Links with Aggregate Demand and Supply Analysis

Links with Aggregate Demand and Supply Analysis

Look at the diagrams below

Links with Aggregate Demand and Supply Analysis
Links with Aggregate Demand and Supply Analysis

On the top diagram, we have the long run AS/AD diagram. We assume that the economy is at the full employment equilibrium, YFE, giving a price level of P1 (point A). Both Keynesians and Monetarists agree that at the full employment level of income, any increase in aggregate demand will lead only to a rise in the price level in the long run. The economy will move to point B temporarily, but the subsequent rise in real wage claims that follow a rise in the price level will shift the short run aggregate supply curve to the left (from SRAS1 to SRAS2) and the economy will end up at point C, back at YFE but with a much higher price level (P2).

Now look at the second diagram. Assume that the economy is operating at point A, with a level of unemployment equal to the NAIRU, U*, and 0% inflation. If aggregate demand is increased, unemployment is assumed to fall only in the short run (a move to point B). Depending on how quickly workers recover from money illusion, the economy will end up at point C with a permanently higher rate of inflation.

These two diagrams are describing the same economy. The rising price level in the diagram on the left is illustrated by the increased inflation rate in the diagram on the right. The temporary rise in the level of real output in the diagram on the left is illustrated by the temporary fall in unemployment in the diagram on the right. The long run equilibrium level of national income (YFE) in the diagram on the left is illustrated by the natural rate of unemployment in the diagram on the right. Even at full employment there will be some unemployment in the economy.

As the analysis above demonstrates, the Keynesians and Monetarists are in broad agreement with regard to the link between the full employment level of national income and the natural rate of unemployment in the long run. They also agree that the original shaped Phillips curve applies in the short run only. The only real arguments are over how quickly the workers expectations adapt to the change in the actual inflation rate (i.e. the length of the short run).

Keynesians believe the short run might actually be quite a long period of time. They are big believers in the stickiness of wages and prices. Even though the workers' expectations may have already changed, wage contracts tend not to be changed overnight.

Monetarists believe that changes in expectations, and the resulting changes in wages and prices, happen much quicker. There is a division, though, between different monetarist economists.

Those who believe in rational expectations believe that everyone, including the workers, has perfect information. The workers actions are, therefore, 'rational'. Their expectations adapt to the change in prices following the increase in money wages almost immediately. In the diagram above, the economy moves straight from point A to point C. The short run does not exist and workers do not suffer from money illusion.

Other monetarists believe in adaptive expectations. As the name suggests, they believe that workers' expectations do adapt, but not immediately. The short run does exist, but does not last as long as the Keynesians believe.

As you can see from the data on unemployment in the 50s and 60s, the natural rate was barely 3% at the time. The huge increase in structural unemployment in the 80s caused the natural rate to rise in the 80s. Estimates varied between 8% and 12%. Remember, the actual unemployment rate can easily be higher than the natural rate. In times of recession, there will be a lot of demand-deficient unemployment (or cyclical unemployment) causing many workers to be involuntarily unemployed. So even though the unemployment rate was well over 10% in the mid 80s, some economists felt that the natural rate was only 8%.

The best way to reduce the natural rates is through supply side policies, especially those aimed at the labour market. Examples include investment in education and training and the 'New Deal'. See the topic called 'Aggregate demand and aggregate supply' for details.

As the UK economy came out of the recession of the early 90s, economists found it hard to estimate what, exactly, was the natural rate of unemployment. They kept revising their estimate downwards as the economy kept creating jobs, but the actual unemployment rate kept falling below their estimates of the natural rate with no increase in the rate of inflation (the inflation rate is meant to rise if unemployment falls below the natural rate). Basically, most economists have been surprised at how far the level of unemployment (and, therefore, the natural rate) has fallen.

Although economists still agree that the original Phillips curve trade off is still only a short term phenomena, most would agree that this short term trade off occurs at much lower levels of inflation and unemployment. In other words, the short run Phillips curve has shifted towards the origin along with the vertical long run Phillips curve.

Patrick Minford, the extreme monetarist economist, has argued all along that the natural rate is as low as 3%-4% due to the success of the supply side reforms of the 80s and 90s. The ILO measure of unemployment is currently around 5.5%, so perhaps the level of unemployment can fall a bit further.