macro summaries
Aggregate expenditure is the sum of all planned (or voluntary) spending on domestically produced goods and services. Actual expenditure in the economy may differ from aggregate expenditure, because the former also includes unplanned (or involuntary) investment spending.
-The spending categories making up aggregate expenditure are
-
i g x
the IS curve shows those combinations of income and the interest rate for which aggregate expenditure equals income (or output). Its name derives from the fact that in an economy with no government (thenT-G = 0) and no trade with other countries (then IM-EX = 0) the required balance of leakages out of and injections into the income circle [(S-I) + (T-G) + (IM-EX) = 0] obtains if I = S.
In an interest rate/income diagram the IS curve slopes downward. To show why we may proceed from a Keynesian cross diagram with the numbers plugged in that we used when discussing aggregate demand (see figure on the right):
The Keynesian cross [deriving its name from the British economist John Maynard Keynes (1883-1946)] is a device that identifies equilibrium income. Here the term equilibrium income refers to the level of income at which planned spending exactly matches the level of output produced. This kind of equilibrium is, therefore, often called demand-side equilibrium.
The Keynesian cross contains two lines:
1. The 45° line measures actual demand which is always the same as income. At points above this line desired demand exceeds output; at points below this line the opposite is true.
2. The aggregate demand line indicates the sum of all spending plans.
The two lines cross in the grey circle, meaning that here actual spending equals planned spending, and that planned spending is perfectly compatible with income. Y0 is demand-side equilibrium income
The LM curve identifies combinations of income and the interest rate for which the demand for money equals the money supply. In an interest rate/income diagram this curve slopes upward for the following reason:
Pick any point on the LM curve and call it point A. Since the point is on the LM curve, the given money supply is exactly demanded at the indicated interest rate and income level. Now suppose income rises, which means that we are moving horizontally to the right, say into point C. Since people spend more at higher income levels, they wish to hold more money too.
Hence in C the demand for money exceeds the unchanged money supply. To drive the demand for money back down to the initial money supply, holding money needs to become more expensive, that is the interest rate must rise until we are in point B. Hence the money supply slopes upward, meaning that if income increases the interest rate must rise as well to keep the money market in equilibrium.
The FE curve identifies combinations of income and the interest rate for which the foreign exchange market is in equlibrium.
In today's world with integrated international capital markets the FE curve is horizontal. The reason is that if financial investors saw higher interest rates (or returns) abroad than at home, they would shift huge amounts of wealth out of the home country into the remaining world capital market. An excess demand for foreign currencies would result, and the foreign exchange market could not possibly be in equlibrium. To prevent this, the yields of financial investments at home must be the same as the yields of financial investments abroad. This is only the case if the domestic interest rate exactly equals the world interest rate (assuming financial investors do not expect exchange rates to change). Therefore, in an interest rate/income diagram the FE curve is a horizontal line at the world interest rate. This means that no matter how high domestic income is, the domestic interest rate must always equal the world interest rate to keep the foreign exchange market in equilibrium
The main purpose of the Mundell-Fleming model is to determine equilibrium income and how this income responds to economic policy and shocks. It merges the foreign exchange market (FE), the goods market (IS) and the money market (LM). Overall equilibrium obtains when these three markets are in equilibrium. Viewed in a diagram, equilibrium is where FE, IS and LM intersect.
-The Mundell-Fleming model refines the IS curve by tying down two loose ends. The IS curve tells us that equilibrium income depends on the interest rate. As long as we do not know the interest rate (which is an endogenous variable) we have not really determined income. Also, since the position of IS shifts when the exchange rate moves, equilibrium income depends on the exchange rate too. If we do not know the exchange rate (another endogenous variable), we cannot determine income (even if we knew the interest rate). The foreign exchange market and the money market, which the Mundell-Fleming model adds to the goods market, serve to determine the interest rate and the exchange rate. This finally permits us to nail down equilibrium income.
-What if the three curves do not intersect in a common point? Do not worry. They always do. The reason is that only two out of these three curves are fixed by the policy maker and/or exogenous variables. The position of the third curve depends on endogenous variables as well. These endogenous variables always adjust so that they move this third curve into the position where the other two curves already intersect. So the third curve is actually redundant. You may forget about it, for it is always where the other two curves are, just as the tail is always where the dog is.
-Which one is the third, redundant curve? And which are the two we need to keep our eyes on? Well, that depends on whether we operate under flexible exchange rates or under fixed exchange rates.
The dynamic aggregate demand (DAD) curve is a negatively sloped line with inflation measured along the vertical axis and income measured along the horizontal axis. This line indicates which demand-side equilibrium levels of income obtain at different inflation rates.
The DAD curve is a generalization of the Mundell-Fleming model. It is useful to derive the DAD curve from the Mundell-Fleming model in two steps:
The aggregate demand (AD) curve is a negatively sloped line in a diagram that measures the price level along the vertical axis and income along the horizontal one. It generalizes the results derived from the Mundell-Fleming model.
The Mundell-Fleming model assumes prices to be fixed. The AD curve asks how the equilibrium income derived in the Mundell-Fleming model changes if the price level was to change after all. To see how the price level bears on equilibrium income, we start by looking at how the market equilibrium lines, that is FE, LM and IS are affected by changes in the price level:
To find out what the aggregate demand curve looks like, we need to merge the three markets into one diagram. The income levels at which all three market-equilibrium planes intersect at different price levels will then mark the AD curve. Just as when we discussed the Mundell-Fleming model, we need to discuss fixed and flexible exchange rates separately.
The FE curve says that the foreign exchange market may be in equilibrium if and only if the domestic interest rate equals the world interest rate. Only then financial investors are indifferent as to where (at home or abroad) they hold their assets. Does this change if, say, the domestic price level doubles? Obviously not: Financial investors still hunt for the highest interest rate, and equilibrium may only obtain if international interest rates are equal. This means that if we generalize the FE curve into an FE plane in a diagram that adds the price level as a third dimension to our previous i/Y diagram, the result is a horizontal FE plane at the level of the world interest rate.
The upwards-sloping LM curve gives the interest rate that needs to go with a given income level to accomplish equilibrium in the money market. We again add a third dimension to the i/Y diagram, measuring the price level along this third axis. The question is how the market-equilibrating interest rate changes if we keep income constant and move along this third axis. Two points need to be noted:
The demand for money, which is a demand for buying power, for real money, does not change if the price level rises. With income unchanged, individuals want to buy as many goods per period as before.
As long as the central bank keeps the nominal supply of money fixed, the real supply of money falls as the price level rises during our move out along the third axis.
So if the interest rate remained unchanged, as we move out the price axis, an excess demand for money would arise and grow bigger and bigger. To prevent this, the interest rate needs to increase. This makes holding money more expensive and induces people to hold less money. The money market can be in equilibrium at a lower money supply.
The crux of this is that the LM plane slopes up as we move along the price axis.
The downwards sloping IS curve indicates that rising income levels must be accompanied by falling interest rates to maintain a demand side equilibrium in the goods market. When drawing this line, the exchange rate is assumed to be constant. Following the procedure previously applied to the money market, we add a third dimension to the usual IS diagram. The question is what happens to the interest rate that clears the goods market (at unchanged income) as we move into this third dimension.
When we move out the newly added price axis, domestic goods become more expensive compared to foreign goods. This is because world prices are considered fixed and the exchange rate is considered fixed as well. So if the interest rate did not change as we move out along the P axis, the demand for all domestically produced goods would fall and an excess supply of home goods would be generated. To prevent this, the interest rate must fall. It must fall just enough to make rising investment demand fill in for falling net exports.
The bottom line is that the IS plane slopes down as we move out along the price axis.
AD curve flexible exchange rates. We only needed to consider the FE curve and the LM curve when discussing the Mundell-Fleming model under flexible exchange rates. We could always rest assured that the exchange rate would adjust so as to move the IS curve into the predetermined position as well.
For the same reason, we now only need to consider the FE plane and the LM plane when deriving the AD curve under flexible exchange rates. Reactions of the exchange rates will make sure that the IS plane passively moves into the proper position.
The following animation shows how to extract the AD curve from a 3-dimensional graph that merges the FE plane and the LM plane.
Fixed exchange rates. We only needed to consider the FE curve and the IS curve when discussing the Mundell-Fleming model under fixed exchange rates. Mandatory intervention of the central bank in the foreign exchange market would adjust the money supply so as to move the LM curve into the predetermined position as well.
For the same reason, we now only need to consider the FE plane and the IS plane when deriving the AD curve under fixed exchange rates. Endogenous adjustment of the money supply through foreign exchange market intervention will make sure that the LM plane passively moves into the proper position.
The following animation shows how to extract the AD curve from a 3-dimensional graph that merges the FE plane and the IS plane.
When deriving the red DAD curve we assumed that last period's price level was P1 and income was Y1. Otherwise we would not have gotten this DAD curve, but a different one! Why?
Suppose last period's price level was P1' and income was Y1' so that last year's position is marked by the blue dot. Let us look again at specific inflation rates and the resulting income levels:
-The spending categories making up aggregate expenditure are
-
i g x
the IS curve shows those combinations of income and the interest rate for which aggregate expenditure equals income (or output). Its name derives from the fact that in an economy with no government (then
In an interest rate/income diagram the IS curve slopes downward. To show why we may proceed from a Keynesian cross diagram with the numbers plugged in that we used when discussing aggregate demand (see figure on the right):
The Keynesian cross [deriving its name from the British economist John Maynard Keynes (1883-1946)] is a device that identifies equilibrium income. Here the term equilibrium income refers to the level of income at which planned spending exactly matches the level of output produced. This kind of equilibrium is, therefore, often called demand-side equilibrium.
The Keynesian cross contains two lines:
1. The 45° line measures actual demand which is always the same as income. At points above this line desired demand exceeds output; at points below this line the opposite is true.
2. The aggregate demand line indicates the sum of all spending plans.
The two lines cross in the grey circle, meaning that here actual spending equals planned spending, and that planned spending is perfectly compatible with income. Y0 is demand-side equilibrium income
The LM curve identifies combinations of income and the interest rate for which the demand for money equals the money supply. In an interest rate/income diagram this curve slopes upward for the following reason:
Pick any point on the LM curve and call it point A. Since the point is on the LM curve, the given money supply is exactly demanded at the indicated interest rate and income level. Now suppose income rises, which means that we are moving horizontally to the right, say into point C. Since people spend more at higher income levels, they wish to hold more money too.
Hence in C the demand for money exceeds the unchanged money supply. To drive the demand for money back down to the initial money supply, holding money needs to become more expensive, that is the interest rate must rise until we are in point B. Hence the money supply slopes upward, meaning that if income increases the interest rate must rise as well to keep the money market in equilibrium.
The FE curve identifies combinations of income and the interest rate for which the foreign exchange market is in equlibrium.
In today's world with integrated international capital markets the FE curve is horizontal. The reason is that if financial investors saw higher interest rates (or returns) abroad than at home, they would shift huge amounts of wealth out of the home country into the remaining world capital market. An excess demand for foreign currencies would result, and the foreign exchange market could not possibly be in equlibrium. To prevent this, the yields of financial investments at home must be the same as the yields of financial investments abroad. This is only the case if the domestic interest rate exactly equals the world interest rate (assuming financial investors do not expect exchange rates to change). Therefore, in an interest rate/income diagram the FE curve is a horizontal line at the world interest rate. This means that no matter how high domestic income is, the domestic interest rate must always equal the world interest rate to keep the foreign exchange market in equilibrium
The main purpose of the Mundell-Fleming model is to determine equilibrium income and how this income responds to economic policy and shocks. It merges the foreign exchange market (FE), the goods market (IS) and the money market (LM). Overall equilibrium obtains when these three markets are in equilibrium. Viewed in a diagram, equilibrium is where FE, IS and LM intersect.
-The Mundell-Fleming model refines the IS curve by tying down two loose ends. The IS curve tells us that equilibrium income depends on the interest rate. As long as we do not know the interest rate (which is an endogenous variable) we have not really determined income. Also, since the position of IS shifts when the exchange rate moves, equilibrium income depends on the exchange rate too. If we do not know the exchange rate (another endogenous variable), we cannot determine income (even if we knew the interest rate). The foreign exchange market and the money market, which the Mundell-Fleming model adds to the goods market, serve to determine the interest rate and the exchange rate. This finally permits us to nail down equilibrium income.
-What if the three curves do not intersect in a common point? Do not worry. They always do. The reason is that only two out of these three curves are fixed by the policy maker and/or exogenous variables. The position of the third curve depends on endogenous variables as well. These endogenous variables always adjust so that they move this third curve into the position where the other two curves already intersect. So the third curve is actually redundant. You may forget about it, for it is always where the other two curves are, just as the tail is always where the dog is.
-Which one is the third, redundant curve? And which are the two we need to keep our eyes on? Well, that depends on whether we operate under flexible exchange rates or under fixed exchange rates.
The dynamic aggregate demand (DAD) curve is a negatively sloped line with inflation measured along the vertical axis and income measured along the horizontal axis. This line indicates which demand-side equilibrium levels of income obtain at different inflation rates.
The DAD curve is a generalization of the Mundell-Fleming model. It is useful to derive the DAD curve from the Mundell-Fleming model in two steps:
The aggregate demand (AD) curve is a negatively sloped line in a diagram that measures the price level along the vertical axis and income along the horizontal one. It generalizes the results derived from the Mundell-Fleming model.
The Mundell-Fleming model assumes prices to be fixed. The AD curve asks how the equilibrium income derived in the Mundell-Fleming model changes if the price level was to change after all. To see how the price level bears on equilibrium income, we start by looking at how the market equilibrium lines, that is FE, LM and IS are affected by changes in the price level:
To find out what the aggregate demand curve looks like, we need to merge the three markets into one diagram. The income levels at which all three market-equilibrium planes intersect at different price levels will then mark the AD curve. Just as when we discussed the Mundell-Fleming model, we need to discuss fixed and flexible exchange rates separately.
The FE curve says that the foreign exchange market may be in equilibrium if and only if the domestic interest rate equals the world interest rate. Only then financial investors are indifferent as to where (at home or abroad) they hold their assets. Does this change if, say, the domestic price level doubles? Obviously not: Financial investors still hunt for the highest interest rate, and equilibrium may only obtain if international interest rates are equal. This means that if we generalize the FE curve into an FE plane in a diagram that adds the price level as a third dimension to our previous i/Y diagram, the result is a horizontal FE plane at the level of the world interest rate.
The upwards-sloping LM curve gives the interest rate that needs to go with a given income level to accomplish equilibrium in the money market. We again add a third dimension to the i/Y diagram, measuring the price level along this third axis. The question is how the market-equilibrating interest rate changes if we keep income constant and move along this third axis. Two points need to be noted:
The demand for money, which is a demand for buying power, for real money, does not change if the price level rises. With income unchanged, individuals want to buy as many goods per period as before.
As long as the central bank keeps the nominal supply of money fixed, the real supply of money falls as the price level rises during our move out along the third axis.
So if the interest rate remained unchanged, as we move out the price axis, an excess demand for money would arise and grow bigger and bigger. To prevent this, the interest rate needs to increase. This makes holding money more expensive and induces people to hold less money. The money market can be in equilibrium at a lower money supply.
The crux of this is that the LM plane slopes up as we move along the price axis.
The downwards sloping IS curve indicates that rising income levels must be accompanied by falling interest rates to maintain a demand side equilibrium in the goods market. When drawing this line, the exchange rate is assumed to be constant. Following the procedure previously applied to the money market, we add a third dimension to the usual IS diagram. The question is what happens to the interest rate that clears the goods market (at unchanged income) as we move into this third dimension.
When we move out the newly added price axis, domestic goods become more expensive compared to foreign goods. This is because world prices are considered fixed and the exchange rate is considered fixed as well. So if the interest rate did not change as we move out along the P axis, the demand for all domestically produced goods would fall and an excess supply of home goods would be generated. To prevent this, the interest rate must fall. It must fall just enough to make rising investment demand fill in for falling net exports.
The bottom line is that the IS plane slopes down as we move out along the price axis.
AD curve flexible exchange rates. We only needed to consider the FE curve and the LM curve when discussing the Mundell-Fleming model under flexible exchange rates. We could always rest assured that the exchange rate would adjust so as to move the IS curve into the predetermined position as well.
For the same reason, we now only need to consider the FE plane and the LM plane when deriving the AD curve under flexible exchange rates. Reactions of the exchange rates will make sure that the IS plane passively moves into the proper position.
The following animation shows how to extract the AD curve from a 3-dimensional graph that merges the FE plane and the LM plane.
Fixed exchange rates. We only needed to consider the FE curve and the IS curve when discussing the Mundell-Fleming model under fixed exchange rates. Mandatory intervention of the central bank in the foreign exchange market would adjust the money supply so as to move the LM curve into the predetermined position as well.
For the same reason, we now only need to consider the FE plane and the IS plane when deriving the AD curve under fixed exchange rates. Endogenous adjustment of the money supply through foreign exchange market intervention will make sure that the LM plane passively moves into the proper position.
The following animation shows how to extract the AD curve from a 3-dimensional graph that merges the FE plane and the IS plane.
| From the AD-curve to the DAD curve |
| To move from the AD curve to the DAD curve is a technical step rather than one of substance. The question is: how can those demand-side equilibria that the AD curve captures in a price/income diagram be displayed in an inflation/income diagram? The coordinate systems for both graphs are laid out below. The AD curve is already in place. Now suppose last year's income was Y1 and the price level was P1. What is this year's income? Well, this is obviously determined by this year's price level. Given last year's prices, this year's prices are determined by how much inflation we had since then. Consider some specific inflation rates: 1. Suppose inflation was zero. Then prices are still at P1, income is still at Y1 and the economy remains in the red dot on the AD curve. Since this point resulted from zero inflation, we may mark this in the inflation/income diagram by the red dot. 2. Next, suppose inflation is 5%. This brings prices to P2 and income down to Y2, as given by the lower pale red dot on AD. Mark this combination in the inflation/income diagram as well (lower pale red dot). 3. Finally, suppose inflation is 10%. This raises prices still higher to P3, and income falls further to P3. This result is represented by the upper pale red dot in the inflation/income diagram. Running a line through the three points obtained combines all the points that may be obtained by tracing income levels at other inflation rates. This line is the DAD curve. The term DAD means dynamic aggregate demand because the curve shifts over time. Reasons are |
When deriving the red DAD curve we assumed that last period's price level was P1 and income was Y1. Otherwise we would not have gotten this DAD curve, but a different one! Why?
Suppose last period's price level was P1' and income was Y1' so that last year's position is marked by the blue dot. Let us look again at specific inflation rates and the resulting income levels:
| The lesson suggested by this exercise is: While the DAD curve slopes down, its position depends on last period's income. The higher income was back then, the further the DAD curve is positioned to the right. |
monetary policy. Up to now we assume that the AD curve stayed put in a given position. What happens if the AD curve shifts, say, because the money supply increases (under flexible exchange rates) [or government spending rises (under fixed exchange rates)]? To find this out, consider the following figure:
These formulas, which for clarity omit some other exogenous variables that we therefore assume not to change, show that expansionary monetary policy (moving to a higher growth rate of the money supply) shifts the DAD curve up under flexible exchange rates. So does an increase of government spending or higher world inflation under fixed exchange rates.
The labour supply curve is a line indicating in a wage/employment diagram how much work (measured in work hours) is being supplied at different wage rates. It is upward sloping, meaning that people want to work more if the pay gets better.
The position of the labour supply curve reflects the institutional arrangements governing the labour market:
In an economy without trade unions, in which each worker negotiates the wage individually with the firm, the aggregate individual labour supply curve that results from summing up all individual work offers is in the blue position.
In an economy in which trade unions negotiate collective wage contracts with firms that are binding for all workers, the trade union labour supply curve is in the red position, to the left of the individual labour supply curve.
The position of the labour supply curve reflects the institutional arrangements governing the labour market:
In an economy without trade unions, in which each worker negotiates the wage individually with the firm, the aggregate individual labour supply curve that results from summing up all individual work offers is in the blue position.
In an economy in which trade unions negotiate collective wage contracts with firms that are binding for all workers, the trade union labour supply curve is in the red position, to the left of the individual labour supply curve.
Trade unions may be viewed as being interested in wages and employment. Trade union utility rises when either or both of these variables increases, as the figure shows.
A trade union indifference curve collects all wage/employment combinations that give rise to the same predetermined utility level. They are similar to altitude lines shown on a geographical map.
We may use union indifference curves to understand the choices unions make during wage negotiations (Figure 2): Let the labour demand curve be in the red position. This curve shows the options the firms offer to the trade union. It says that higher wages may only be obtained at the cost of less employment; or more employment at the cost of lower wages. Given this trade off, which it cannot change, what does the union do? Since it can only run up and down the labour demand curve, it will move to the point it likes best among all points on the curve. Which one does it like best? The red one, because this yields the highest utility level, that is, lets the union achieve the indifference curve located further north-east than any other indifference curve it could meet while moving along the curve. So the red point represents the wage bargaining outcome between the monopolistic trade union and a group of firms with the given labour demand.
By the same line of argument, the blue point results if the labour demand curve is in the blue position, the green point if labour demand is in the green position, and so on. Now run a line through the obtained points. The intersection between this line and the labour demand curve marks the labour market equilibrium that obtains at the presence of a monopolistic trade union. This line may therefore be interpreted as the labour supply offered by a trade union that exercises monopoly power. We therefore call it the trade union labour supply curve.
The labour supply curve resulting from the monopoly power of trade unions sits left of the labour supply curve that would result if each individual acted alone.
A trade union indifference curve collects all wage/employment combinations that give rise to the same predetermined utility level. They are similar to altitude lines shown on a geographical map.
We may use union indifference curves to understand the choices unions make during wage negotiations (Figure 2): Let the labour demand curve be in the red position. This curve shows the options the firms offer to the trade union. It says that higher wages may only be obtained at the cost of less employment; or more employment at the cost of lower wages. Given this trade off, which it cannot change, what does the union do? Since it can only run up and down the labour demand curve, it will move to the point it likes best among all points on the curve. Which one does it like best? The red one, because this yields the highest utility level, that is, lets the union achieve the indifference curve located further north-east than any other indifference curve it could meet while moving along the curve. So the red point represents the wage bargaining outcome between the monopolistic trade union and a group of firms with the given labour demand.
By the same line of argument, the blue point results if the labour demand curve is in the blue position, the green point if labour demand is in the green position, and so on. Now run a line through the obtained points. The intersection between this line and the labour demand curve marks the labour market equilibrium that obtains at the presence of a monopolistic trade union. This line may therefore be interpreted as the labour supply offered by a trade union that exercises monopoly power. We therefore call it the trade union labour supply curve.
The labour supply curve resulting from the monopoly power of trade unions sits left of the labour supply curve that would result if each individual acted alone.
The labour demand curve is a graph, indicating in a wage/employment diagram how much work (measured in work hours) firms demand at different wage rates. The curve is negatively sloping, meaning that firms want to cut down on employment if work becomes more expensive.
-The labour demand curve is derived from the partial production function (K fixed). Microeconomics teaches that utility-maximizing individuals buy another shirt if the utility derived from the shirt exceeds its price. In the same vein, a firm that maximizes profits hires another hour of work if the value of what will be produced during this hour exceeds the cost.
-We know that the slope of the partial production function (K fixed) measures the marginal product of labour (MPL), that is the output gained by employing one more hour of labour. The partial production function is steep when little labour is employed, it becomes successively flatter as firms employ more labour. Therefore, the MPL is high at low values of L and low at high values of L. Thus the MPL may be represented in a diagram with a marginal product of labour on the vertical axis and work hour on the horizontal axis as a line that falls from left to right.
-In a final step we need to show that this downwards sloping MPL curve is also the labour demand curve. Recall that the marginal product of labour indicates the value of one more work hour to the firm. If the hourly wage is, say, w1 the MPL remains above this cost as long as less than L1 work hours are being employed. If employment exceeds L1, additional work costs more than the revenue it generates for the firm. Hence the profit-maximizing firm demands employment up to L1, but not beyond.
-The same argument applies at other wage rates. Going to the right from a selected wage rate, the MPL curve always indicates how much labour firms may profitably employ. Hence the marginal product of labour curve is also the labour demand curve.
-The labour demand curve is derived from the partial production function (K fixed). Microeconomics teaches that utility-maximizing individuals buy another shirt if the utility derived from the shirt exceeds its price. In the same vein, a firm that maximizes profits hires another hour of work if the value of what will be produced during this hour exceeds the cost.
-We know that the slope of the partial production function (K fixed) measures the marginal product of labour (MPL), that is the output gained by employing one more hour of labour. The partial production function is steep when little labour is employed, it becomes successively flatter as firms employ more labour. Therefore, the MPL is high at low values of L and low at high values of L. Thus the MPL may be represented in a diagram with a marginal product of labour on the vertical axis and work hour on the horizontal axis as a line that falls from left to right.
-In a final step we need to show that this downwards sloping MPL curve is also the labour demand curve. Recall that the marginal product of labour indicates the value of one more work hour to the firm. If the hourly wage is, say, w1 the MPL remains above this cost as long as less than L1 work hours are being employed. If employment exceeds L1, additional work costs more than the revenue it generates for the firm. Hence the profit-maximizing firm demands employment up to L1, but not beyond.
-The same argument applies at other wage rates. Going to the right from a selected wage rate, the MPL curve always indicates how much labour firms may profitably employ. Hence the marginal product of labour curve is also the labour demand curve.
The short-run (or surprise) aggregate supply (SAS) curve is a positively sloped line in a diagram with inflation measured along the vertical and income measured along the horizontal axis. This line indicates how much output all firms are willing to produce at different inflation rates.
The SAS curve draws together the production function and the employment decisions obtained at differed inflation rates (or price levels) in the labour market. The SAS curve is derived in two steps:
The SAS curve draws together the production function and the employment decisions obtained at differed inflation rates (or price levels) in the labour market. The SAS curve is derived in two steps:
The AS curve is a positively sloped line in a diagram with prices P on the vertical axis and with income Y on the horizontal axis. It states that firms are willing to produce larger volumes of output at higher price levels. The AS curve can be derived by bringing together the supply-side concepts of the production function and of the labour market that were introduced previously.
To move from the AS curve to the SAS curve again is only a mechanical step. Here the question is: how can the firms' supply decisions, which the AS curve visualizes in a price/income diagram, be displayed in an inflation/income diagram?
The coordinate systems for both graphs are shown in the figure below. The AS curve derived previously is given in the left diagram. It is assumed that last year's price level was P0 and that the labour market expected the price level Pe=P1 for this year. What is this year's income? Well, this is obviously determined by this year's actual price level. And, given last year's price level, this year's prices are determined by how much inflation we had in the meanwhile. Let us put some numbers in the graph:
1. Suppose the price level is P1, as had been expected. Then firms supply potential income. Note that by prices being what they were last year, and being expected to move to P1 this year, the labour market expected inflation to be 5%. So if inflation really does turn out to be 5%, income is at potential income, as marked by the red dot in the right-hand-side diagram.
2. Next, suppose price moved higher than expected, to P2. We know that this drives down real wages and spurs production, to Y2 (which exceeds Y*). We mark this in the inflation/income diagram by noting that if inflation is 10% (while it was expected to equal 5%) income rises to Y2.
3. Finally, suppose prices rose to P3, way higher than expected. This raises output still further to Y3. We note this again on the right, marking output to be Y3 when inflation equals 15%.
Running a line through the three points combines all the points that may be obtained by tracing income levels at all kinds of inflation rates. This line is the SAS curve.
When deriving the red SAS curve we assumed that prices were expected to move to P1. Now, what if the labour market expected prices to move, say to P3 (that is, expected inflation was 15%)? We shall see that this yields a new SAS curve:
1. Suppose prices did move to P3, as expected. Then potential output is being produced. As shown in the diagram on the right, now income is at Y* if inflation stands a 15%. This blue point is off the previous (red) SAS curve.
2. Now suppose prices move to P2. This lower-than-expected price hike generates income Y2'. Record this point in the inflation/income diagram, where the combination of 10% inflation and output at Y2' is marked by the upper pale blue dot.
3. Finally, let prices rise to P1 only, meaning an inflation rate of 5%. Then income stands at Y1' as marked by the lower pale blue dot in the inflation/income graph.
Running a new line through these three new points gives a new (blue) SAS curve.
The lesson to be learned here is that while the SAS curve is upward sloping, its position depends on expected inflation. The higher expected inflation (the expected price level), the higher is the position of the SAS curve (the AS curve). Whenever actual inflation is as expected (no matter whether expected inflation is 0%, 7% or 20%) potential income obtains. This is captured in the algebraic equation
The coordinate systems for both graphs are shown in the figure below. The AS curve derived previously is given in the left diagram. It is assumed that last year's price level was P0 and that the labour market expected the price level Pe=P1 for this year. What is this year's income? Well, this is obviously determined by this year's actual price level. And, given last year's price level, this year's prices are determined by how much inflation we had in the meanwhile. Let us put some numbers in the graph:
1. Suppose the price level is P1, as had been expected. Then firms supply potential income. Note that by prices being what they were last year, and being expected to move to P1 this year, the labour market expected inflation to be 5%. So if inflation really does turn out to be 5%, income is at potential income, as marked by the red dot in the right-hand-side diagram.
2. Next, suppose price moved higher than expected, to P2. We know that this drives down real wages and spurs production, to Y2 (which exceeds Y*). We mark this in the inflation/income diagram by noting that if inflation is 10% (while it was expected to equal 5%) income rises to Y2.
3. Finally, suppose prices rose to P3, way higher than expected. This raises output still further to Y3. We note this again on the right, marking output to be Y3 when inflation equals 15%.
Running a line through the three points combines all the points that may be obtained by tracing income levels at all kinds of inflation rates. This line is the SAS curve.
When deriving the red SAS curve we assumed that prices were expected to move to P1. Now, what if the labour market expected prices to move, say to P3 (that is, expected inflation was 15%)? We shall see that this yields a new SAS curve:
1. Suppose prices did move to P3, as expected. Then potential output is being produced. As shown in the diagram on the right, now income is at Y* if inflation stands a 15%. This blue point is off the previous (red) SAS curve.
2. Now suppose prices move to P2. This lower-than-expected price hike generates income Y2'. Record this point in the inflation/income diagram, where the combination of 10% inflation and output at Y2' is marked by the upper pale blue dot.
3. Finally, let prices rise to P1 only, meaning an inflation rate of 5%. Then income stands at Y1' as marked by the lower pale blue dot in the inflation/income graph.
Running a new line through these three new points gives a new (blue) SAS curve.
The lesson to be learned here is that while the SAS curve is upward sloping, its position depends on expected inflation. The higher expected inflation (the expected price level), the higher is the position of the SAS curve (the AS curve). Whenever actual inflation is as expected (no matter whether expected inflation is 0%, 7% or 20%) potential income obtains. This is captured in the algebraic equation
The EAS curve (EAS standing for equilibrium aggregate supply) is a vertical line in a diagram with inflation on the vertical axis and with income on the horizontal axis. It indicates how much output firms produce at different inflation rates, given that firms and workers (or unions) anticipated this rate of inflation correctly.
The EAS curve being vertical means that properly anticipated inflation does not bear on production. Output is always at potential output Y*, no matter how high inflation is. The reason is that with inflation being as anticipated, the real wage is exactly where it clears the labour market. Inflation that trade unions did foresee only affects nominal wages, but not real wages. Thus it also does not affect employment, and it does not affect output produced.
The EAS curve being vertical means that properly anticipated inflation does not bear on production. Output is always at potential output Y*, no matter how high inflation is. The reason is that with inflation being as anticipated, the real wage is exactly where it clears the labour market. Inflation that trade unions did foresee only affects nominal wages, but not real wages. Thus it also does not affect employment, and it does not affect output produced.
The DAD curve gives demand-side equilibrium income levels at different inflation rates. But as long as inflation has not been determined, income cannot be determined.
The SAS curve gives output produced at different inflation rates. Again, without knowing the inflation rate, output remains unknown.
The DAD-SAS model combines the two curves to determine unique values for the inflation rate and income in the current period.
What makes working with the DAD-SAS model a bit tricky is
first, that the position of the DAD curve depends on last period's income. So as long as income changes (say during a recession), the curve keeps moving.
Second, the position of the SAS curve depends on expected inflation. Again, as long as inflation expectations change, the curve keeps moving.
The key to working with the DAD-SAS model is to be able to position the DAD curve and to position the SAS curve properly. Once this has been mastered, the DAD-SAS model proves very useful in working out the dynamic response of a modern economy to changes in its macroeconomic environment and to monetary and fiscal policy measures of all kinds.
The SAS curve gives output produced at different inflation rates. Again, without knowing the inflation rate, output remains unknown.
The DAD-SAS model combines the two curves to determine unique values for the inflation rate and income in the current period.
What makes working with the DAD-SAS model a bit tricky is
first, that the position of the DAD curve depends on last period's income. So as long as income changes (say during a recession), the curve keeps moving.
Second, the position of the SAS curve depends on expected inflation. Again, as long as inflation expectations change, the curve keeps moving.
The key to working with the DAD-SAS model is to be able to position the DAD curve and to position the SAS curve properly. Once this has been mastered, the DAD-SAS model proves very useful in working out the dynamic response of a modern economy to changes in its macroeconomic environment and to monetary and fiscal policy measures of all kinds.
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