Home Economics Essentials of Macroeconomics
The AD curve over time
With inflation, the AD curve will no longer be stable over time. Instead, it will glide upwards or downwards at a rate determined by the growth rate of the money supply nM. Let us look at the case nM = 10%.
If AD1 is AD curve in year 1, AD1 will show us all combinations of P and Y where both markets are in equilibrium in year 1. For example, both markets are equilibrium at point A where P = 100 and Y = 10.
Fig. 14.5:AD curve glides if nM * 0.
In year 2, the money supply is higher - it has increased by just 10%. If P had increased by 10%, then this new value of P together with the level of GDP we had last year would still give us equilibrium in both markets. Inflation has then been 10% and none of the IS or LM curves have shifted.
In year 2, P = 110 and Y = 10 must be on AD2. In year 3, by the same arguments, P = 1101.1 = 121 and Y = 10 must be on the AD3 and we see that the AD curve glides upwards by 10% per year - exactly the same rate as the growth in the money supply.
We must remember that if %M ^ 0, then the AD curve is applicable only for a given point in time. At another point in time, we must draw a different AD-curve. The rate at which the AD curve glides is equal to nM - if nM is high, a higher inflation is necessary if the same level of GDP is to lead to equilibrium in both markets.
Even though nM determines the evolution of the AD curve over time, there are still many combinations of P and Y leading to equilibrium in the goods- and money market (all points on the AD curve at precisely the given point in time). Only one point will be an equilibrium point for the entire economy and, as before, the AS curve will help us to find this point.
The Labor Market
Remember the model of labor market in the AS-AD model with constant wages. On the y-axis, we had real wage and on the x-axis, we had L (see Figure 13.6). The response curve had two parts, a horizontal part and a downward sloping part. On the horizontal part, prices where constant and L was determined by the aggregate demand. Real wages in this part of the response curve may be denoted by (W/P)MAX as real wages can never be higher than this level. On the downward sloping part of the response curve, P is no longer constant and L is determined by P. On this part of the curve, the real wage is lower than ( W/P)MAX. We also concluded that the real response curve is a smooth version of this one.
With inflation, the reaction curve will not change. The reason for this is that we have real wages on the y-axis. If wages increase by 10% while prices increase by 10%, real wage will not change.
In our model of the labor market with inflation, there is still a maximum real wage (W/P)MAX. As long as we are to the left of point B, there is no reason for firms to change the growth rate of prices (which is given by n = nW) and the real wage will remain constant. In order to induce firms to go past the LB, real wages must fall below ( W/P)MAX which means that prices must increase faster than wages: n > nW
However, we must be careful with the notation:
• With no inflation, we said that said prices were constant on the horizontal part. With inflation, we must say that we have neutral inflation (n = nw) on the horizontal part.
• With no inflation, we said prices increase as L increase on the downward sloping part. With inflation, we must say that prices increase faster than wages as L increase on this part.
Fig. 14.6:The labor market with inflation.
The AS curve
Say that the nominal wage in year 1 (at a particular point in time) is equal to 1000. On the horizontal part of the response curve, real wage is constant and equal to its maximum value. Say that (W/P)MAX = 10. On the horizontal part, P1 = 100, where P1 is the price level in year 1. Firms will employ at most LB at this real wage. For firms to hire more than LB, P must be higher than 10. We realize that the AS curve at this point in time, AS1, will look like before. First, it is horizontal along P = 10, then, for higher Y. it is upward sloping.
Suppose that nW is equal to 10%. Next year, nominal wages will be equal to 1100. Wages in year 2 are determined by nW which is an exogenous variable, making wages in year 2 exogenous. As the maximum real wage is given and equal to 10, we conclude that P2 is equal 110 on the horizontal part of the response curve and that P2 > 110 on the downward sloping part. AS2 glides upwards up by 10% as given by the wages inflation. Using the same argument, P3 = 121 on the horizontal part of the response curve at year 3 and so on.
Just like the AD curve, the AS curve is to glide upwards or downwards depending on whether nw > 0 or nw < 0 when we allow for inflation. As for the AD curve, the AS curve is applicable only at a particular point in time if nW ^ 0. At another point in time, we must draw a new AS curve.
Fig. 14.7:AS curve gliding if nW * 0.
The AS-AD model with inflation
When we have inflation, both the AD curve and the AS curve will be gliding. "The glide rate" of the AD curve is given by nM while it is nW which applies to the AS curve (where both rates are exogenous). Using the AS-AD curves, we can determine the equilibrium price P (and thus n) at any point in time and we can determine all endogenous variables. For example, we realize that if nM = n , both curves glide at exactly the same rate. Y will then be unchanged and nwill be equal to nw.
Fig. 14.8: Determination of Y and P in the AS-AD model with inflation.
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