Static Model for Macroeconomics in Medium Run
In the short run, we had assumed that the expectations of prices are fixed in the short run but not in the medium run. In the short run price expectations can be wrong, in the medium run they cannot. In this model, we will extend the analysis of the IS-LM model by removing the assumptions that prices (P) are fixed. But prices are sticky, this means that while we remain on the AD function, adjustment to the medium run AS function takes time. The result is that what occurs in the short run can differ from the changes that occur in the medium run. Short run fluctuations (around long-run path) constitute the business cycle (1-2 years) and recover back to the medium run (3-4 years)
In the short run IS-LM model, we had assumed flat AS curve, that is, output was determined purely by AD and supply always adjusted to fulfil the required demand. In the AS-AD model, in the short run demand and supply both determine the general price level, that is, AS curve is upward sloping. In the medium run of the AS-AD model, however, the output level returns to its natural level.
So, in the short run, the output can be above or below the natural rate but will come back to the natural rate in the medium run. The policy will determine how and how quickly we get back to the medium run equilibrium.
In the long run, the natural level of output moves.
So in the medium run AS-AD model, firstly, the goods and financial markets change the demand for goods. In the short run model, the supply used to adjust accordingly to produce this output. But in this model, the change in demand leads to changes in the level of production. The change in production level leads to a change in employment and wages, and so subsequently the prices.
LABOUR MARKET
Assumptions:
1. Closed economy
2. Labour is the only factor of production
3. Firms are price setters (monopolists)
4. Constant returns to scale technology
5. The wage is bargained between firms and workers, or unilaterally set by firms
6. The labour force is fixed in number
In the EU-27 economy (2010), the labour market looks the following way,
As we had discussed, the AS curve would be upward sloping. So, we need to derive the AS curve. The AS captures the effects of output on the price level. It is derived from equilibrium in the labour market.
So, W = Pe*F(u,z) and P = (1+mew)W => P = Pe*(1+mew)*F(u,z)
Substituting for u, we get our AS curve,
Not, u = 1-(Y/L), and u has a negative association with P.
The AS relation gives the level of output consistent with equilibrium in labour market conditions, conditional on Pe, mew, and z.
The AS relation has two important properties:
1. An increase in output leads to an increase in the price level. This happens since the increase in output leads to an increase in employment. Increase in employment then leads to a decrease in unemployment, which increases nominal wage. Increase in nominal wage leads to an increase in the price set by firms and therefore an increase in the price level.
2. An increase in the expected price level leads, one for one, to an increase in the actual price level. This happens because when wage setters expect the price level to be higher, they set a higher nominal wage. The increase in nominal wage leads to an increase in costs, which leads to an increase in the prices set by firms and a higher price level.
AS is upward sloping. Given the expected price level, an increase in output leads to an increase in the price level. When the output is equal to the natural level of output, the price level is equal to the expected price level.
Changes in Pe, mew, z shifts the AS curve, or, any variable other than P, that shifts either price-setting or wage-setting relations also shifts the AS curve.
AGGREGATE DEMAND CURVE (AD)
The AD captures the effects of the price level on output. we know that starting from the equilibrium conditions for the goods and financial markets, we get the AD relation. This relation implies that the level of output is a decreasing function of the price level. It is represented by a downward-sloping curve, the AD curve. Any variable other than P, that shifts either the IS or LM curve also shifts the AD curve.
So, we have,
POLICY IMPLICATIONS
1. Monetary Policy:
The impact of monetary expansion on the interest rates can be illustrated by the IS-LM diagram. The short-run effect of the monetary expansion is to shift the LM curve down (change in the nominal money supply) while moving along the IS (changing Y and i). So, the interest rate is lower, the output is higher. In the AS-AD curve, a shift in LM (due to nominal money supply changes) causes a rightwards shift in AD while moving along the AS curve (since prices and output are rising with fixed price expectations).
Now, in the medium run, wage setters will upwardly revise their expectations of the future price level. This will cause the AS curve to shift upwards while moving along AD (since increasing P leads to decreasing Y). The price level increase, shifts LM curve back up (no nominal money supply change) until the output is back at the natural level and interest rates are back at their original levels, moving along IS (changing Y and i). The adjustment ends when output falls back to the natural rate of output and wage setters have no longer a reason to change their expectations.
2. Fiscal Policy:
Contractionary fiscal policy or decrease in government expenditure would shift IS curve leftwards (change in autonomous factor) while moving along LM (changing Y and i). This leftward shift of IS would shift AD leftwards along the AS (changing P and Y). So, both output and interest rates are lower than before the fiscal contraction. Also, lower output lowers nominal wages and the real wages (at fixed Pe), which therefore increases the unemployment rates.
In the medium run, workers and firms adjust down their price expectations Pe, so that it eventually reaches the actual price level. This leads to an increase in the real wages and a decrease in the unemployment rates, such that, they reach back to the natural rate of unemployment. Decreasing price expectations Pe, shifts AS curve downwards, moving along AD (changing Y and P). Decreasing prices lead to increasing real money stock, causing LM to shift downwards along IS (changing Y and i). So, in the medium run, the output returns to its natural level, while interest rate declines further.
The composition of output is different from what it was before the deficit reduction. Since the income and taxes remain unchanged, the consumption is the same as before. Government spending is lower than before, but investment increases, compensating it. This is because of the lower interest rates.
SUPPLY SHOCKS
Supply shocks affect output not only in the short run but also in the medium run. Thus, it changes the natural level of output. One example of supply-side shock is the increase in the price of oil. This increase increases the cost of production, thus firms are forced to increase the prices. In the labour market model, this is equivalent to an increase in mew.
Thus, this shifts AS curve upwards while moving along the AD curve both in short and the medium run.
Each of the two large oil price increases of the 1970s was associated with a sharp recession and large inflation - a combination macroeconomists call stagflation, to capture the combination of stagnation and inflation characterised by these episodes. As can be seen here, this also leads to a higher natural rate of unemployment (UK unemployment rate since 1970 data).
In the short run IS-LM model, we had assumed flat AS curve, that is, output was determined purely by AD and supply always adjusted to fulfil the required demand. In the AS-AD model, in the short run demand and supply both determine the general price level, that is, AS curve is upward sloping. In the medium run of the AS-AD model, however, the output level returns to its natural level.
So, in the short run, the output can be above or below the natural rate but will come back to the natural rate in the medium run. The policy will determine how and how quickly we get back to the medium run equilibrium.
In the long run, the natural level of output moves.
So in the medium run AS-AD model, firstly, the goods and financial markets change the demand for goods. In the short run model, the supply used to adjust accordingly to produce this output. But in this model, the change in demand leads to changes in the level of production. The change in production level leads to a change in employment and wages, and so subsequently the prices.
LABOUR MARKET
Assumptions:
1. Closed economy
2. Labour is the only factor of production
3. Firms are price setters (monopolists)
4. Constant returns to scale technology
5. The wage is bargained between firms and workers, or unilaterally set by firms
6. The labour force is fixed in number
In the EU-27 economy (2010), the labour market looks the following way,
So we see that the unemployment rate (ratio of unemployed workers to the labour force) may give a distorted picture of the development of the labour market. For example, even if the employment is increasing, the unemployment rate may increase if the labour force increases more rapidly than employment.
The labour market is formed through the wage setting and price setting equations, which would be discussed now to understand the labour market.
WAGE DETERMINATION
Modern theories of the labour market do not treat it as a simple story of supply and demand and therefore labour market clearing (supply=demand). This is because of the existence of unemployment (workers who are looking for a job but cannot find one). Had it been a simple supply-demand problem, then wages would have changed over time accordingly such that supply of labour equals the demand for labour and we would not have had any unemployment issues. But this is not what we observe. To understand that why an employer would not offer a job to a worker who is willing to work at a lower wage and why a worker with no job would be willing to accept it, we need to incorporate some frictions (imperfect information) within the labour market. So, we use a model of labour market based on the ideas of wage bargaining and efficiency wages.
From the perspective of employees:
Employees want a wage that exceeds their reservation wage, the wage that would make them indifferent between working or being unemployed. But wages will depend on the labour market conditions. The lower the unemployment rate, the higher the wages. This is because labour market conditions affect the bargaining power of employees.
The bargaining power of workers depends on the two factors:
First, how costly would it be for the firms to replace the workers after his/her dismissal? Second, how difficult would it be for the worker to find another job.
So, the bargaining power of workers depends on the nature of the job and the labour market conditions. So, wage bargaining between employers and employees can take different forms such as - individual bargaining, take it or leave it, or collective bargaining.
From the perspective of employers:
Economists call the theories that link the productivity or the efficiency of workers to the wage they are paid efficiency wage theories. In these models, employers pay workers a wage that exceeds their reservation wage because to be useful to an employer a worker has to exert an effort on the job. When the employer hires a worker at an hourly wage or annual salary they cannot pin down the level of effort that the worker must apply. Moreover, they cannot precisely observe the level of effort the worker is marking. In the presence of this imperfect information, employer designs a contract that minimises its effects. Paying a wage in excess of the reservation creates a cost from losing their job and ensures effort by the worker. Thus, firms may want to pay higher wages to reduce turnover cost and encourage workers productivity.
So, as per our discussion, the wage determination model can be represented as,
So, the aggregate nominal wage, W, depends on three factors, the expected price level, Pe, the unemployment rate, u, and a catchall variable, z, that stands for all other variables that may affect the outcome of wage setting (mainly institutional factors)
Both workers and firms care about real wages (W/P), not the nominal wage. P is the actual price level. Workers do not care about how many dollars they receive but about how many goods they can buy with those dollars. They care about W/P. Similarly, firms do not care about the nominal wages they pay but about the nominal wages W they pay relative to the price of the goods they sell P, that is, they care about W/P.
Difference between P and Pe: Workers contracts set the nominal wages for a given duration (usually 2-3 years). When workers sign their contracts they make predictions about the future price level and accordingly set their nominal wages so that they get the real wage they want. Work hours supplied depends on this expected real wage, W/Pe. So, in the short run in the booming period, W may increase and since Pe is fixed, employees would feel their real wage is increasing and will put in more work hours leading to growth. But higher nominal wages will increase prices, P, and eventually, in the medium run, they would realize that their real wages are actually not high so they would reduce their work hours, bringing production back to the natural rate. We will discuss this later too.
Also, affecting the aggregate wage is the unemployment rate, u. If we think of wages as being determined by bargaining, then higher unemployment weakens workers bargaining power, forcing them to accept lower wages (pushes them closer to their reservation wage). Higher unemployment strengthens the bargaining of firms allowing them to pay lower wages and still keep workers willing to work. So, bargaining power is not constant over the business cycle.
Other factors, the third variable, z, stands for all the factors that affect wages, given the expected price level and the unemployment rate. There is a positive correlation between z and the wage level. z is affected by unemployment benefits, minimum wage rate, job protection laws and regulations.
PRICE DETERMINATION
Prices set by firms depend on costs. Costs depend on: the technology of production (the function linking inputs and produced output - how much labour they need to produce a given level of output) and input prices (in this case wage).
Production technology, under the assumptions of constant returns of scale (A=1) and only labour as input, becomes, Y = AN, where Y is the output, A is the technology, N is labour.
Firms also have market power and so fix a price above the unit cost of production. Under imperfect competition, firms set P as a markup over MC. So, P = (1+mew)W
Rearranging, we get the price setting relation. This relation shows that the price setting decisions determine the real wage paid by the firms. Further, the real wage implied by price setting equation does not depend on the unemployment rate.
mew is a measure of the market power of firms. Under perfect competition, mew is zero.
LABOUR MARKET EQUILIBRIUM
This equilibrium holds in the medium run (firm adjust prices and workers will adjust expectations of prices)
Suppose for some reason, u<u_n, unemployment is lower. Then this would cause nominal wages to rise (as the bargaining power of workers rises). Now since workers have fixed expectations in the short run, they believe that rising nominal wage actually is increasing their real wages. So, according to the workers the real wage rises above the equilibrium real wage (W/P > W/Pe). The rise in nominal wage leads to rising in P, so P > Pe. Short run ends and the medium run begins, allowing workers to update Pe. Over time workers had observed that prices P have risen and so they update their expectations (increasing Pe) in the medium run. So, real wages decline, increasing unemployment back towards the natural rate.
The natural rate of unemployment, u_n, is not fixed. It depends on institutions, z, and on firms market power, mew. The denomination 'natural' is a bit misleading. A better name would be the structural rate.
GENERAL EQUILIBRIUM: AS-AD model
Assumptions:
1. IS
a. Consumption - Depends on disposable income
b. Investment - Depends on income and interest rate
c. Government Expenditure - Exogenous
d. Taxation - Exogenous
e. Net exports - Equal to zero - Closed economy
f. Exchange rate - Not considered - Closed economy
2. LM
a. Money demand - Choice between money and bonds
b. Money supply - Exogenous, growth rate of money supply is zero in the medium run
3. Production function - One type of output and technological change. Depends on labour only, with constant returns to scale. Labour force is constant.
4. Labout market - Determined by the interaction of wage setting and price setting equations. Expectations of inflation are fixed in the short run
5. Technological change - Exogenous, positive and constant
AGGREGATE SUPPLY CURVE (AS)
As we had discussed, the AS curve would be upward sloping. So, we need to derive the AS curve. The AS captures the effects of output on the price level. It is derived from equilibrium in the labour market.
So, W = Pe*F(u,z) and P = (1+mew)W => P = Pe*(1+mew)*F(u,z)
Substituting for u, we get our AS curve,
Not, u = 1-(Y/L), and u has a negative association with P.
The AS relation gives the level of output consistent with equilibrium in labour market conditions, conditional on Pe, mew, and z.
The AS relation has two important properties:
1. An increase in output leads to an increase in the price level. This happens since the increase in output leads to an increase in employment. Increase in employment then leads to a decrease in unemployment, which increases nominal wage. Increase in nominal wage leads to an increase in the price set by firms and therefore an increase in the price level.
2. An increase in the expected price level leads, one for one, to an increase in the actual price level. This happens because when wage setters expect the price level to be higher, they set a higher nominal wage. The increase in nominal wage leads to an increase in costs, which leads to an increase in the prices set by firms and a higher price level.
AS is upward sloping. Given the expected price level, an increase in output leads to an increase in the price level. When the output is equal to the natural level of output, the price level is equal to the expected price level.
Changes in Pe, mew, z shifts the AS curve, or, any variable other than P, that shifts either price-setting or wage-setting relations also shifts the AS curve.
AGGREGATE DEMAND CURVE (AD)
The AD captures the effects of the price level on output. we know that starting from the equilibrium conditions for the goods and financial markets, we get the AD relation. This relation implies that the level of output is a decreasing function of the price level. It is represented by a downward-sloping curve, the AD curve. Any variable other than P, that shifts either the IS or LM curve also shifts the AD curve.
So, we have,
POLICY IMPLICATIONS
1. Monetary Policy:
The impact of monetary expansion on the interest rates can be illustrated by the IS-LM diagram. The short-run effect of the monetary expansion is to shift the LM curve down (change in the nominal money supply) while moving along the IS (changing Y and i). So, the interest rate is lower, the output is higher. In the AS-AD curve, a shift in LM (due to nominal money supply changes) causes a rightwards shift in AD while moving along the AS curve (since prices and output are rising with fixed price expectations).
Now, in the medium run, wage setters will upwardly revise their expectations of the future price level. This will cause the AS curve to shift upwards while moving along AD (since increasing P leads to decreasing Y). The price level increase, shifts LM curve back up (no nominal money supply change) until the output is back at the natural level and interest rates are back at their original levels, moving along IS (changing Y and i). The adjustment ends when output falls back to the natural rate of output and wage setters have no longer a reason to change their expectations.
2. Fiscal Policy:
Contractionary fiscal policy or decrease in government expenditure would shift IS curve leftwards (change in autonomous factor) while moving along LM (changing Y and i). This leftward shift of IS would shift AD leftwards along the AS (changing P and Y). So, both output and interest rates are lower than before the fiscal contraction. Also, lower output lowers nominal wages and the real wages (at fixed Pe), which therefore increases the unemployment rates.
In the medium run, workers and firms adjust down their price expectations Pe, so that it eventually reaches the actual price level. This leads to an increase in the real wages and a decrease in the unemployment rates, such that, they reach back to the natural rate of unemployment. Decreasing price expectations Pe, shifts AS curve downwards, moving along AD (changing Y and P). Decreasing prices lead to increasing real money stock, causing LM to shift downwards along IS (changing Y and i). So, in the medium run, the output returns to its natural level, while interest rate declines further.
The composition of output is different from what it was before the deficit reduction. Since the income and taxes remain unchanged, the consumption is the same as before. Government spending is lower than before, but investment increases, compensating it. This is because of the lower interest rates.
SUPPLY SHOCKS
Supply shocks affect output not only in the short run but also in the medium run. Thus, it changes the natural level of output. One example of supply-side shock is the increase in the price of oil. This increase increases the cost of production, thus firms are forced to increase the prices. In the labour market model, this is equivalent to an increase in mew.
Thus, this shifts AS curve upwards while moving along the AD curve both in short and the medium run.
Each of the two large oil price increases of the 1970s was associated with a sharp recession and large inflation - a combination macroeconomists call stagflation, to capture the combination of stagnation and inflation characterised by these episodes. As can be seen here, this also leads to a higher natural rate of unemployment (UK unemployment rate since 1970 data).
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