greater than its target. User JoENA: Job EFFo1429: 6264_ch13: Pg 349: 27756#/eps at 100smml Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 349:27756#/eps at 100% *27756* Mon, Feb 18, 2002 12:56 AM The Sticky-Wage Model To explain why the short-run aggregate supply curve is upward sloping, many economists stress the sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term contracts, so wages cannot adjust quickly when economic conditions change. Even in industries not covered by formal contracts, implicit agreements between workers and firms may limit wage changes. Wages may also depend on social norms and notions of fairness that evolve slowly. For these reasons, many economists believe that nominal wages are sticky in the short run. The sticky-wage model shows what a sticky nominal wage implies for aggregate supply.To preview the model, consider what happens to the amount of output produced when the price level rises: 1. When the nominal wage is stuck, a rise in the price level lowers the real wage, making labor cheaper. 2. The lower real wage induces firms to hire more labor. 3. The additional labor hired produces more output. This positive relationship between the price level and the amount of output means that the aggregate supply curve slopes upward during the time when the nominal wage cannot adjust. To develop this story of aggregate supply more formally, assume that workers and firms bargain over and agree on the nominal wage before they know what the price level will be when their agreement takes effect. The bargaining parties—the workers and the firms—have in mind a target real wage.The target may be the real wage that equilibrates labor supply and demand. More likely, the target real wage is higher than the equilibrium real wage: as discussed in Chapter 6, union power and efficiency-wage considerations tend to keep real wages above the level that brings supply and demand into balance. The workers and firms set the nominal wage W based on the target real wage q and on their expectation of the price level Pe .The nominal wage they set is W = q × Pe Nominal Wage = Target Real Wage × Expected Price Level. After the nominal wage has been set and before labor has been hired, firms learn the actual price level P.The real wage turns out to be W/P = q × (Pe /P) Real Wage = Target Real Wage × . This equation shows that the real wage deviates from its target if the actual price level differs from the expected price level.When the actual price level is greater than expected, the real wage is less than its target; when the actual price level is less than expected, the real wage is greater than its target. Expected Price Level Actual Price Level CHAPTER 13 Aggregate Supply | 349
Worth: Mankiw Economics 5e 350 PART IV Business Cycle Theory: The Economy in the Short Run The final assumption of the sticky-wage model is that employment is deter- by the qu labor that firms demand. In other words, the bargain between the workers and the firms does not determine the level of employment in advance; instead, the workers ag sNe describe the firms' hiring decisions by the gree to provide as much labor as the firms wish to buy at the predetermined wage. We L=Ld(W/P), hich states that the lower the real wage, the more labor firms hire. The labor demand curve is shown in panel(a)of Figure 13-1. Output is determined by the Y=F(L, which states that the more labor is hired, the more output is produced. This is shown in panel(b)of Figure 13-1 Panel (c)of Figure 13-1 shows the resulting aggregate supply curve. Be ause the nominal wage is sticky, an unexpected change in the price level (a) Labor Demand (b)Production Function Real wage Income, output, Y W/P Y2 2 Labor. L Labor. L 3.. which raises (c) Aggregate Supply The Sticky-Wage Model Panel (a) Price level. P shows the labor demand curve. Because Y=Y+ a(P-Pe) the nominal wage Wis stuck, an in in the price level from P, to P2 reduces the real wage from W/P, to W/P2.The P2 6. The aggregate lower real wage raises the quantity of abor demanded from L1 to L2. Panel (b) shows the production function. An nese ch increase in the quantity of labor fror 1. An increase L, to L2 raises output from Y, to Y2 in the price Y,Income,output,Y Panel(c)shows the aggregate supply curve summarizing this relationship 5... and income between the price level and output.An increase in the price level from P, to P raises output from Y, to Y2 User JoENA: Job EFFo1429: 6264_ch13: Pg 350: 27757#/eps at 100sm Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 350:27757#/eps at 100% *27757* Mon, Feb 18, 2002 12:56 AM The final assumption of the sticky-wage model is that employment is determined by the quantity of labor that firms demand. In other words, the bargain between the workers and the firms does not determine the level of employment in advance; instead, the workers agree to provide as much labor as the firms wish to buy at the predetermined wage.We describe the firms’ hiring decisions by the labor demand function L = Ld (W/P), which states that the lower the real wage, the more labor firms hire.The labor demand curve is shown in panel (a) of Figure 13-1. Output is determined by the production function Y = F(L), which states that the more labor is hired, the more output is produced.This is shown in panel (b) of Figure 13-1. Panel (c) of Figure 13-1 shows the resulting aggregate supply curve. Because the nominal wage is sticky, an unexpected change in the price level 350 | PART IV Business Cycle Theory: The Economy in the Short Run figure 13-1 Real wage, W/P Income, output, Y Price level, P Income, output, Y Labor, L Labor, L W/P1 W/P2 L Ld(W/P) L2 L1 Y2 Y1 Y F(L) L2 L1 P2 P1 Y Y a(P Pe ) Y2 Y1 1. An increase in the price level . . . 3. . . .which raises employment, . . . 4. . . . output, . . . 5. . . . and income. 2. . . . reduces the real wage for a given nominal wage, . . . 6. The aggregate supply curve summarizes these changes. (a) Labor Demand (b) Production Function (c) Aggregate Supply The Sticky-Wage Model Panel (a) shows the labor demand curve. Because the nominal wage W is stuck, an increase in the price level from P1 to P2 reduces the real wage from W/P1 to W/P2. The lower real wage raises the quantity of labor demanded from L1 to L2. Panel (b) shows the production function. An increase in the quantity of labor from L1 to L2 raises output from Y1 to Y2. Panel (c) shows the aggregate supply curve summarizing this relationship between the price level and output. An increase in the price level from P1 to P2 raises output from Y1 to Y2.
Worth: Mankiw Economics 5e CHAPTER 13 Aggregate Supply 351 moves the real wage away from the target real wage, and this change in the real wage influences the amounts of labor hired and output produced. The aggre gate supply curve can be written as Y=Y Output deviates from its natural level when the price level deviates from the ex pected price level CASE STUDY The Cyclical Behavior of the Real Wage In any model with an unchanging labor demand curve, such as the model we just discussed, employment rises when the real wage falls. In the sticky-wage del, an unexpected rise in the price level lowers the real wage and thereby raises the quantity of labor hired and the amount of output produced. Thus, the eal wage should be countercyclical: it should fluctuate in the opposite direction from employment and output. Keynes himself wrote in The General Theory that an increase in employment can only occur to the accompaniment of a decline in the rate of real wages. The earliest attacks on The General Theory came from economists challenging Keynes's prediction. Figure 13-2 is a scatterplot of the percentage change in real compensation per hour and the percentage change in real GDP using annual data for the U.S. economy from 1960 to 2000. If Keynes's prediction were cor- rect, the dots in this figure would show a downward-sloping pattern, indicating a negative relationship. Yet the figure shows only a weak correlation between the real wage and output, and it is the opphdy procyclical: the real wage tends to rise osite of what Keynes predicted. That is, if he real wage is cyclical at all when output rises Abnormally high labor costs cannot explain the low employ ment and output observed in recessions How should we interpret this evidence? Most economists conclude that the in which the labor demand curve shifts over the bis apply. They advocate models sticky-wage model cannot fully explain aggregate Usiness cycle. These shifts may arise because firms have sticky prices and cannot sell all they want at those prices; we discuss this possibility later. Alternatively, the labor demand curve may shift because of shocks to technology, which alter labor productivity. The theor we discuss in Chapter 19, called the theory of real business cycles, gives a promi- nent role to technology shocks as a source of economic fluctuations For the sticky-wage model, see Jo Anna Gray, Wage Indexation: A Macroeconomic Ap- proach, "Journal of Monetary Economics 2(April 1976): 221-235; and Stanley Fischer, ""Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule, "Joumal of Political Econ y85( February1977:191-205 For some of the recent work on the cyclical behavior of the real wage, see Scott Sumner and Stephen Silver, "Real Wages, Employment, and the Phillips Curve, " Journal of Political Economy 97 (une 1989): 706-720; and Gary Solon, Robert Barsky, and Jonathan A. Parker, "Measuring the Cyclicality of Real Wages: How Important Is Composition Bias? "Quarterly Journal of Economics 109 User JoENA: Job EFFo1429: 6264_ch13: Pg 351: 27758#/eps at 100sm Mon,Feb18,200212:56
User JOEWA:Job EFF01429:6264_ch13:Pg 351:27758#/eps at 100% *27758* Mon, Feb 18, 2002 12:56 AM moves the real wage away from the target real wage, and this change in the real wage influences the amounts of labor hired and output produced.The aggregate supply curve can be written as Y =Y − + a(P − Pe ). Output deviates from its natural level when the price level deviates from the expected price level.1 CHAPTER 13 Aggregate Supply | 351 1 For more on the sticky-wage model, see Jo Anna Gray,“Wage Indexation:A Macroeconomic Approach,’’ Journal of Monetary Economics 2 (April 1976): 221–235; and Stanley Fischer, “Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule,’’ Journal of Political Economy 85 (February 1977): 191–205. 2 For some of the recent work on the cyclical behavior of the real wage, see Scott Sumner and Stephen Silver, “Real Wages, Employment, and the Phillips Curve,’’ Journal of Political Economy 97 ( June 1989): 706–720; and Gary Solon, Robert Barsky, and Jonathan A. Parker, “Measuring the Cyclicality of Real Wages: How Important Is Composition Bias?’’Quarterly Journal of Economics 109 (February 1994): 1–25. CASE STUDY The Cyclical Behavior of the Real Wage In any model with an unchanging labor demand curve, such as the model we just discussed, employment rises when the real wage falls. In the sticky-wage model, an unexpected rise in the price level lowers the real wage and thereby raises the quantity of labor hired and the amount of output produced.Thus, the real wage should be countercyclical: it should fluctuate in the opposite direction from employment and output. Keynes himself wrote in The General Theory that “an increase in employment can only occur to the accompaniment of a decline in the rate of real wages.’’ The earliest attacks on The General Theory came from economists challenging Keynes’s prediction. Figure 13-2 is a scatterplot of the percentage change in real compensation per hour and the percentage change in real GDP using annual data for the U.S. economy from 1960 to 2000. If Keynes’s prediction were correct, the dots in this figure would show a downward-sloping pattern, indicating a negative relationship.Yet the figure shows only a weak correlation between the real wage and output, and it is the opposite of what Keynes predicted.That is, if the real wage is cyclical at all, it is slightly procyclical: the real wage tends to rise when output rises.Abnormally high labor costs cannot explain the low employment and output observed in recessions. How should we interpret this evidence? Most economists conclude that the sticky-wage model cannot fully explain aggregate supply.They advocate models in which the labor demand curve shifts over the business cycle.These shifts may arise because firms have sticky prices and cannot sell all they want at those prices; we discuss this possibility later.Alternatively, the labor demand curve may shift because of shocks to technology, which alter labor productivity.The theory we discuss in Chapter 19, called the theory of real business cycles, gives a prominent role to technology shocks as a source of economic fluctuations.2