Lecture 4. AD AS model. - Universidad Autónoma de … · Lecture 4. The AD‐AS ... • frictional unemployment: caused by the time it ... • Cons: The longer a worker is eligible

Lecture 4. The AD‐AS model.

Carlos Llano (P)& Nuria Gallego (TA)

References: these slides have been developed based on the ones provided byBeatriz de Blas and Julián Moral (UAM), as well as the official materials fromMankiw, 2009 and Blanchard, 2007 books. We are grateful for that.• Mankiw (2009): Chapters 6, 9, 13

Learning objectives

• An introduction to the Labor Market in Spain…• … reflexions about the natural rate of unemployment:

– what it means– what causes it– understanding its behavior in the real world

• an introduction to aggregate supply in the short run and long run

• three models of aggregate supply in which output depends positively on the price level in the short run

2

Outline

1. An introduction to the Labor Market in Spain…2. One step forward: understanding unemployment3. Introduction to aggregate supply in the short and long

run4. Three models of aggregate supply5. The aggregate supply curve6. Integrating aggregate demand and aggregate supply7. Aggregate demand policies8. Aggregate supply policies

3

1. UNDERSTANDING UNEMPLOYMENT

4

• Mankiw (2009): Chapter 6

• CONCEPTS:– Población potencialmente activa (16<x<65)– Población activa (16<x<65) que buscan activamente empleo:

• Ocupados (Employed)• Parados (Unemployed)

– Inactivos/Inactives (estudiantes, rentistas, am@s de casa, incapacitados…)

• RATES– Activity rate/Tasa de actividad: Población activa/Población pot. activa– Unemployment rate/Tasa de paro: Población parada/Población activa– Employment Rate/Tasa de empleo: Población ocupada/Población pot.

Activa

• MAIN STATISTICAL SOURCES IN SPAIN ON THE LABOR MARKET:– EPA (INE)– REGISTRO DE EMPLEO (MTAS: INEM)

THE LABOR MARKET

Main definitions

salariedEmployed

Un‐employed

Inactive

Active

EPA (Encuesta Población Activa)

The Labor market in Spain (EPA:4 Trim /2012)

Employed16.9 millones

Unemployed5,9 millones

Inactives15,4 millones

15,27%

5%

Labor transitions in the Spanish Labor Market. 4ºTrim/2012

• Population >16 years= 38,3 millions. • Active population= 22,9 millions.• # of hoseholds= 17 million.• Activity Rate: 57,82• Unemployment rate: 24,23



3 Types of Unemployment

• Frictional: associated with the process of searching a job. Searching is costly and takes time.

• Structural: associated with imperfections in the Labor Market: wage rigidity (non clearing of the Labor market)

• Cyclical (coyuntural): associated with variations of the observed unemployment rate over the natural unemployment rate.– In a boom, the actual unemployment rate falls

below the natural rate. – In a recession, the actual unemployment rate rises

above the natural rate.

11

Un:Natural Unemployment

‐ Actual Unemployment (observable) = Natural Unemployment + Cyclical unemployment‐ Natural Unemployment (non‐observable): The trend behind the observed unemployment rate, which accounts for the frictional and structural unemployment:

0

5

10

15

20

25

30

1981TII

1982TII

1983TII

1984TII

1985TII

1986TII

1987TII

1988TII

1989TII

1990TII

1991TII

1992TII

1993TII

1994TII

1995TII

1996TII

1997TII

1998TII

1999TII

2000TII

2001TII

2002TII

2003TII

2004TII

2005TII

2006TII

2007TII

2008TII

2009TII

Tendencia Tasa de paro (Estimación Tasa natural de paro)

Tasa de paro (EPA)

Estimate for the natural Un

In this period, the unemployment rate is greater than the natural rate: positive cyclical unemployment rate

Fuente: EPA y Estimaciones propias

3 Types of Unemployment

Natural Rate of Unemployment

• Natural rate of unemployment: the average rate of unemployment around which the economy fluctuates.

• In a recession, the actual unemployment rate rises above the natural rate.

• In a boom, the actual unemployment rate falls below the natural rate.

13

U.S. Unemployment: 1958‐2002

14

A first model of the natural rate

Notation:

L = # of workers in labour force

E = # of employed workers

U = # of unemployed

U/L = unemployment rate

15

Assumptions:

1. L is exogenously fixed.

2. During any given month, s = fraction of employed workers that become separated from their jobs, f = fraction of unemployed workers that find jobs.

16

s = rate of job separationsf = rate of job finding

(both exogenous)

The transitions between employment and unemployment

17

Employed Unemployed

Job separation: s E

Job finding: f U

The steady state condition

• Definition: the labour market is in steady state, or long‐run equilibrium, if the unemployment rate is constant.

• The steady‐state condition is:

18

s E = f U

# of employed people who lose or leave their jobs

# of unemployed people who find jobs

Solving for the “equilibrium” U rate

f U = s E

= s (L –U )

= s L – s U

Solve for U/L:

(f + s)U = s L

so,

19

U sL s f

Example:

• Each month, 1% of employed workers lose their jobs (s = 0.01)

• Each month, 19% of unemployed workers find jobs (f = 0.19)

• Find the natural rate of unemployment:

• Policy implication: A policy will reduce the natural rate of unemployment only if it lowers s or increases f.

20

0.010.05, or 5%

0.01 0.19U sL s f

Why is there unemployment?

• If job finding were instantaneous (f = 1), then all spells of unemployment would be brief, and the natural rate would be near zero.

• There are two reasons why f < 1:1. job search

2. wage rigidity

21

Job Search & Frictional Unemployment

• frictional unemployment: caused by the time it takes workers to search for a job

• occurs even when wages are flexible and there are enough jobs to go around

• occurs because:– workers have different abilities, preferences.– jobs have different skill requirements.– geographic mobility of workers is not instantaneous– flow of information about vacancies and job candidates is imperfect.

22

Cause for frictional Unemployment:1. Sectoral shifts

• Def: changes in the composition of demand among industries or regions

• example: Technological change increases demand for computer repair persons, decreases demand for typewriter repair persons

• example: A new international trade agreement labor demand increases in export sectors, decreases in import‐substitution sectors.

• Result: frictional unemployment.

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4,2%

28,0%9,9%

57,9%

AgricultureManufacturingOther industryServices

1960

73,5%

1,6%

17,2%7,7%

2000

Cause for frictional Unemployment:1. Sectoral shifts

Link between frictional Unempl. & Policy:2. Public Policy and Job Search

Govt programmes affecting unemployment• Govt employment agencies: (like the Spanish INEM)disseminate info about job openings to better match workers & jobs (Objetive: reduce frictional unempl.)

• Watch: “Company Man”.

• Public job training programs: (Active policies)help workers displaced from declining industries get skills needed for jobs in growing industries

25

Link between frictional Unempl. & Policy:3. Unemployment insurance (UI)

• UI pays part of a worker’s former wages for a limited time after losing his/her job.

• UI increases search unemployment, because it:– reduces the opportunity cost of being unemployed– reduces the urgency of finding work– hence, reduces f

• Pros: By allowing workers more time to search, UI may lead to better matches between jobs and workers, which would lead to greater productivity and higher incomes.

• Cons: The longer a worker is eligible for UI, the longer the duration of the average spell of unemployment.

26

Why is there unemployment?

• There are two reasons why f < 1:1. job search (frictional unemployment)

2. wage rigidity (structural unemployment)

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The natural rate of unemployment: U sL s f

DONE Next

Unemployment from real wage rigidity

28

Labour

Real wage

Supply

Demand

Unemployment

Rigid real wage

Amount of labour willing to work

Amount of labour hired

If the real wage is stuck above the eq’m level, then there aren’t enough jobs to go around.

Spanish minimum wage.

Unemployment from real wage rigidity

29

If the real wage is stuck above the eq’m level, then there aren’t enough jobs to go around.

Then, firms must ration the scarce jobs among workers.

Structural unemployment: the unemployment resulting from real wage rigidity and job rationing.

Reasons for wage rigidity (structural unempl.)

1. Minimum wage laws

2. Labour unions

3. Efficiency wages

30

Reasons for wage rigidity 1. The minimum wage

• The minimum wage may exceed the eq’m wage of unskilled workers, especially teenagers.

• Studies: a 10% increase in min. wage reduces teen unemployment by 1‐3%.

• But, the min. wage cannot explain the majority of the natural rate of unemployment, as most workers’ wages are well above the min. wage.

31

Reasons for wage rigidity 1. The minimum wage in the real world:

• In Sept 1996, the minimum wage in the U.S. was raised from $4.25 to $4.75. Here’s what happened:

32

Unemployment rates, before & after3rd Q 1996 1st Q 1997

Teenagers 16.6% 17.0%Single

mothers 8.5% 9.1%

All workers 5.3% 5.3%

Reasons for wage rigidity 2. Labor unions

• Unions exercise monopoly power to secure higher wages for their members.

• When the union wage exceeds the eq’m wage, unemployment results.

• Employed union workers are insiders whose interest is to keep wages high.

• Unemployed non‐union workers are outsiders and would prefer wages to be lower (so that labor demand would be high enough for them to get jobs).

33

Workers Covered by Collective Bargaining

country % of employed

country % of employed

U.S. 18 Norway 75Japan 23 Portugal 79U.K. 35 Australia 80Canada 38 Sweden 83Switzerland 53 Germany 90New Zealand 67 France 92

Spain 68 Finland 95Netherlands 71 Austria 98

Watch (17:00’): How green was my valley

Reasons for wage rigidity3. Efficiency Wage Theory

• Theories in which high wages increase worker productivity: – attract higher quality job applicants – increase worker effort and reduce “shirking” (absentismo)– reduce turnover (rotación), which is costly – improve health of workers

(in developing countries)

• The increased productivity justifies the cost of paying above‐equilibrium wages.

• Result: structural unemployment35

The duration of unemployment

• The data: – More spells of unemployment are short‐term than medium‐term or long‐term.

– Yet, most of the total time spent unemployed is attributable to the long‐term unemployed.

• This long‐term unemployment is probably structural and/or due to sectoral shifts among vastly different industries.

• Knowing this is important because it can help us craft policies that are more likely to succeed.

36

The Labor‐Market Experience: US vs Europe

Standardized Unemployment Rates in Western Europe

37

0

4

8

12

16

20

Austria

Belgium

Denmark

Finlan

dFran

ceGerm

any

Greece

Irelan

dIta

ly

Netherl

ands

Norway

Portug

alSpa

inSwed

en

Switzerl

and

U.K.

perc

enta

ge o

f lab

or fo

rce

19942004

Unemployment Rates in the OECD

38

0

4

8

12

France

German

y

Italy

Switzerl

and

U.K.

Austra

liaCan

ada

Japa

n

USA

perc

enta

ge o

f lab

or fo

rce

19942004

The minimum wage in the U.S.

39

0

1

2

3

4

5

6

7

8

1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

$ pe

r hou

r

nominal (in current dollars) real (in 2002 dollars)

0

20

40

60

80

100

1970 1975 1980 1985 1990 1995 2000 2005

Oil

pric

e (p

er b

arre

l)

in current U.S. dollars (nominal)in 2005 U.S. dollars (real)

EXPLAINING THE TREND: Sectoral shifts

40

Watch: Mota and job search

EXPLAINING THE TREND: Demographics

• 1970s: The Baby Boomers were young. Young workers change jobs more frequently (high value of s).

• Late 1980s through today: Baby Boomers aged. Middle‐aged workers change jobs less often (low s).

41


42


43

The rise in European Unemployment

0

2

4

6

8

10

12

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

Year

Perc

ent U

nem

ploy

ed

FranceGermanyItalyU.K.

44

The rise in European Unemployment

Two explanations:1. Most countries in Europe have generous social

insurance programs.2. Shift in demand from unskilled to skilled

workers, due to technological change.

45

This demand shift occurred in the U.S., too. However, with more labor market and wage flexibility, the shift caused an increase in the skilled‐to‐unskilled wage gap instead of an increase in unemployment.

46

Spain

47

Spain

2. INTRODUCTION TO AGGREGATE SUPPLY IN THE SHORT AND LONG RUN

48


The model of aggregate demand and supply

• the paradigm that most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy

• shows how the price level and aggregate output are determined

• shows how the economy’s behavior in the short run differs from the long run

49

Aggregate demand

• The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.

50

An increase in the price level causes a fall in real money balances (M/P ),causing a decrease in the demand for goods & services.

Y

P

AD

Shifting the AD curve

An increase in the money supply shifts the AD curve to the right.

51

Y

P

AD1

AD2

Aggregate Supply in the Long Run

• In the long run, output is determined by factor supplies and technology

52

, ( )Y F K L

is the full‐employment or natural level of output, the level of output at which the economy’s resources are fully employed.

Y

“Full employment” means that unemployment equals its natural rate (not zero).

The long‐run aggregate supply curve

The LRAS curve is vertical at the full‐employment level of output.

53

Y

P LRAS

Y

Long‐run effects of an increase in M

An increase in M shifts the AD curve to the right.

54

Y

P

AD1

AD2

LRAS

Y

P1

P2In the long run, this increases the price level…

…but leaves output the same.

Aggregate Supply in the Short Run

• Many prices are sticky.

• For now, we assume – all prices are stuck at a predetermined level in the short run…

– …and firms are willing to sell as much as their customers are willing to buy at that price level.

• Therefore, the short‐run aggregate supply (SRAS) curve is horizontal:

55

The short run aggregate supply curve

The SRAS curve is horizontal:The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

56

Y

P

P SRAS

Short‐run effects of an increase in M

…an increase in aggregate demand…

57

Y

P

AD1

AD2

In the short run when prices are sticky,…

…causes output to rise.

P SRAS

Y2Y1

From the short run to the long run

Over time, prices gradually adjust. When they do, will they rise or fall?

58

Y Y

Y Y

Y Y

rise

fall

remain constant

In the short‐run equilibrium, if

then over time, the price level will

The adjustment of prices is what moves the economy to its long‐run equilibrium.

The SR & LR effects of M > 0

A = initial equilibrium

59

Y

P

AD1

AD2

LRAS

Y

P SRAS

P2

Y2

AB

CB = new short‐run

eq’m after central bank increases M

C = long‐run equilibrium

LRAS

AD2

P SRAS

The effects of a negative demand shock

The shock shifts AD left, causing output and employment to fall in the short run

60

Y

P

AD1

Y

P2

Y2

AB

COver time, prices fall and the economy moves down its demand curve toward full‐employment.

Supply shocks

• A supply shock alters production costs, and therefore affects the prices that firms charge. (also called price shocks)

• Examples of adverse supply shocks:– Bad weather reduces crop yields, pushing up food prices.

– Workers unionize, negotiate wage increases. – New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance.

• Favorable supply shocks lower costs and prices.

61

CASE STUDY: The 1970s oil shocks

• Early 1970s: OPEC coordinates a reduction in the supply of oil.

• Oil prices rose11% in 197368% in 197416% in 1975

• Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

62

1P SRAS1

Y

P

AD

LRAS

YY2


The oil price shock shifts SRAS up, causing output and employment to fall.

63

A

B

In absence of further price shocks, prices will fall over time and economy moves back toward full employment.

2P SRAS2

A


Predicted effects of the oil price shock:• inflation • output • unemployment

…and then a gradual recovery.

64

0%

10%

20%

30%

40%

50%

60%

70%

1973 1974 1975 1976 19771%

5%

9%

13%

17%

21%

25%

Change in oil prices (left scale)

Inflation rate-RPI (right scale)

Unemployment rate (right scale)


Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

65

-10%

0%

10%

20%

30%

40%

50%

60%

1977 1978 1979 1980 1981 19823%

7%

11%

15%

19%





1980s: A favourable supply shock‐‐a significant fall in oil prices.

As the model would predict, inflation and unemployment fell:

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-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1982 1983 1984 1985 1986 1987 19880%

2%

4%

6%

8%

10%

12%




Stabilisation policy

• def: policy actions aimed at reducing the severity of short‐run economic fluctuations.

• Example: Using monetary policy to combat the effects of adverse supply shocks:

67

Stabilising output with monetary policy

68

1P SRAS1

Y

P

AD1

B2P SRAS2

A

Y2

LRAS

Y

The adverse supply shock moves the economy to point B.

Stabilising output with monetary policy

69

1P

Y

P

AD1

B2P SRAS2

A

C

Y2

LRAS

Y

AD2

But the central bank accommodates the shock by raising A.D.

results: P is permanently higher, but Y remains at its full‐employment level.

3. THREE MODELS OF AGGREGATE SUPPLY

70


Three models of aggregate supply

1. The sticky‐wage model2. The sticky‐price model3. The imperfect‐information model.

All three models imply:

71

( )eY Y P P

natural rate of output

a positive parameter

the expected price level

the actual price level

agg. output

The sticky‐wage model

• Assumes that firms and workers negotiate contracts and fix the nominal wage before they know what the price level will turn out to be.

• The nominal wage they set , W, is the product of a target real wage, , and the expected price level:

72

eW ω P eW Pω

P P


If it turns out that

73

eW PωP P

eP P

eP P

eP P

thenunemployment and output are at their natural ratesreal wage is less than its target, so firms hire more workers and output rises above its natural rate

real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate

Real wage, W/P

Income, output, Y

Price level, P

Income, output, Y

Labor, L Labor, L

W/P 1

W/P 2L 5 Ld(W/P )

L2L1

Y2

Y1

Y 5 F(L)

L2L1

P2

P1

Y 5 Y 1 a (P 2 P

e)

Y2Y1

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 aggregatesupply curvesummarizes these changes.

(a) Labor Demand (b) Production Function

(c) Aggregate Supply

74


• Implies that the real wage should be counter‐cyclical, should move in the opposite direction as output during business cycles:– In booms, when P typically rises,

real wage should fall. – In recessions, when P typically falls,

real wage should rise.

• This prediction does not come true in the real world:

75

The cyclical behavior of the real wage in the U.S.

76

Percentage change in realwage

Percentage change in real GDP

1982

1975

19931992

1960

1996

19991997

1998

1979

1970

1980

1991

1974

1990

19842000

1972

1965

-3 -2 -1 0 1 2 3 7 8654

4

3

2

1

0

-1

-2

-3

-4

-5

The sticky‐price model

• Reasons for sticky prices:– long‐term contracts between firms and customers– menu costs– firms do not wish to annoy customers with frequent price changes

• Assumption:– Firms set their own prices (e.g. as in monopolistic competition)

77


• An individual firm’s desired price is

78

where a > 0. Suppose two types of firms:• firms with flexible prices, set prices as above• firms with sticky prices, must set their price before they know how P and Y will turn out:

( )p P Y Y a

( )e e ep P Y Y a


• Assume firms w/ sticky prices expect that output will equal its natural rate. Then,

79

( )e e ep P Y Y a

ep P

• To derive the aggregate supply curve, we first find an expression for the overall price level.

• Let s denote the fraction of firms with sticky prices. Then, we can write the overall price level as


• Subtract (1s )P from both sides:

80

(1 )[ ( )]eP s P s P Y Y a

price set by flexible price firms

price set by sticky price firms

(1 )[ ( )]esP s P s Y Y a

• Divide both sides by s :

(1 )( )e sP P Y Y

s

a


• High P e High PIf firms expect high prices, then firms who must set prices in advance will set them high.Other firms respond by increasing prices.

• High Y High PWhen income is high (with respect to the natural level), the demand for goods is high. Firms with flexible prices set high prices.

• The greater the fraction of flexible price firms, the smaller is s and the bigger is the effect of Y on P.

81

(1 )( )e sP P Y Y

s

a


• Finally, derive AS equation by solving for Y :

82

(1 )( )e sP P Y Y

s

a

( ),eY Y P P

where (1 )

ss

a


• In contrast to the sticky‐wage model, the sticky‐price model implies a pro‐cyclical real wage:Suppose aggregate output/income falls. Then,• Firms see a fall in demand for their products. • Firms with sticky prices reduce production, and hence reduce their demand for labor.

• The leftward shift in labor demand causes the real wage to fall.

83

The imperfect‐information model

• Assumptions:– all wages and prices perfectly flexible, all markets clear

– each supplier produces one good, consumes many goods

– each supplier knows the nominal price of the good he/she produces, but does not know the overall price level

84

The imperfect‐information model

• Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level.

• Supplier doesn’t know price level at the time he/she makes her production decision, so uses the expected price level, P e. – Note that in this case P e is not the expected price of “all

products” (mine included) in t+1, but the expected price of “the other products” even in t.

• Suppose P rises but P e does not. – Supplier thinks her relative price has risen, so she produces more.

– With many producers thinking this way, Y will rise whenever P rises above P e.

85

Summary & implications

Each of the three models of agg. supply imply the relationship summarised by the SRAS curve & equation

86

Y

P LRAS

Y

SRAS

( )eY Y P P

eP P

eP P

eP P

Summary & implications

Suppose a positive AD shock moves output above its natural rate and Pabove the level people had expected.

87

Y

P LRAS

SRAS1

equation: ( )eY Y P P SRAS

1 1eP P

SRAS2

AD1

AD22eP

2P3 3

eP P

Over time, P e rises, SRAS shifts up,and output returns to its natural rate.

1Y Y 2Y3Y

4. AGGREGATE DEMAND POLICIES

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5. AGGREGATE SUPPLY POLICIES

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Lecture 4. AD AS model. - Universidad Autónoma de … · Lecture 4. The AD‐AS ... • frictional unemployment: caused by the time it ... • Cons: The longer a worker is eligible