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13-3 Conclusion

We began this chapter by discussing two models of aggregate supply, each of which focuses on a different reason why, in the short run, output rises above its natural level when the price level rises above the level that people had expected. Both models explain why the short-run aggregate supply curve is upward sloping, and both yield a short-run tradeoff between inflation and unemployment. A convenient way to express and analyze that tradeoff is with the Phillips curve equation, according to which inflation depends on expected inflation, cyclical unemployment, and supply shocks.

Keep in mind that not all economists endorse all the ideas discussed here. There is widespread disagreement, for instance, about the practical importance of rational expectations and the relevance of hysteresis. If you find it difficult to fit all the pieces together, you are not alone. The study of aggregate supply remains one of the most unsettled—and therefore one of the most exciting—research areas in macroeconomics.

Summary

1.The two theories of aggregate supply—the sticky-price and imperfect-information models—attribute deviations of output and employment from their natural levels to various market imperfections. According to both theories, output rises above its natural level when the price level exceeds the expected price level, and output falls below its natural level when the price level is less than the expected price level.

2.Economists often express aggregate supply in a relationship called the Phillips curve. The Phillips curve says that inflation depends on

expected inflation, the deviation of unemployment from its natural rate, and supply shocks. According to the Phillips curve, policymakers who control aggregate demand face a short-run tradeoff between inflation and unemployment.

3.If expected inflation depends on recently observed inflation, then inflation has inertia, which means that reducing inflation requires either a beneficial supply shock or a period of high unemployment and reduced output. If people have rational expectations, however, then a credible announcement of a change in policy might be able to influence expectations directly and, therefore, reduce inflation without causing a recession.

4.Most economists accept the natural-rate hypothesis, according to which fluctuations in aggregate demand have only short-run effects on output and unemployment. Yet some economists have suggested ways in which recessions can leave permanent scars on the economy by raising the natural rate of unemployment.

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K E Y C O N C E P T S

Q U E S T I O N S F O R R E V I E W

P R O B L E M S A N D A P P L I C A T I O N S

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13 Alan Blinder, Hard Heads, Soft Hearts:Tough-Minded Economics for a Just Society (Reading, Mass.: Addison-Wesley, 1987), 5.

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A P P E N D I X

The Mother of All Models

In the previous chapters, we have seen many models of how the economy works. When learning these models, it can be hard to see how they are related. Now that we have finished developing the model of aggregate demand and aggregate supply, this is a good time to look back at what we have learned. This appendix sketches a large, comprehensive model that incorporates much of the theory we have already seen, including the classical theory presented in Part Two and the business cycle theory presented in Part Four. The notation and equations should be familiar from previous chapters. The goal is to put much of our previous analysis into a common framework to clarify the relationships among the various models.

The model has seven equations:

These seven equations determine the equilibrium values of seven endogenous

−

variables: output Y, the natural level of output Y , the real interest rate r, the nominal interest rate i, the real exchange rate e, the nominal exchange rate e, and the price level P.

There are many exogenous variables that influence these endogenous variables. They include the money supply M, government purchases G, taxes T, the capital stock K, the labor force L, the world price level P*, and the world real interest rate r *. In addition, there are two expectation variables: the expectation of future inflation Ep and the expectation of the current price level formed in the past EP. As written, the model takes these expectations as exogenous, although additional equations could be added to make them endogenous.

Although mathematical techniques are available to analyze this seven-equation model, they are beyond the scope of this book. But this large model is still useful, because we can use it to see how the smaller models we have examined are

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You should now see the value in this big model. Even though the model is too large to be useful in developing an intuitive understanding of how the economy works, it shows that the different models we have been studying are closely related. In each chapter, we made some simplifying assumptions to make the big model smaller and easier to understand.

Figure 13-6 presents a schematic diagram that illustrates how various models are related. In particular, it shows how, starting with the mother of all models above, you can arrive at some of the models examined in previous chapters. Here are the steps:

1.Classical or Keynesian? You decide whether you want a classical special case (which occurs when EP = P or when a equals zero, so output is at its natural level) or a

FIGURE 13-6

How Models Are Related This schematic diagram illustrates how the large, comprehensive model presented in this appendix is related to the smaller, simpler models developed in earlier chapters.

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Keynesian special case (which occurs when a equals infinity, so the price level is completely fixed).

2.Closed or Open? You decide whether you want a closed economy (which occurs when the capital flow CF always equals zero) or an open economy (which allows CF to differ from zero).

3.Small or Large? If you want an open economy, you decide whether you want a small one (in which CF is infinitely elastic at the world interest rate r*) or a large one (in which the domestic interest rate is not pinned down by the world rate).

4.Floating or Fixed? If you are examining a small open economy, you decide whether the exchange rate is floating (in which case the central bank sets the money supply) or fixed (in which case the central bank allows the money supply to adjust).

5.Fixed velocity? If you are considering a closed economy with the Keynesian assumption of fixed prices, you decide whether you want to focus on the special case in which velocity is exogenously fixed.

By making this series of modeling decisions, you move from the more complete and complex model to a simpler, more narrowly focused special case that is easier to understand and use.

When thinking about the real world, it is important to keep in mind all the models and their simplifying assumptions. Each of these models provides insight into some facet of the economy.

M O R E P R O B L E M S A N D A P P L I C A T I O N S

C H A P T E R 14

A Dynamic Model of Aggregate

Demand and Aggregate Supply

The important thing in science is not so much to obtain new facts as to discover

new ways of thinking about them.

William Bragg

This chapter continues our analysis of short-run economic fluctuations. It presents a model that we will call the dynamic model of aggregate demand and aggregate supply. This model offers another lens through which to view the

business cycle and the effects of monetary and fiscal policy.

As the name suggests, this new model emphasizes the dynamic nature of economic fluctuations. The dictionary defines the word “dynamic” as “relating to energy or objects in motion, characterized by continuous change or activity.” This definition applies readily to economic activity. The economy is continually bombarded by various shocks. These shocks have an immediate impact on the economy’s short-run equilibrium, and they also affect the subsequent path of output, inflation, and many other variables. The dynamic AD –AS model focuses attention on how output and inflation respond over time to exogenous changes in the economic environment.

In addition to placing greater emphasis on dynamics, the model differs from our previous models in another significant way: it explicitly incorporates the response of monetary policy to economic conditions. In previous chapters, we followed the conventional simplification that the central bank sets the money supply, which in turn is one determinant of the equilibrium interest rate. In the real world, however, many central banks set a target for the interest rate and allow the money supply to adjust to whatever level is necessary to achieve that target. Moreover, the target interest rate set by the central bank depends on economic conditions, including both inflation and output. The dynamic AD –AS model builds in these realistic features of monetary policy.

Although the dynamic AD –AS model is new to the reader, most of its components are not. Many of the building blocks of this model will be familiar from previous chapters, even though they sometimes take on slightly different forms. More important, these components are assembled in new ways. You can think of this model as a new recipe that mixes familiar ingredients to

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