Aggregate supply in open economy and it's components
- 1. Summary of ISLM Model
- 2. Chapter Five:-Aggregate Supply Analysis • 5.1.Introduction • Aggregate supply is the relationship between quantity of goods and services supplied and the price level. Because the firms that supply goods and services have flexible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the time horizon. • Here we need to discuss two different aggregate supply curves: the long run aggregate supply curve LRAS (the classical supply curve) and that of the Keynesian supply curve the short-run aggregate supply curve SRAS (). • Finally an attempt will be made to present four prominent models of short-run aggregate supply curve.
- 3. 5.2.The Long Run: the Vertical Aggregate Supply Curve Because the classical model describes how the economy behaves in the long run, we derive the long- run aggregate supply curve from the classical model. The classical aggregate supply curve is vertical, indicating that the same amount of goods will be supplied whatever the price level i.e. output does not depend on the price level (see figure below). The classical supply curve is based on the assumption that the labor market is in equilibrium with full employment of the labor force
- 4. Cont'd……….
- 5. Cont'd…….. • If the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not output. • For example, if the money supply falls, the aggregate demand curve shifts downwards, as in figure below. The economy moves from the old intersection of aggregate supply and aggregate demand, point A to the new intersection, point B. • If it is an increase in money supply, the economy moves from A to C. The shift in aggregate demand affects only prices.
- 6. Cont'd…… • The vertical aggregate supply curve satisfies the classical dichotomy, because it implies that the level of out put is independent of the money supply. This long run level of output is called the full employment or natural level of output.
- 7. 5.3.Keynesian approach to aggregate supply • The Short Run: the Horizontal Aggregate Supply Curve and the move from the Short Run to the Long run • It is clear from the above discussion that the classical model and the vertical aggregate supply curve apply only in the long run. In the short run, some prices are sticky and, therefore, do not adjust to changes in demand. • Because of this price stickiness, short run aggregate supply curve is not vertical (you can consider the issue of menu costs and aggregate demand externality that make price sticky). • This is what we call the Keynesian aggregate supply curve. In the extreme Keynesian case aggregate supply curve is horizontal; indicating that firms will supply whatever amount of goods is demanded at the existing price level (see figure below).
- 8. Cont'd…….
- 9. Cont'd………… • The short run equilibrium of the economy is obtained at the intersection of the aggregate demand curve and the horizontal short run aggregate supply curve. In this case changes in aggregate demand either through fiscal policy or monetary policy do affect the level of out put in the economy. • Suppose for instance the central bank reduces the money supply and the aggregate demand curve shifts downward as in the following figure. In the short run, prices are sticky, so the economy moves from point A to point B. Output and employment fall below their natural levels, which means the economy, is in recession. Over time, in response to the low demand, wages and prices fall. The gradual reduction in the price level moves the economy down ward along the aggregate demand curve to pint C, which is the new long run equilibrium.
- 10. Cont'd…………….
- 11. 5.4.The Four Models of Aggregate Supply • 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 affects the price level, but output remains unchanged. • By contrast, in the short run, prices are sticky, and the aggregate supply curve is not vertical. In this case, shifts in the aggregate demand do cause fluctuations in output. • In the last section we took the extreme Keynesian case where aggregate supply curve is horizontal in which all prices are fixed. Our task in this section is to refine this understanding of short-run aggregate supply.
- 12. Cont'd…. • the short-run and the long-run aggregate supply curves differ and a common conclusion that short-run aggregate supply curve is upward sloping i.e. the final destination is a short run aggregate supply equation of the form • Y=Y+ α(p-pe ), α >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 α indicates how much output responds to unexpected changes in the price level; 1/α is the slope of the aggregate supply curve.
- 13. A. 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 where there is no such formal contract, 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. •
- 14. Cont'd………… • The sticky-wage model shows what a sticky nominal wage implies for aggregate supply. To understand the model let us consider what happens to the amount of output produced when the price level rises: A. When nominal wage is stuck, a rise in the price level lowers the real wage (W/P), making labor cheaper. B. The lower real wage induces firms to hire more labor because labor demand is a function of (W/P). C. The additional labor hired produces more output since output(Y) is a function of employment (L).
- 15. B.The Imperfect Information Model • The second explanation for the upward slope of the short run aggregate supply curve is called the imperfect- information model. • Unlike the sticky –wage model, this model assumes that market clear i.e. all wages and prices are free to adjust to balance supply and demand. In this model, the short run and long-run aggregate supply curves differ because of temporary misperceptions about prices. • The imperfect-information model assumes that each supplier in the economy produces a single good and consumes many goods. Because the number of goods is so large, suppliers cannot observe all prices at all times.
- 16. Cont’d…….. • They monitor closely the price of what they produce but less closely the prices of all the goods they consume. Because of imperfect information, they some times confuse changes in the overall level of prices with changes in the relative prices. • This confusion influences decisions about how much to supply, and it leads to a positive relationship between the price level and output in the short-run. • The model implies an aggregate supply curve that is now familiar: • The equation states that output deviates from its natural rate when the price level deviates from the expected price level.
- 17. C.The Sticky-Price Model • Our third explanation for the upward sloping short-run aggregate supply curve is called the sticky-price model. This model emphasizes that firms do not instantly adjust the prices they charge in response to changes in demand. • Sometimes prices are set by long-term contracts between firms and customers. Even with out formal agreements, firms may hold prices steady in order not to annoy their regular customers with frequent price changes. Some prices are sticky because of the way markets are structured: once a firm has printed and distributed its catalog or price list, it is costly to alter prices. • To see how sticky prices can help explain an upward sloping aggregate supply curve, we first consider the pricing decisions of individual firms and then add together the decisions of many firms to explain the behavior of the economy as a whole
- 18. Cont’d……….. • Consider the pricing decision facing a typical firm. The firm’s desired price P depends on two macroeconomic variables: • The overall level of prices P. A higher price level implies that the firm’s costs are higher. Hence, the higher the overall price level, the more the firm would like to charge for its product. • The level of aggregate income Y. A higher level of income raises the demand for the firm’s product. Because marginal cost increases at higher levels of production, the greater the demand, the higher the firm’s desired price.
- 19. Cont’d………..
- 20. D.The Workers –misperception Model
- 21. Cont’d………..
- 22. Cont’d…
- 23. Conclusion
- 24. Cont’d……….. • In the short run, the equilibrium moves from point A to B. the increase in aggregate demand raises the actual price level from P1 to P2. • Because people did not expect this increase in the price level, the expected price level remains at Pe2, and output rises from Y1 to Y2, which is above the natural rate Y. Thus, the unexpected expansion in aggregate demand causes the economy to boom. • Yet the boom does not last forever. In the long run, the expected price level rises to catch up with reality, causing the SR aggregate supply curve to shift upward. As the expected price level rises from Pe2 to Pe3, the equilibrium of the economy moves from point B to point C. • The actual price level rises from P2 to P3, and output falls from Y2 to Y3 = Y . In other words, the economy returns to the natural level of output in the long run, but at a much higher price level.
- 25. Diagrammatic Summary of the theory of short-run fluctuations