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Recent Trends in Economic Volatility

Charles Notzon and Dan Wilson of the San Francisco Fed summarize "papers presented at a conference on 'Recent Trends in Economic Volatility' (we may soon find out if the recent trend, i.e. The Great Moderation, was truly Great, or just a flash in the pan):

Recent Trends in Economic Volatility: Conference Summary, by Charles Notzon and Dan Wilson, FRBSF Economic Letter: Over the last 25 years, the U.S. economy has become much less volatile; that is, the swings from boom to bust have been greatly reduced, as has the pain typically associated with such cycles. As Figure 1 illustrates, the volatility of GDP growth has fallen by more than half since 1985. Many observers refer to this phenomenon as the "Great Moderation." To what can we credit this improved environment? Researchers have uncovered several potential drivers, including improved technology (especially related to inventory and supply chain management), better monetary policy, and simple good luck, but to date they have found little consensus on which factor is most important.

Source: Bureau of Economic Analysis.

Also in dispute is the extent to which the decline in aggregate volatility has been mirrored in the microeconomic data on income and employment. In other words, have households and businesses also experienced a decline in volatility? The seven papers presented at the Center for the Study of Innovation and Productivity's conference on "Recent Trends in Economic Volatility" investigate these questions. Although the debate is not over, the papers have moved the research forward and highlighted key questions for future work.

Structural change vs. good luck in explaining the Great Moderation

The first paper of the conference, by Galí and Gambetti, begins with a useful summary of the various explanations for the Great Moderation, placing them into two broad categories: structural changes and "good luck." Structural changes include changes in the way monetary policy is conducted and technology-driven changes that affect the way firms operate. "Good luck" essentially means smaller and fewer economic shocks. Galí and Gambetti go on to use a standard empirical model known as a structural vector autoregression in order to characterize the correlations in post-World War II data among key U.S. macroeconomic variables. They posit that if declining volatility is merely the result of "good luck," then the data should show no change in the correlations between them. Their model, however, finds that this is not the case, as correlations between output, labor hours, and productivity have indeed changed since the early 1980s. Having eliminated good luck as an explanation, they attribute most of the decline in volatility to a decline in nontechnology shocks, which have come about due to a change in the Federal Reserve's monetary policy "rules" (specifically, an increased emphasis on fostering low and stable inflation in addition to strong economic growth) as well as a reduction in labor adjustment costs. It is worth noting that the authors' finding that reduced labor adjustment costs may have played an important role in the Great Moderation is consistent with evidence, discussed below, provided by the paper of Davis et al., which explores the secular decline in labor market volatility.

The role of technological change

Several papers ascribe a key role to technological progress in explaining declining volatility. The first of these papers, by Koren and Tenreyro, looks at how development of new technologies affects both the rate of growth and the volatility of growth in an economy. Their model posits that, just as households benefit from investing in a diversified portfolio of stocks (smoothing their returns and minimizing losses stemming from shocks to specific assets), having a larger and more diverse "menu" of technologies available to firms in a country means that each specific technology plays less of a role in production. The diversification of technologies in an economy makes it easier for firms to offset price or supply shocks to specific inputs (oil, for example) by substituting with other technologies that rely less on those inputs. In this way, technological advances reduce firm-level volatility, which consequently reduces overall volatility. Technological change also boosts the level of growth, since it allows firms to move to a new technology before reaching the point of diminishing returns in their old technology. While sensible and consistent with data that Koren and Tenreyro bring to bear, this finding contrasts sharply with the conclusions of previous research, which point to an explicit tradeoff between risk (volatility) and return (fast growth).

Comin and Mulani also examine the effects of technological change on economic growth and volatility and, similarly, find that technological change leads to both faster growth and lower volatility. But in contrast to the previous paper, Comin and Mulani argue that this good result holds only for the national, or macro, measures. Indeed, predictions from their model suggest that firm-level, or micro, volatility should increase as the pace of technological innovation increases. To get this result, they consider an economy with two types of technologies: general innovations (GIs), which are not patentable and are used by all firms in the economy, and research and development innovations (RDI), which are patentable and used by a limited number of firms. They then assume that GIs are produced by large, stable firms and RDIs are produced by smaller, more volatile firms. Under these conditions, they show that increases in RDIs (for example, due to government research and development (R&D) subsidies) lead to market "shake-up," whereby smaller firms gain market share and perhaps even leapfrog ahead of the previous market leaders. Since GI activity relies on the presence of stable market leaders, this shake-up creates both firm-level volatility and lower GI activity. The decline in GIs, which by definition help all firms, reduces the comovement between firms in the economy, ultimately reducing the volatility of aggregate outcomes. Said more simply, if the increase in the innovative activity comes from small firms jockeying for position in the industry, aggregate volatility will go down, as winners and losers will offset each other, but microvolatility will rise, as losing firms compete to get back on top. Comin and Mulani provide empirical evidence showing that increased R&D activity in the U.S. has coincided with increased volatility in sales and market shares for publicly traded firms, reduced comovement across industries, and reduced volatility in aggregate economic growth.

Turning to the purely micro data, Brynjolfsson et al. analyze the impact of information technology (IT) on industry volatility or turbulence. Use of IT allows an innovation to diffuse rapidly throughout a firm, increasing productivity and market share faster than was previously possible. Although first movers on an innovation are able to gain market share quickly creating the opportunity for concentration, the speed of diffusion that IT affords also enables new entrants to leapfrog ahead of leaders in a given sector, thus increasing sectoral turnover rates (turbulence). Empirically, IT-intensive industries have indeed experienced both greater concentration and turbulence. This evidence is consistent with the findings of Comin and Mulani that firms in more R&D-intensive industries tend to have more volatile sales and market shares, since there is a strong correlation between an industry's R&D intensity and its IT intensity.

Supply chain management

The role of supply chain management in the Great Moderation is the subject of a paper by Davis and Kahn as well as one by Irvine and Schuh. Davis and Kahn argue that dramatic technology-driven improvements in supply chain management in the durable goods sector, combined with a secular shift away from domestic durable goods manufacturing and toward services, is the explanation for the decline in aggregate volatility. They suggest that changes in monetary policy, on the other hand, played a minimal role. Their model of the firm's inventory decision process mirrors observed declines in output and sales volatility, as well as the sales-to-output ratio, and the authors suggest that a shorter lead time for materials orders (more precise inventory control) is the key mechanism through which this change has occurred.

Irvine and Schuh also find that improvement in supply chain management likely played the predominant role in reduced aggregate volatility. Using a multi-sector, vector-autoregression empirical model, they find that a decline in the comovement of output among inventory-holding industries (for example, manufacturing and wholesale trade) can explain a substantial share of the decline in aggregate output volatility. Their model suggests that a change in structural relationships between inventory-holding industries seems to be the cause of this decline, and industries in which firms share supply and distribution chains exhibited the largest decline in covariance in volatility. As in Davis and Kahn, Irvine and Schuh find little evidence that changes in monetary policy or "good luck" are major factors behind the Great Moderation.

Volatility in the labor market

In the final paper of the conference, Davis et al. establish and attempt to explain two interesting facts from the data. The first fact is that volatility of employment levels within firms, particularly those not publicly traded, has declined over the past 25 years. The second fact is that the flows of individuals into unemployment have fallen over time. In the early 1980s about 4% of employed persons fell into unemployment (either voluntarily or involuntarily) in the average month; by the early 1990s, this figure had dropped to just 2%. The focus of their paper, then, is to investigate whether the decline in volatility in employment demand by businesses is responsible for the decline in unemployment inflows. Using industry-level data, they find a strong statistical association between an industry's volatility in employment demand, as measured by the variance in its job destruction rate, and the industry's unemployment inflow rate (the rate at which workers in the industry go into unemployment in a given period). They conclude that the decline in firm level employment volatility likely has reduced flows into unemployment.

Conclusion

While there is broad agreement that aggregate economic volatility has declined over the last 25 years, the relative roles of economywide factors, such as changes in monetary policy and technological change, remain topics of dispute. Also in dispute is the extent to which this decline in aggregate volatility is mirrored in microeconomic variables, such as income and employment. Reductions in aggregate and firm-level volatility do not necessarily translate into a reduction in volatility at the individual level. Rather, some studies argue that household consumption and individual earnings have become more volatile in recent decades, not less. The linkages between the disparate trends in volatility at the aggregate level and at the individual level remain important areas of economic research.

Microeconomics Made Easy. The Basics in Less Than an Hour

What is difficult about microeconomics? Basically nothing. Microeconomics is one of the most rigorous edifices of thought that has ever been built. The two pillars on which it rests - the theories of supply and demand - are completely symmetrical, which gives this edifice transparency, structure, logic, clarity, even an air of beauty, and above all surprising simplicity.

The symmetry and the aesthetic quality that symmetry always creates were achieved at a high price: Supply theory had to be constructed as the exact mirror image of demand theory. This has disastrous consequences: Any beginner can see that substantial parts of supply theory and some important theories derived from it are wrong. As a result, students feel that some of the theories they are expected to learn are faulty and that most of them are rather complicated.

The best way to escape from this dilemma is to learn the essentials of micro as thoroughly and rapidly as possible. This endeavour takes less than an hour and will reveal how simple microeconomics is. Thereafter you must, of course, put some flesh on this structure with the help of the Crash Course or some other textbook. But the impression that you are expected to master masses of complicated and at times confused theories will be gone for good.

What will also be gone is the feeling of helplessness that often accompanies pontificating instruction in economics. The Chapter-by-Chapter Critique enables you to explain precisely why many of the theories you are taught are simply wrong.

Further support for students comes from the References and Further Reading Sections following the Critique. Introducing you to the critical writings of eminent mainstream economists, they reveal that textbook authors not only conceal the criticism levelled at microeconomics by heterodox - i.e. non-neoclassical - economists but also conceal the critical writings by their mainstream colleagues.

So, let's get going. The first step for newbies and self-styled dummies is to get a sound grasp of the logical structure of supply and demand theory. Below you will find the standard graph that illustrates the fundamentals of microeconomics and a chart that summarises them.

GRAPH
The Standard Graph Illustrates the Fundamentals of Microeconomics

This simple graph illustrates demand theory, supply theory, price theory and equilibrium theory. The latter is the culmination of microeconomic theory.
The demand curve slopes downwards. This is due to two laws. (1) The law of demand, which states that more is bought as prices fall. (2) The law of diminishing utility, which states that the utility of additional units diminishes as more is consumed.
The supply curve slopes upwards. This is also due to two laws. (1) The law of supply, which states that more is supplied as prices rise. (2) The law of diminishing returns, which states that marginal costs (costs of additional units) rise as output in expanded because increases in output following increases in some but not all inputs diminish.
The interaction between demand, supply and prices leads to equilibrium at the equilibrium price where the market is cleared.

CHART
The Symmetry between the Theories of Supply and Demand

Quantity Supplied and Demanded
These are the quantities supplied or demanded at particular prices. They are represented by particular points on the respective curves.

Supply and Demand
They are the quantities supplied or demanded at any possible price. They are represented by the respective curves as a whole.

Movements along the Curves
They are changes in quantities supplied or demanded in response to price changes.

Shifts of the Curves
They are changes in supply or demand in response to changes in exogenous variables.

Reasons for the Slopes of the Curves
The slope of the demand curve: The law of demand and diminishing marginal utility.
The slope of the supply curve: The law of supply and diminishing marginal returns.

The Ability to Buy
It is explained by the law of demand.

The Willingness to Buy
It is explained by diminishing marginal utility.

The Ability to Produce
It is explained by diminishing marginal returns.

The Willingness to Produce
It is explained by the law of supply.

Price Elasticity
Price elasticity of supply and demand is measured by a fraction.
Percentage change in quantity supplied/demanded is given in the numerator.
Percentage change in price is given in the denominator.
Supply and demand are elastic if the numerator exceeds the denominator.

Utility/Profit Maximisation
Consumers maximise utility by expanding their purchases until the utility received from the last unit equals the price to be paid for this unit.
Producers maximise profits by expanding output until the price received for the last unit produced equals the cost incurred by producing this unit.

The Equimarginal Principle
Consumer and supplier behaviour is guided by the equimarginal principle.
Consumers buy bundles. Utility has been maximised when the ratio of the marginal utilities of the commodities in their bundles to the market prices of these commodities (MU/P) is equal for all commodities.
Producers employ combinations of factors. Costs have been minimised when the ratio of marginal products (increase in output generated by one additional unit of a factor) to prices of factors (MP/P) is equal for all factors.

Indifference/Isoquant Analysis
These are additional approaches to explain consumer and producer behaviour.
Consumers are indifferent about the contents of the commodity bundles they buy.
Producers are indifferent about the mix of factors they employ.
Consumers buy a bundle when the ratio of their subjective barter prices to actual market prices is equal for all commodities in their bundle.
Producers employ a combination of factors when the ratio of marginal product to the actual price of a factor is equal for all factors.
In either case, the decision on the commodity/factor mix is ultimately determined by budget constraints.

Staffing & Employment News – June 2010

Staffing & Employment News

Most experts tell us that the recession starting in December 2007 ended in mid-2009 when real GDP and industrial production bottomed and then started growing again. According to the National Bureau of Economic Research (NBER) business cycle committee, domestic production and employment are the primary conceptual measures of economic activity.

The committee views the payroll employment measure as the most reliable estimate of employment. Our employment recovery has been the slower in the 3 quarters following the ‘end of the recession’ than after other recent downturns. However the economy has added jobs in the last three consecutive months, a reversal of the prior 24 months of employment decreases. (First graph below from ADP)

According to Macroeconomic Advisors LLC, the GDP Index was positive each of the months in Q1 2010 and is showing an upward swing, showing a negative annualized growth only twice since mid-2009. (Second graph below from Macroeconomic Advisors)

ADP Employment Graph

MA GDP Index

Unsurprisingly, as we come out of the bottom of this business cycle, hiring will increase and that has already begun. The Q2 2010 U.S. Hiring Forecast shows that 23% of employers increased their full-time, permanent staff in the first quarter, up from 13% in the same period last year and up from 20 % in the fourth quarter. This is the third quarter that employers projected hiring increases.
Responses to the survey indicate that many companies are reviewing current employees in light of the upturn ahead, and more than one quarter anticipate replacing low performers with top performers in the second quarter.
The top staffing challenges are going to be 1) Competing on salary/compensation, 2) Maintaining productivity, and 3) Retaining Top Talent. Strategies for retaining your top performers include: Flexibility on work time/location; Training and Development opportunities; and Future Benefits and Performance-Based Incentives as the company’s bottom lines improve.
Recommended Further Reading:
Undoing IT Staffing and ROI Myths by Patty Azzarello
U.S. Recovery Approaches One-Year Anniversary in Good Shape May 2010 by the National Association for Business Economics
Short Takes, SI Review May 2010 by the Staffing Industry Review Magazine
Slowdown Ahead, But Not a Recession by the Economic Cycle Research Institute
Q2 2010 U.S. Hiring Forecast by Career.Builder.com and USA Today

MACROECONOMIC EQUILIBRIUM: Putting it all Together

So, we have the aggregate supply curve and we have the aggregate demand curve.
AD measures levels of production which won't change over time as a function of price
AS measures levels of production which suppliers will actually produce at as a function of price.
SO... what happens when you put both of them together?

Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!

The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)
GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment

This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium

Aggregate Demand Shocks and Macroeconomic Equilibrium:

These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!

As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)

You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.

The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.

When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.

When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.

When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.

Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.

We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.


Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.

Structure of Financial System

I. SUPERVISING ENTITIES

1. Central Reserve Bank of El Salvador

Its objective is to promote macroeconomic stability, particularly monetary stability. Low inflation promotes savings, increases productivity and promotes low interest rates. All of this encourages investment creating a healthy cycle, i.e. macroeconomic stability –better opportunities–macroeconomic stability.

It also safeguards financial system stability, establishing prudent measures and regulations to assure its financial solvency and enabling it to offer efficient financial services. This reduces operating costs, fostering savings and making credit easier to obtain, thus promoting financial development and economic growth.

2. Financial System Superintendence (SSF)

Its main function is to enforce all provisions applicable to the Central Bank, other banks, financial institutions, insurance companies, non-banking financial intermediaries, mutual guarantee companies, exchange bureaus, and Official Credit Institutions. It is also in charge of their control.

3. Securities Superintendence

Its main function is to enforce compliance with the provisions applicable to the stock exchange, exchange broker companies, bonded warehouses, specialized companies for the safe custody of securities and valuables, risk classification companies, etc. It is in charge of controlling the above institutions. It also inspects and supervises the issuers who are inscribed in the Public Stock Exchange Registry.

4. Pension Superintendence

It is mainly in charge of enforcing compliance with the provisions applicable to the Retirement Savings System and the Public Pension Fund System, and mainly those applicable to Pension Fund Administration institutions, the INPEP (National Institute for Public Employees Pension), and the Disability, Old-Age and Death Program of the Social Security Institution, being also in charge of their control.

5. Deposit Guarantee Institute

In the event that a member bank is forced to be dissolved and liquidated, it guarantees the public deposits for up to US$6,700 dollars. Likewise, it contributes to the restructuring of member banks, which may have solvency problems, in order to defend the rights of the depositors and those of the institution.

* Pursuant to Article 181 of the Banking Law, the Financial System Superintendence is in charge of controlling this institution.

II. PARTICIPANT ENTITIES

1. Banks

They are organized as incorporated companies, having a minimum capital of US$11.43 million. They require prior authorization from the Financial System Superintendence in order to begin operations.

2. Stock Exchange Companies

a) Stock Exchange

Corporations aiming to provide its members with the necessary means to efficiently carry out securities transactions and enable them to carry out securities intermediary activities. The country has a Stock Exchange.

b) Exchange broker companies

Corporations whose objective is to act as securities brokers. They can also carry out portfolio administration operations, prior authorization from the Securities Superintendence.

c) Specialized companies for the safe custody of securities and valuables.

These Corporations receive securities in custody from financial brokers and from the public; they also provide amortization-collecting services. Currently there is only one firm providing such services.

3. Welfare Institutions

a) National Institute for Public Employees Pension (INPEP).

An autonomous institution whose aim is to manage and invest its economical resources destined to the payment of benefits to cover Disability, Old Age and Death of public employees.

b) Salvadoran Institute of Social Security (ISSS): Disability, Old Age and Death Program.

c) Armed Forces Institute for Social Prevision, Disability, Old Age and Death (IPSFA).

An autonomous credit institution whose objective is to achieve welfare and social security goals on behalf of the members of the Armed Forces

d) Pension Fund Administration Institutions (AFP’s)).

These are welfare institutions organized as corporations whose sole aim is to administer a pension fund while they administer and award the benefits and entitlements provided by the Pension Fund System Law.

4. Auxiliary Organizations and Bonded Warehouses

Their main function the oversight and preservation of merchandise submitted to their custody, issuing certificates of deposit and warrants over said merchandise.

5. Non Banking Financial Intermediaries

a) Cooperatives:

These entities are organized to render credit-financial services to their partners and to the public. They may be organized as partnerships, or as cooperative associations. Some of them are supervised by the SSF (the ones authorized to collect funds from the general public) and others shall be supervised by the Federation they belong (receiving funds only from their members).

b) Federations.

These are organizations that group into financial cooperatives. Their aim is to render financial, consultancy and technical assistance services to the member cooperatives.

c) Sociedades de Ahorro y Crédito (Credit and Savings Societies, SAC).

These corporations are authorized to collect deposits from the public and to grant credits, these are incorporated with a minimum capital of US $2.9 million. They cannot collect deposits in current accounts; they must comply with the corresponding requirements set forth for such purpose in the Banking Law and in the Non Banking Financial Intermediaries Law.

6. Official Institutions

a) Banco Multisectorial de Inversiones (Multisector Investment Bank, BMI).

A public credit institution created to promote the development of investment projects from the private sector by granting loans under the current market conditions, through the financial institutions of the system.

b) Banco de Fomento Agropecuario (Agriculture Promotion Bank, BFA).

Official credit institution whose aim is to create, foster and maintain financial conveniences and other associated services necessary to contribute to foster agriculture.

c) Fondo de Financiamiento y Garantía para la Pequeña Empresa (Finance and Guarantee Fund for Small Businesses, FIGAPE).

Autonomous institution whose objective is to grant small loans to small business and Industry holders.

d) Fondo Nacional de Vivienda Popular (National Low-Cost Housing Fund FONAVIPO)

Its objective is to allow low-income Salvadoran families to have access to credit to enable them to procure housing under the most favorable conditions. It also fosters activities of social interest.

e) Fondo Social para la Vivienda (Social Housing Fund, FSV).

Its purpose is to render financial services to solve housing problems of the working population.

7. Mutual Guaranty Companies

Corporations whose exclusive purpose is to grant its associated members endorsements, bonds and other guarantees. They are controlled by the Financial System Superintendence.

8. Insurance Companies

These are Corporations who operate insurance, reassurance, bonds and reinsurance services. In the insurance contract (pursuant to the Code of Commerce) the insurance company is bound, by the payment of a premium, to compensate for damages or to pay an amount of money upon verification of the occurrence of an event provided in the contract. In the bond contract, on the other hand, one or more persons are responsible for someone else’s obligation, being committed on behalf of the creditor to comply in full or in part if the main debtor does not comply.

9. Foreign Currency Exchange Bureau

Companies whose usual activity is the purchase and sale of foreign currency in bills, bank drafts, traveler’s checks and other payment instruments issued in foreign currencies, at prices set by offer and supply.

Economics - Macroeconomics - DEMAND AND SUPPLY ANALYSIS

	TOTAL DEMAND AND SUPPLY ANALYSIS
	The Keynesian IS-LM model developed earlier is a model of only demand behavior. It tells us how the equilibrium between planned aggregate demand and output is achieved. It describes demand behavior but says absolutely nothing about supply behavior. Total supply and demand analysis breaks that implicit assumption and introduces the possibility of supply constraints or economic issues that can affect supply behavior. The total demand curve shows how the Keynesian equilibrium changes for different values of the price level. The total demand curve shows how changes in the price level affect the IS-LM or demand side equilibrium. Total Demand Curve The price level determines the real value, or purchasing power, of the nominal money supply, thus positioning the LM curve and determining the aggregate demand equilibrium. The total demand curve is a locus of Keynesian aggregate demand equilibrium for different price levels. If the price level changes while everything else (including the nominal money supply, M) remains the same, then the resulting change in the real money supply ( ) causes the IS-LM equilibrium to change Total Supply Curve It describes the amount of output that producers are willing and able to supply to the goods market. Keynesian Supply Curve: The total supply curve implicit in the Keynesian IS-LM model is based on the notion that there are no supply constraints and that prices are pre-determined in the short-run (one year or less). Thus, whatever output level is demanded will be produced and the total supply curve is a horizontal line.There is sufficient excess capacity so that an increase in demand leads to more production without increasing production costs and prices. Long-run or Classical Supply Curve: At the opposite extreme to the Keynesian short-run horizontal supply curve lies the supply curve implicit in the long-run equilibrium or classical view of the Macroeconomic world. The classical view implies a vertical supply curve, The classical vertical total supply curve and the Keynesian horizontal total supply curve represent two theoretical extremes, neither of which is a satisfactory representation of behavior in the real world. The traditional Keynesian approach leaves us without a theory of price determination. The classical approach introduces a theory of price determination, but at the cost of eliminating an explanation of fluctuations in real output. By assuming that competitive markets at all times generate equilibrium levels of output, the model cavalierly does away with fluctuations in output. Some More Reasons Why Prices are Sticky: Labor Contracts: Implicit labor contracts are a term that refers to the type of agreements that are often made between employers and employees. Career Labor Markets: The idea here is that employers adopt policies that promote the long-run attachment of workers to the firm. This is important to employers because finding able workers and providing training can be expensive. In addition, employees find it in their interest to agree to such arrangements. A Demand Shock: In the short run. The monetary policy expansion leads to a fall in interest rates which gets the multiplier process under way and output increases. Over time, the multiplier process that leads to an increase in output also leads to increases in prices. Quantity adjustments become less common and price adjustments become more common. Nevertheless, additional output is forthcoming, and after a period of several years, there are both output and price increases. Expansionary monetary policy: A major theoretical point of our discussion is the tendency to return to a long-run equilibrium—the normal, natural, or long-run equilibrium level of output termed Y*. It is an output level associated with balance in the macroeconomics; in particular, there is an absence of inflationary or deflationary pressures at this output level. It is very important to add that this output need not be one where all resources are fully employed. The long-run equilibrium is “natural” because the economy tends to move toward it. The term does not convey a value judgment that this equilibrium is desirable or good. There may be more unemployment at Y* than a democratic society would like to endure. INFLATION Since the inflation rate is probably the most closely followed macroeconomic phenomenon, it will be helpful to have a theoretical framework that concentrates on the determination of the inflation rate directly. Our inflation equation will also help us understand one of the most unusual characteristics of inflation—its persistence. That is, we will discuss the momentum to inflation. Price Adjustment Function: where π = is the inflation rate. An important implication of this specification of equation is that when Y =Y* , there are not inflationary pressures. Phillips Curve: The term Phillips curve refers to the empirical relationship between wage or price inflation and the unemployment rate. Since Phillips’ early econometric studies in the 1950s, the relationship has been extended and developed into an important analytic tool for understanding the inflation process. An expansionary policy could reduce the unemployment rate at the cost of only a small increase in the inflation rate. Expectations of Inflation The influence of market supply and demand on the inflation rate that emerges will depend as well on the expected inflation rate. A given degree of slack will result in a higher or lower overall inflation rate depending on how much inflation the price-setting agents expect to occur. Augmented Price Adjustment The effect of an increase in expectations of inflation on the actual rate of inflation can be seen by envisioning a particular price or wage negotiation. The parties in a particular negotiating session will be influenced by supply and demand conditions in the market and also by their expectations of aggregate inflation. The price or wage agreement that emerges from the negotiations will be higher if both parties expect more inflation to take place in the overall economy. Expectations-augmented price adjustment equation Where the expected rate of inflation and the coefficient b is measures the impact of expectations on the inflation rate. Rational Expectations Formation of expectations have indicated that expectations adjust slowly when inflation changes. This has often turned out to be an accurate description of reality, but it is not necessarily true. Starting in the early 1970s an alternative hypothesis about the formation of expectations had a very profound effect on economic thinking. The rational expectations hypothesis states that expectations are knowledgeable and informed predictions of the actual outcome. That is, expectations are formed by individuals with an understanding of the workings of the economy and with available information on all relevant phenomena. Expectations of inflation are thus based on all available information that relates to price determination and with an understanding of how prices are in fact determined. With rational expectations, the expected inflation rate can be expressed as the actual inflation rate (π) plus a random error term: New Classical Macroeconomics The natural rate Phillips curve model implies that the unemployment rate differs from the natural rate hen inflation is unanticipated. With rational expectations, unanticipated inflation is always a random or unpredictable phenomenon. Therefore, all deviations, including short-run deviations, of the unemployment rate from the natural rate are random events. Sources of Inflation The distinction among the different sources of inflation is somewhat artificial because they can all be present and are often related to one another. However , different inflationary episodes can be often be ascribed to a particular dominant causal factor. Monetary Growth Excess Demand Relative Price Shocks Wage Price Spiral Inflation Expectations