An Aggregate-Demand-Aggregate-Supply Model

Pigou Curve ("Aggregate Demand" Curve)

The Pigou Curve is a curve that shows the relationship between the price level and the GDP, showing each respective price level and the quantity of goods and services that people want to buy.

Friedman Curve ("Short Run Aggregate Supply" Curve)

The Friedman Curve is a curve that shows the relationship between the price level and the GDP, showing each respective price level and the real GDP that businessmen are willing to sell at that price level.

Equilibrium

The "equilibrium" is the intersection of the Pigou Curve and the Friedman Curve, that is, the price level high enough that the RGDP that businessmen want to sell is the same as the RGDP that customers want to buy.

It was inflation in the second half of the twentieth century that got economists (New Classical and Keynesian both) thinking seriously about Aggregate Supply.

Keynesians tended to sort inflationary surges into two groups:

demand pull

These were the cases in which prices rose because increased demand allowed businessmen to raise both prices and profit margins.

cost push

These were cases in which prices rose because business costs had gone up, and businessmen passed them on to the customers -- with no increase in profit margins. This could be more serious, since the increases in prices could cause further increases in cost, creating an "inflationary spiral."

New Classical Interpretation

In explaining "inflationary spirals," though, the New Classical economists put more stress on expectations. The idea was that people, having lived with inflation over a period of years, would eventually come to expect that the inflation would continue.

Thus, in a world of ongoing inflation,

• Even if people didn't learn very efficiently, they would "adapt" their expectations by correcting their mistakes, and eventually come to expect that inflation would continue. This reasoning produced the "adaptive expectations" approach.
• If people are rational enough to maximize profits and net benefits from consumption -- as we assume in microeconomics -- then they would be rational enough to learn rapidly, and would get it right on the average. This is the "rational expectations" approach.

Dynamic Friedman Curve

The Dynamic Friedman Curve is a curve that shows the relationship between the rate of inflation and the rate of growth of the GDP, showing the rate of inflation that corresponds to each respective rate of growth of the GDP.

So the Dynamic Friedman Curve does give us a relationship between RGDP and the price level, as the definition of the Friedman Curve says -- but it will be a changing, not a stable relationship. Even if the Dynamic Friedman Curve is stable, the relationship of RGDP to the price level will vary depending on the price level and RGDP the year starts with. And it will generally shift from year to year as the price level and RGDP shift from year to year. This is shown in Figure 3.

Potential output is represented in our diagram by a vertical line, like this:

That is "Aggregate Supply" in the Long Run!

But the Friedman Curve leads us to expect an upward-sloping relationship between output and the price level in the short run, like this:

What that means is that a higher price level makes people want to supply more output in the short run, even if not in the long run. But why should that be so?

Surprise!

Producers react differently depending on whether an increase in the price level comes as a surprise. If it does come as a surprise, then it takes some time for the input prices to catch up -- and in the meanwhile, it seems profitable to increase production. Therefore, production is greater at higher price levels. That is, the Aggregate Supply curve is upward sloping.

On the other hand, if the increase in the price level is not a surprise, the input prices will move right up with it, so that there will be no reason to increase production. In that case, the aggregate supply curve would be vertical.

More Surprise

Production would seem profitable when inflation comes as a surprise because

• Businessmen have incomplete information, and believe that the price increase is a relative price increase -- increasing their margin over costs -- when it is not.
• Contracts based on the old price level have some time to run, and while they are in force, it really is more profitable to increase production.
• If businessmen have adaptive expectations, then it takes some time for them to adjust their expectations even if they have complete information. However, most New Classical economists did not stress this reason, since they believed that businessmen had rational -- not adaptive -- expectations.

Definitions

Macroeconomic Long Run

The macroeconomic long run is a period long enough so that businessmen have complete information about price levels, contracts based on old price levels expire, and expectations are fully adapted to the new situation.

Macroeconomic Short Run

The macroeconomic short run is a period short enough so that businessmen believe it is profitable to increase output when the price level is higher than they had expected, either because they have incomplete information about relative prices or because contracts for inputs at the old price level are still in force.

Inflation and Unemployment

In Keynesian terms, there is the "inflationary spiral," in which a rise in costs causes prices to go up, which in turn raises costs, which again rises prices, and so on.

Wage costs are among the costs that rise in response to higher prices. When unemployment is low, employees can hold out for full compensation for the higher prices, and raises above that. When unemployment is high, however, the employees will have to settle for less, and so costs do not rise as fast as prices when unemployment is high.

In New Classical terms, there are "inflationary expectations." When people expect prices to go up, they sign contracts and make long-term plans based on higher prices in the future. These contracts and plans may make it necessary for them to raise their own prices.

Unusually high unemployment is a sign that employees have mis-estimated the value of their labor. However, as time goes on and they get more information, they will learn what they can get for their work, and then wage costs will moderate, and so costs do not rise as fast as prices.

NAIRU

From either point of view, then, high unemployment means that costs rise less rapidly than prices when unemployment is high, so that inflation slows down. On the other hand, low enough unemployment will cause costs to rise faster than prices, with the result that inflation speeds up. In between the two extremes is a rate of unemployment just high enough that costs and prices rise at the same level, so there is no tendency for inflation either to speed up or slow down. This unique rate of unemployment is called the NAIRU, short for non-accelerating-inflation rate of unemployment.

NAIRU

The rate of unemployment at which inflation neither speeds up nor slows down.

NAIRU and GDP

• When unemployment is less than the NAIRU, inflation tends to speed up;
• When unemployment is more than the NAIRU, inflation tends to slow down;
• When unemployment is equal to the NAIRU, inflation continues at an unchanged rate.

NAIRGDP

the non-accelerating-inflation real gross domestic product.

• When RDGP is more than the NAIRGDP, inflation tends to speed up;
• When RGDP is less than the NAIRGDP, inflation tends to slow down;
• When RGDP is equal to the NAIRGDP, inflation continues at an unchanged rate.

Where is the Friedman Curve?

Figure 5: The Long and Short Run Aggregate Supply

Inflationary Expectations

Figure 6. Inflationary Expectations

The Problem of Disinflation

Aggregate Demand with the existing money supply of 500 (billion dollars) is shown by the dark green curve. If Aggregate Demand remains unchanged, there will be more unemployment. The drop in production is 4%, so if employment drops proportionally with production, four percent of the labor force would become unemployed.

Should the monetary authority try to prevent the recession?

Accommodation

Here we see that an increase of the money supply from 500 to 597.50 shifts the AD curve. That gives us an equilibrium in the coming year as shown by the orange lines -- in this case, the price level is at 120 but we have full employment this year.

Credible Disinflation

Incredible Disinflation

The evidence says that people don't believe that inflation is going away until experience teaches them that it is.

New Classical economists might explain this in two ways:

• Governments have announced that "they really mean it this time" so often that people have good reason not to believe them.
• The monetary authorities cannot make their plans credible, even when they "really mean it, this time," because people know that the temptation to accommodate inflation is so great.

Whatever the reason, our experience has been that recession is the price of disinflation because people do not change their inflationary expectations until a recession has slowed inflation.

What Do We Know About Aggregate Supply?

We know three things about Aggregate Supply:

1. In the long run, it is vertical.
2. In the short run, it isn't.
3. If the price level is what people to expect it to be, both long and short run aggregate supply are at the NAIRGDP level.