Lecture 35

Some factors that shift the long-run aggregate supply curve are

• change in labour because of
  • immigration
  • retirement
  • government policies to reduce the natural unemployment rate
    An increase in labour would shift the curve to the right (more goods/services are produced).
• change in capital because of
  • investment in equipment
  • higher education rate (human capital)
  • destruction of factories due to some natural disaster
    An increase in capital would shift the curve to the right.
• changes in natural resources because of
  • discovery of new mineral deposits
  • reduction in supply of imported oils
  • changing weather patterns
    An increase in the availability of resources would shift the curve to the right. It should be noted that it can even shift due to the availability of resources abroad, events in the global oil market for example.
• changes in technology because of productivity improvements from technological process. If they get more advanced, the curve shifts to the right.

In the long run, the aggregate supply curve gradually shifts to the right (due to technological progress) and so does the aggregate demand (due to an increase in money supply). The short-term occurrences should be viewed as deviations from this general trend of output growing and presence of inflation.

The short-run aggregate supply curve is upward sloping. An increase in the price level raises the amount of goods and services supplied. Three theories that attempt to explain this are:

• According to the sticky-wage theory, nominal wages are sticky in the short run and adjust sluggishly.
  If the price level is greater than expected, the revenue is higher but not the labour cost. Production is profitable, so output and employment increase.
• According to the sticky-price theory, prices are sticky in the short run and adjust sluggishly.
  This may be due to menu costs, which is the cost of adjusting prices. Suppose the price level is greater than expected. Then firms with menu costs wait to raise prices, so sales increase, and output and employment increase as well.
• According to the misperceptions theory, firms may confuse changes in price level with changes in the relative price of the products they sell.
  If the price level increases more than expected, then a firm sees its own price rise before realizing that all prices are rising. So, thinking that its relative price is increasing, it may increase output and employment as well.

In all three theories, \(Y\) deviates from \(Y_N\) when \(P\) deviates from \(P_E\).

\[Y = Y_N + a(P-P_E),\]

where \(a > 0\) measures how much \(Y\) responds to changes in \(P\). The imperfections in these theories are only short-run, and the stickiness disappears in the long run.

If the expected price level \(P_E\) changes, the short-run aggregate supply curve shifts. If it rises, workers and firms set higher wages, so at a fixed \(P\), production is less profitable, \(Y\) falls, and the curve shifts to the left.

In the long-run, \(P_E = P\), \(Y = Y_N\), and the unemployment is at its natural rate.

Stagflation is a period of falling output and rising prices.

The theory of liquidity preference is a theory about the interest rate, denoted \(r\). It adjusts to balance supply and demand for money.
Money demand reflects how much wealth people want to hold in liquid form. Suppose there are only two types of assets - money (which is liquid but pays no interest), and bonds (which pay interest but are not as liquid). Then, money demand reflects the preference for liquidity, which is influenced by \(Y\), \(r\), and \(P\).

• If \(Y\) rises, the money demand increases (people want to buy more goods and services).
• If \(r\) rises, the money demand falls (the opportunity cost of holding money increases).
• If \(P\) rises, the money demand increases (people need more money to buy the same amount of goods and services).

The money supply curve is vertical (it is fixed by the RBI). To change both the interest rate and shift the aggregate demand curve, the RBI conducts OMOs to change the money supply. Reducing the money supply increases \(r\), which in turn reduces the quantity of goods and services demanded.

Fiscal policies are undertaken by the government, and monetary policies by the central bank.

• Expansionary fiscal policy increases \(G\) and/or decreases \(T\) (it shifts the aggregate demand curve to the right).
• Contractionary fiscal policy decreases \(G\) and/or increases \(T\) (it shifts the aggregate demand curve to the left).

There are two effects that fiscal policy has:

• The multiplier effect - additional shifts in aggregate demand that result when fiscal policy increases income and thus increases consumer spending.
  Marginal propensity to consume is the fraction of extra income that households consume rather than save. Using this, we can quantify the multiplier effect.
  We have

  \[\Delta Y = \Delta C + \Delta G = (MPC) \Delta Y + \Delta G = \frac{1}{1 - MPC} \Delta G.\]

  \(I\) and \(NX\) do not change. This multiplicative factor is the multiplier.

• The crowding out effect - if a fiscal policy raises \(r\), then investment drops, and the net increase in aggregate demand drops. So, the actual aggregate demand shift may be less than the initial fiscal expansion.

People who believe that fiscal policy affects aggregate supply significantly are called supply-siders. These effects are usually more relevant in the long run.

It is desirable to have a relatively stable economy.

• When GDP falls below its natural rate, expansionary monetary/fiscal policy should be implemented to avoid a recession.
• When it goes above its natural rate, contractionary policy should be implemented to avoid (too much) inflation.
  Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into recession, without the policymakers actively taking any action.
  For example, in a recession, taxes fall automatically and government spending rises automatically (more people apply for public assistance).