Supply and Inflation
IMQF course in International Finance
Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson
Outline
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How changes in monetary policy are reflected in both output and prices? - Aggregate
supply relationship
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Frictionless neoclassical supply relationship
Modified keynesian supply relationship
Friedman-phelps supply relationship
Lucas-sargent-barro supply relationship (New Classical Macroeconomics)
Aggregate Supply Relationship
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If prices rise (e.g. oil shock), real money supply decreases (LM=M/P curve shifting to the left) –
decrease in demand reduces output
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The inverse relationship between P and Y is downward sloping AD curve
Monetary expansion – shifting AD to the right
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Only if 10% increase in money supply triggers 10% rise in prices, will the LM curve be unchanged, i.e. would
Y be unchanged
Aggregate Supply Relationship
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Five aggregate supply relationships exist:
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Frictionless neoclassical
Keynesian
Friedman-Phelps (expectations augmented)
Lucas-Sargent-Barro (New Classical)
Indexed wages
The basic model
(Y / Y )  ( wP / W )
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Exponent sigma is the elasticity of supply with respect to price level, given the wage rate W, i.e. the increase
in output that firm chooses to supply when the price level goes up by 1%
Aggregate Supply Relationship
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Competitive firms choose employment so as to
maximize profits
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Output Y=f(N), where N is the number of workers
employed
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Firms decide on the number of workers to be employed
based on the real wages (W/P) – sloped downwards
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When firms receive higher prices, relative to the cost of
their variable input, the incentive provided by higher
profits encourages them to produce more
Aggregate Supply Relationship
FRICTIONLESS NEOCLASSICAL SUPPLY RELATIONSHIP
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In the absence of frictions either in prices or wages, labor is fully employed and output is at the
potential level – aggregate supply is inelastic
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Real wages adjust frictionlessly to equal marginal product of labor – labor force is fully employed (at
the natural rate of employment) – output is at the full level capacity
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If W/P>w – excess supply of labor – wage rate declines – rise in demand for labor
If W/P<w – excess demand of labor – wage rate rises – pushing down demand for labor
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Wage rate adjusts so as to provide equilibrium at the labor market
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Any increase in aggregate demand goes entirely into prices and wages, rather than output or
employment (monetary expansion by 10%, raises W and P by 10%)
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Changes in Y over time attributed to changes in potential output, not to changes in demand
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Potential output is a function of capital stock, labor force and human capital, productivity and firms’ efficiency
Aggregate Supply Relationship
MODIFIED KEYNESIAN SUPPLY RELATIONSHIP
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Keynesian view assumes wage and price rigidity – firms set prices and supply output demanded at
that price (adequate in short run) – aggregate supply curve is horizontal
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In mid run, aggregate supply curve can have some upward slope: prices are flexible, while wages
are predetermined
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e.g. set by means of collective bargaining contract, which lasts for more than a year or by means of implicit
contracts
(Y / Y )  ( wP / W )
Aggregate Supply Relationship
MODIFIED KEYNESIAN SUPPLY RELATIONSHIP
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Starting point A (full employment)
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Monetary expansion goes partily into prices and partly
into output (point B)
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Adverse supply shock (e.g. fall in productivity, bad
harvests, etc.) shifts the AS curve to the left
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To avoid inflation (at cost of fall in output) government
can restrict demand (e.g. Switzerland 1974) – point C
To avoid recession (at cost of inflation) government can
go for expansionary demand policy (e.g. Sweden and
US, 1974) -- point D
After the collective contract expires, wages go up,
shifting the AS curve up
Aggregate Supply Relationship
FRIEDMAN-PHELPS SUPPLY RELATIONSHIP
1) Adding inflation expectations to the supply relationship
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Wage rate to reflect expected inflation during the life of
the contract
e
W  wP
Y / Y  ( P / P e )
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Short run AS curve passes through the reference unit
e
( P  P , Y  Y ), point A
– if inflation corresponds to the expected inflation, wages will
clear the market (fully employment, no output gap)
– if sudden monetary expansion shifts prices, output will rise, as
real wages will decline (below the marginal produtivity), point B
2) Expected inflation adjusts to actual inflation, with the
passage of time
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Reference point is rising, as the expected prices adjust to
the price level observed most recently
Aggregate Supply Relationship
LUCAS-SARGENT-BARRO SUPPLY RELATIONSHIP (New Classical Macroeconomics)
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Only unanticipated rise in prices can lift the output beyond the potential level
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However, as inflation expectations are adaptive, i.e. rational, output cannot exceed potential level for
many consecutive periods
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If people could perfectly foresight inflation, expected inflation would equal actual inflation, thus output
being equal to potential
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Rational expectations: variable in question (P) can differ from expected value by a random error term:
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Error is uncorrelated with any information available at the time expectations were formed, so in average it shall
equal zero
P / Pe  1  
Y / Y  (1   )
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Government may want to raise demand before elections or in case of recession. But, if it does so systemically, it will
be reflected into the expected inflation, which means that such policy will have no impact on output, as actual
inflation equals expected inflation