Macroeconomics
January 07, 2012
Aggregate Supply
Analysis – Classical View

2
Aggregate Supply

»Role of Aggregate Demand in determining
the economy‟s output

»What does the AD curve signify?
»What is...
Production Function

»Technological relation between the rates of
input of productive resources and the
maximum rate of ou...
Production Function

»Output‟s relationship to capital stock and
labor employed?

»Recall diminishing returns!
»Assumption...
Demand for Labor Function

»Assumption: Given capital stock, pure
competition

»Demand for labor curve consists of the MP
...
Demand for Labor Function

»W/P = MPL
»To obtain the demand curve, the
relationship between real wage and the
amount of la...
Supply of Labor Function

»Real wages play a key role!
»NS = f(W/P)

»Relationship between real wages and labor
supplied

...
Summary of labor demand and supply

» Production is entirely a function of the quantity
of labor: Y = f(N)

» Amount of la...
Keynesian Aggregate Supply Model

» Criticism of assumptions made in Classical
model

» Similarity of views on Aggregate P...
Classical Analysis of Income Determination

» Say‟s Law of Markets: Supply creates its own
demand

» Exchange between part...
Equilibrium in the Classical Model

» Economy consists of 3 markets: Labor, money
and goods

» Labor Market:
» Y = f(N)
» ...
Equilibrium in the Classical Model

» Money Market:
» M = KPY

» Goods Market:
» S = f(r)
» I = f(r)
»S = I

13
Aggregate Supply Analysis –
Keynesian View

14
Great Depression

» Classical economists and Say‟s law of demand
» Possibility of producing too much of one type of
good a...
Great Depression

» Spending induces supply
» What happens when individuals and firms spend
lesser or cut back on their bu...
Equilibrium in the Keynesian Model

» Economy consists of the same 3 markets in
Keynesian view as well

» Labor Market:
» ...
Equilibrium in the Keynesian Model

» Money Market:
» M = KPY + L(r)

» Goods Market:
» S = f(r)
» I = f(r)
»S = I
»Y = C ...
Wage rigidity

» Implicit agreement between a business firm and
its key employees

» What happens to a firm that reduces w...
Classical Vs. Keynesian Income Determination

»3 most important differences in Keynes‟
theory

»Wage rigidity Vs. wage-pri...
Classical Vs. Keynesian Analysis
Classical

Keynesian

Full Employment exists.
Equilibrium at full employment
Supply creat...
Classical Vs. Keynesian Analysis
Classical

Keynesian

Static approach to income/output
analysis
No faith in fiscal or mon...
Keynesian Chain of causation
Changes in the quantity of money

Changes in the rate of interest
Changes in Aggregate Demand...
Economic Fluctuations and
Unemployment

24
Introduction

» Efficient operation of an economy is determined
by:

» Real output
» Full employment
» Price Stability

» ...
Business Cycles

» Business Cycle is a swing in total national
output, income and employment (usually lasting
for a period...
Business Cycles

» 4 stages of a business cycle
» Recovery or revival of economic activity

» Prosperity or expansion of a...
A few examples

» What happens to the following variables during
recovery, boom, recession and depression?

» Industrial p...
Theories of business cycles

» Interaction between the multiplier and the
accelerator

» Multiplier theory – Income is det...
Theories of business cycles

» Stabilization policies - ?
» How effective are stabilization policies in
developing countri...
Indicator forecasting

» Can business cycles be predicted earlier? How?

» What do you understand by leading and lagging
i...
Employment Fluctuations

» What is the importance of employment rates in
an economy?

» Barometer effect
» Keynes – Level ...
Employment Fluctuations

» Unemployment:
» (Number of persons unemployed/number in
civilian labor force)*100

» Sign of ec...
Full Employment

» Zero unemployment?
» Level of employment that results when the rate
of unemployment is normal

» Thumb ...
Full Employment

» Natural rate of unemployment is the long run
average of unemployment caused due to
frictional and struc...
Measurement Problems

» People excluded though they prefer to work,
people being included who are not active job
seekers

...
Unemployment Programs

» Not launched at a large scale
» Result – Reduction in unemployment is marginal

» Problems in imp...
Disguised unemployment

» No standard unit to measure labor productivity
» Too many people involved for a job involving
le...
Price Stability

39
Inflation

» An increase in the general level of prices over a
sustained period of time

» Is increase in the price of a p...
Economic Impacts of Inflation

» Effect of Inflation on distribution of income and
wealth?

» What happens to wealth durin...
Inflation in AD-AS Framework

» Demand-Pull Inflation
» “Too much money chasing too few goods”

» Logic: General rise in p...
Inflation in AD-AS Framework

» Cost-Push Inflation
» Inflation originates from the supply side
» Wage-Push Inflation
» Pr...
Introduction to Phillips Curve

» Phillips curve establishes a relationship between
rate of wage increase and rate of unem...
Introduction to Phillips Curve

» Justification for downward slope: Organized
labor‟s effort to increase wages unmatched w...
Inflation in India

» Problem of inflation exists right from the first
Five Year Plan

» Observed that whenever inflation ...
Factors driving inflation

» Demand-Pull:
» Government Expenditure

» Hoarding, black-marketing activities
» Population ex...
Questions???
Have a happy Sunday!
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Macroeconomics 07 jan

  1. 1. Macroeconomics January 07, 2012
  2. 2. Aggregate Supply Analysis – Classical View 2
  3. 3. Aggregate Supply »Role of Aggregate Demand in determining the economy‟s output »What does the AD curve signify? »What is Aggregate Supply and how does the curve look like? »Combinations of output and the price level at which firms are willing, at the given price level, to supply the given quantity of output 3
  4. 4. Production Function »Technological relation between the rates of input of productive resources and the maximum rate of output that can be had from the inputs, given the technology of production »Example? »What does production function mean in the microeconomic context? »Y = f(K, N) 4
  5. 5. Production Function »Output‟s relationship to capital stock and labor employed? »Recall diminishing returns! »Assumption for the model: Constant capital stock and technology »New production function: Y = f(N) »The production function graph »Reason why the slope reduces? 5
  6. 6. Demand for Labor Function »Assumption: Given capital stock, pure competition »Demand for labor curve consists of the MP of labor curve »The condition of W = P * MPL »Cost of hiring an additional worker vis-à-vis the revenue associated with the employment of the additional laborer 6
  7. 7. Demand for Labor Function »W/P = MPL »To obtain the demand curve, the relationship between real wage and the amount of labor is used »Slope of the production function »Downward sloping demand curve for labor: ND = f(W/P) »Shifts in demand for labor 7
  8. 8. Supply of Labor Function »Real wages play a key role! »NS = f(W/P) »Relationship between real wages and labor supplied 8
  9. 9. Summary of labor demand and supply » Production is entirely a function of the quantity of labor: Y = f(N) » Amount of labor supplied depends only on real wage and increases with real wage » Amount of labor demanded also depends only on real wage rate and decreases with it » Real wages perfectly flexible (“flex price”) » Economy is made up of efficiently operating − markets that are very flexible (ND = NS = N) 9
  10. 10. Keynesian Aggregate Supply Model » Criticism of assumptions made in Classical model » Similarity of views on Aggregate Production Function and demand for labor » Keynesian Assumptions: » Nominal wage is exogenous (No rapid adjustment) » Labor market is not always in equilibrium 10
  11. 11. Classical Analysis of Income Determination » Say‟s Law of Markets: Supply creates its own demand » Exchange between parties involves two transactions of the counteractive nature » No overproduction of goods » Possibility of preference of total output surpassing total demand » Extension of this theory: Money is not preferred for money! 11
  12. 12. Equilibrium in the Classical Model » Economy consists of 3 markets: Labor, money and goods » Labor Market: » Y = f(N) » dY/dN = W/P » ND = f(W/P) » NS = f(W/P) » ND = NS 12
  13. 13. Equilibrium in the Classical Model » Money Market: » M = KPY » Goods Market: » S = f(r) » I = f(r) »S = I 13
  14. 14. Aggregate Supply Analysis – Keynesian View 14
  15. 15. Great Depression » Classical economists and Say‟s law of demand » Possibility of producing too much of one type of good and not enough of other type » Mechanism of wage-price flexibility » Reasoning: What happens to price when there is excess supply or excess demand? » What happens during „glut‟? » Keynes viewed AS from a supply side – supply creates its own demand 15
  16. 16. Great Depression » Spending induces supply » What happens when individuals and firms spend lesser or cut back on their budgets? And how can it be linked to employment? » Classical economists‟ argument on employment and surplus labor » Keynesian framework equilibrium does not happen at the full employment stage. Why or How? 16
  17. 17. Equilibrium in the Keynesian Model » Economy consists of the same 3 markets in Keynesian view as well » Labor Market: » Y = f(N) » dY/dN = − w/P » ND = f(w/P) − »W = w 17 −
  18. 18. Equilibrium in the Keynesian Model » Money Market: » M = KPY + L(r) » Goods Market: » S = f(r) » I = f(r) »S = I »Y = C + I » Y – C = I; Y – C = S 18
  19. 19. Wage rigidity » Implicit agreement between a business firm and its key employees » What happens to a firm that reduces wages? » As real wages rise the firm lays off workers » Does inflexible wage mean nominal wages are also inflexible? » When will there be an excess supply of labor? » What happens when price level falls? » Unemployment arises because of sticky wages 19
  20. 20. Classical Vs. Keynesian Income Determination »3 most important differences in Keynes‟ theory »Wage rigidity Vs. wage-price flexibility (for situations less than full employment) »Speculative demand for money »Income being a far more important determinant of saving and consumption than rate of interest (r) 20
  21. 21. Classical Vs. Keynesian Analysis Classical Keynesian Full Employment exists. Equilibrium at full employment Supply creates its own demand Demand creates its own supply No overproduction Possibility of glut. Supply doesn’t always match demand No government intervention No ‘laissez faire’. Wage cut can solve unemployment problem Wage cuts increases unemployment Importance of savings and thrift 21 Full Employment is a special case. Equilibrium at lesser than full employment Saving was a private virtue and can’t be forced
  22. 22. Classical Vs. Keynesian Analysis Classical Keynesian Static approach to income/output analysis No faith in fiscal or monetary policies State intervention through fiscal and monetary policy advocated Did not take into account business cycles Considered business cycles in the form of employment Balanced budget policy 22 Dynamic and a macro approach to output analysis Deficit budget during deflation and surplus budget during inflation
  23. 23. Keynesian Chain of causation Changes in the quantity of money Changes in the rate of interest Changes in Aggregate Demand Changes in Total Output Changes in Marginal Costs Changes in Prices 23
  24. 24. Economic Fluctuations and Unemployment 24
  25. 25. Introduction » Efficient operation of an economy is determined by: » Real output » Full employment » Price Stability » Can economic expansion lead to recession? » What happens to the 3 factors mentioned above in times of recession/depression? » Fluctuations observed in growth rate of NNPFC 25
  26. 26. Business Cycles » Business Cycle is a swing in total national output, income and employment (usually lasting for a period of 2-10 years) » Marked by widespread expansion or contraction in many sectors of the economy » Business peak or boom – Rapid growth of real GNP » Contraction or recessionary trough – Businesses slow, unemployment increases » Recovery or expansion - ? 26
  27. 27. Business Cycles » 4 stages of a business cycle » Recovery or revival of economic activity » Prosperity or expansion of activity » Recession or downturn of activity » Depression or contraction in activity » What order do they follow? Does there need to be an order? » What is meant by the length of a cycle? » Do all businesses go through the same cycle? 27
  28. 28. A few examples » What happens to the following variables during recovery, boom, recession and depression? » Industrial production » Profits » Investment » Wage rate » Business failure » Business expectations 28
  29. 29. Theories of business cycles » Interaction between the multiplier and the accelerator » Multiplier theory – Income is determined by investment » Accelerator theory – Current investment depends upon the change in aggregate output » To maintain constant investment „ceiling‟ and „floor‟ are necessary » Theories concentrating on inventories, public expenditure 29
  30. 30. Theories of business cycles » Stabilization policies - ? » How effective are stabilization policies in developing countries? » Factors driving ups and downs in a country like India: » Performance of agricultural sector » Behavior of public investments » Ad hoc policy changes (licensing, subsidies?) 30
  31. 31. Indicator forecasting » Can business cycles be predicted earlier? How? » What do you understand by leading and lagging indicators? » Examples of leading, lagging and coinciding indicators » Gives advance warning about turning points in economic activity 31
  32. 32. Employment Fluctuations » What is the importance of employment rates in an economy? » Barometer effect » Keynes – Level of employment is driven by effective demand » Unemployment arises because of a deficiency. What deficiency does this imply? » Would providing incentives to investors help? » Involuntary and frictional unemployment 32
  33. 33. Employment Fluctuations » Unemployment: » (Number of persons unemployed/number in civilian labor force)*100 » Sign of economic inefficiency » Frictional unemployment » Cyclical unemployment » Structural unemployment » Link between employment and output 33
  34. 34. Full Employment » Zero unemployment? » Level of employment that results when the rate of unemployment is normal » Thumb rule – 94 – 95% employment Some statistics: 1. Indian population 2011 – 1.21 bn 2. Unemployment rate for 2011 – 9.4% 3. Unemployment rate for 2010 – 10.7% 34
  35. 35. Full Employment » Natural rate of unemployment is the long run average of unemployment caused due to frictional and structural changes » Major cause of increase in unemployment – Power to reject job offers » Actual and Natural rate of unemployment – Difference? » What happens to these two during periods of booms or recessions? 35
  36. 36. Measurement Problems » People excluded though they prefer to work, people being included who are not active job seekers » People seeking employment are not counted as unemployed » Part-time workers – Is one hour a week enough? » People who are not seeking employment are classified as unemployed 36
  37. 37. Unemployment Programs » Not launched at a large scale » Result – Reduction in unemployment is marginal » Problems in implementing employment guarantee programs: » Resources » Choice of appropriate works to be done » Charity » Agreement among decision makers is low 37
  38. 38. Disguised unemployment » No standard unit to measure labor productivity » Too many people involved for a job involving less number of people » Relocation of productive resources can add to saving potential » Problems in relocating additional human resources? » Is there a way to identify sectors of improvement? 38
  39. 39. Price Stability 39
  40. 40. Inflation » An increase in the general level of prices over a sustained period of time » Is increase in the price of a particular type of good called inflation? » Recall some common measures of inflation » 3 classifications: Creeping, galloping and hyperinflation » If WPI is 314.6 in year 1 and 329.8 in year 2, what would be the inflation? 40
  41. 41. Economic Impacts of Inflation » Effect of Inflation on distribution of income and wealth? » What happens to wealth during inflation? Does it always erode? » Who gains during inflation? » Is income of poor indexed to inflation? » Effect of Inflation on Output and Growth » Short Run » Long Run 41
  42. 42. Inflation in AD-AS Framework » Demand-Pull Inflation » “Too much money chasing too few goods” » Logic: General rise in price level is because demand always exceeds the supply at existing prices » Real factors: Increase in Government expenditure with no change in tax receipts and vice versa » Monetary factors: Decrease in demand or increase in supply of money 42
  43. 43. Inflation in AD-AS Framework » Cost-Push Inflation » Inflation originates from the supply side » Wage-Push Inflation » Profit-Push Inflation » Supply-shock Inflation 43
  44. 44. Introduction to Phillips Curve » Phillips curve establishes a relationship between rate of wage increase and rate of unemployment » What happens to unemployment when wage rates increase? » Modified Phillips Curve measures inflation and unemployment » Example: If money-wage rates are increasing by 5% and labor productivity is increasing by 2%, then inflation is? 44
  45. 45. Introduction to Phillips Curve » Justification for downward slope: Organized labor‟s effort to increase wages unmatched with the increase in labor productivity » Degree to which organized labor can obtain a wage increase depends on? » Phillips curve indicates a trade-off between inflation and unemployment » Indicates policy makers flexibility » “Stagflation” where both increase simultaneously 45
  46. 46. Inflation in India » Problem of inflation exists right from the first Five Year Plan » Observed that whenever inflation has been high, agricultural production was the cause » Inflation in India could be attributed to the excess of money supply and bottlenecks in supply of goods and services » Is there one reason explaining the inflation rates in India? 46
  47. 47. Factors driving inflation » Demand-Pull: » Government Expenditure » Hoarding, black-marketing activities » Population explosion? » Cost-Push factors: » Violent fluctuations in output » Upward revision of administered prices » Oil shocks and global inflation 47
  48. 48. Questions???
  49. 49. Have a happy Sunday!
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