1. Macroeconomics
January 07, 2012

2. Aggregate Supply
Analysis – Classical View
2

3. Aggregate Supply
»Role of Aggregate Demand in determining
the economy‟s output
»What does the AD curve signify?
»What is Aggregate Supply and how does the
curve look like?
»Combinations of output and the price level
at which firms are willing, at the given price
level, to supply the given quantity of output
3

4. Production Function
»Technological relation between the rates of
input of productive resources and the
maximum rate of output that can be had
from the inputs, given the technology of
production
»Example?
»What does production function mean in the
microeconomic context?
»Y = f(K, N)
4

5. Production Function
»Output‟s relationship to capital stock and
labor employed?
»Recall diminishing returns!
»Assumption for the model: Constant capital
stock and technology
»New production function: Y = f(N)
»The production function graph
»Reason why the slope reduces?
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6. Demand for Labor Function
»Assumption: Given capital stock, pure
competition
»Demand for labor curve consists of the MP
of labor curve
»The condition of W = P * MPL
»Cost of hiring an additional worker vis-à-vis
the revenue associated with the
employment of the additional laborer
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7. Demand for Labor Function
»W/P = MPL
»To obtain the demand curve, the
relationship between real wage and the
amount of labor is used
»Slope of the production function
»Downward sloping demand curve for labor:
ND = f(W/P)
»Shifts in demand for labor
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8. Supply of Labor Function
»Real wages play a key role!
»NS = f(W/P)
»Relationship between real wages and labor
supplied
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9. Summary of labor demand and supply
» Production is entirely a function of the quantity
of labor: Y = f(N)
» Amount of labor supplied depends only on real
wage and increases with real wage
» Amount of labor demanded also depends only on
real wage rate and decreases with it
» Real wages perfectly flexible (“flex price”)
» Economy is made up of efficiently operating
−
markets that are very flexible (ND = NS = N)
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10. Keynesian Aggregate Supply Model
» Criticism of assumptions made in Classical
model
» Similarity of views on Aggregate Production
Function and demand for labor
» Keynesian Assumptions:
» Nominal wage is exogenous (No rapid
adjustment)
» Labor market is not always in equilibrium
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11. Classical Analysis of Income Determination
» Say‟s Law of Markets: Supply creates its own
demand
» Exchange between parties involves two
transactions of the counteractive nature
» No overproduction of goods
» Possibility of preference of total output
surpassing total demand
» Extension of this theory: Money is not preferred
for money!
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12. Equilibrium in the Classical Model
» Economy consists of 3 markets: Labor, money
and goods
» Labor Market:
» Y = f(N)
» dY/dN = W/P
» ND = f(W/P)
» NS = f(W/P)
» ND = NS
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13. Equilibrium in the Classical Model
» Money Market:
» M = KPY
» Goods Market:
» S = f(r)
» I = f(r)
»S = I
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14. Aggregate Supply Analysis –
Keynesian View
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15. Great Depression
» Classical economists and Say‟s law of demand
» Possibility of producing too much of one type of
good and not enough of other type
» Mechanism of wage-price flexibility
» Reasoning: What happens to price when there is
excess supply or excess demand?
» What happens during „glut‟?
» Keynes viewed AS from a supply side – supply
creates its own demand
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16. Great Depression
» Spending induces supply
» What happens when individuals and firms spend
lesser or cut back on their budgets? And how
can it be linked to employment?
» Classical economists‟ argument on employment
and surplus labor
» Keynesian framework equilibrium does not
happen at the full employment stage. Why or
How?
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17. Equilibrium in the Keynesian Model
» Economy consists of the same 3 markets in
Keynesian view as well
» Labor Market:
» Y = f(N)
» dY/dN = −
w/P
»
ND
= f(w/P)
−
»W = w
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−

18. Equilibrium in the Keynesian Model
» Money Market:
» M = KPY + L(r)
» Goods Market:
» S = f(r)
» I = f(r)
»S = I
»Y = C + I
» Y – C = I; Y – C = S
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19. Wage rigidity
» Implicit agreement between a business firm and
its key employees
» What happens to a firm that reduces wages?
» As real wages rise the firm lays off workers
» Does inflexible wage mean nominal wages are
also inflexible?
» When will there be an excess supply of labor?
» What happens when price level falls?
» Unemployment arises because of sticky wages
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20. Classical Vs. Keynesian Income Determination
»3 most important differences in Keynes‟
theory
»Wage rigidity Vs. wage-price flexibility
(for situations less than full employment)
»Speculative demand for money
»Income being a far more important
determinant of saving and consumption
than rate of interest (r)
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21. Classical Vs. Keynesian Analysis
Classical
Keynesian
Full Employment exists.
Equilibrium at full employment
Supply creates its own demand
Demand creates its own supply
No overproduction
Possibility of glut. Supply doesn’t
always match demand
No government intervention
No ‘laissez faire’.
Wage cut can solve
unemployment problem
Wage cuts increases
unemployment
Importance of savings and thrift
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Full Employment is a special case.
Equilibrium at lesser than full
employment
Saving was a private virtue and
can’t be forced

22. Classical Vs. Keynesian Analysis
Classical
Keynesian
Static approach to income/output
analysis
No faith in fiscal or monetary
policies
State intervention through fiscal
and monetary policy advocated
Did not take into account
business cycles
Considered business cycles in the
form of employment
Balanced budget policy
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Dynamic and a macro approach
to output analysis
Deficit budget during deflation
and surplus budget during
inflation

23. Keynesian Chain of causation
Changes in the quantity of money
Changes in the rate of interest
Changes in Aggregate Demand
Changes in Total Output
Changes in Marginal Costs
Changes in Prices
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24. Economic Fluctuations and
Unemployment
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25. Introduction
» Efficient operation of an economy is determined
by:
» Real output
» Full employment
» Price Stability
» Can economic expansion lead to recession?
» What happens to the 3 factors mentioned above
in times of recession/depression?
» Fluctuations observed in growth rate of NNPFC
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26. Business Cycles
» Business Cycle is a swing in total national
output, income and employment (usually lasting
for a period of 2-10 years)
» Marked by widespread expansion or contraction
in many sectors of the economy
» Business peak or boom – Rapid growth of real
GNP
» Contraction or recessionary trough – Businesses
slow, unemployment increases
» Recovery or expansion - ?
26

27. Business Cycles
» 4 stages of a business cycle
» Recovery or revival of economic activity
» Prosperity or expansion of activity
» Recession or downturn of activity
» Depression or contraction in activity
» What order do they follow? Does there need to
be an order?
» What is meant by the length of a cycle?
» Do all businesses go through the same cycle?
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28. A few examples
» What happens to the following variables during
recovery, boom, recession and depression?
» Industrial production
» Profits
» Investment
» Wage rate
» Business failure
» Business expectations
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29. Theories of business cycles
» Interaction between the multiplier and the
accelerator
» Multiplier theory – Income is determined by
investment
» Accelerator theory – Current investment
depends upon the change in aggregate output
» To maintain constant investment „ceiling‟ and
„floor‟ are necessary
» Theories concentrating on inventories, public
expenditure
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30. Theories of business cycles
» Stabilization policies - ?
» How effective are stabilization policies in
developing countries?
» Factors driving ups and downs in a country like
India:
» Performance of agricultural sector
» Behavior of public investments
» Ad hoc policy changes (licensing, subsidies?)
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31. Indicator forecasting
» Can business cycles be predicted earlier? How?
» What do you understand by leading and lagging
indicators?
» Examples of
leading, lagging and coinciding
indicators
» Gives advance warning about turning points in
economic activity
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32. Employment Fluctuations
» What is the importance of employment rates in
an economy?
» Barometer effect
» Keynes – Level of employment is driven by
effective demand
» Unemployment arises because of a deficiency.
What deficiency does this imply?
» Would providing incentives to investors help?
» Involuntary and frictional unemployment
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33. Employment Fluctuations
» Unemployment:
» (Number of persons unemployed/number in
civilian labor force)*100
» Sign of economic inefficiency
» Frictional unemployment
» Cyclical unemployment
» Structural unemployment
» Link between employment and output
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34. Full Employment
» Zero unemployment?
» Level of employment that results when the rate
of unemployment is normal
» Thumb rule – 94 – 95% employment
Some statistics:
1. Indian population 2011 – 1.21 bn
2. Unemployment rate for 2011 – 9.4%
3. Unemployment rate for 2010 – 10.7%
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35. Full Employment
» Natural rate of unemployment is the long run
average of unemployment caused due to
frictional and structural changes
» Major cause of increase in unemployment –
Power to reject job offers
» Actual and Natural rate of unemployment –
Difference?
» What happens to these two during periods of
booms or recessions?
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36. Measurement Problems
» People excluded though they prefer to work,
people being included who are not active job
seekers
» People seeking employment are not counted as
unemployed
» Part-time workers – Is one hour a week
enough?
» People who are not seeking employment are
classified as unemployed
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37. Unemployment Programs
» Not launched at a large scale
» Result – Reduction in unemployment is marginal
» Problems in implementing employment
guarantee programs:
» Resources
» Choice of appropriate works to be done
» Charity
» Agreement among decision makers is low
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38. Disguised unemployment
» No standard unit to measure labor productivity
» Too many people involved for a job involving
less number of people
» Relocation of productive resources can add to
saving potential
» Problems in relocating additional human
resources?
» Is there a way to identify sectors of
improvement?
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39. Price Stability
39

40. Inflation
» An increase in the general level of prices over a
sustained period of time
» Is increase in the price of a particular type of
good called inflation?
» Recall some common measures of inflation
» 3 classifications: Creeping, galloping and
hyperinflation
» If WPI is 314.6 in year 1 and 329.8 in year 2,
what would be the inflation?
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41. Economic Impacts of Inflation
» Effect of Inflation on distribution of income and
wealth?
» What happens to wealth during inflation?
Does it always erode?
» Who gains during inflation?
» Is income of poor indexed to inflation?
» Effect of Inflation on Output and Growth
» Short Run
» Long Run
41

42. Inflation in AD-AS Framework
» Demand-Pull Inflation
» “Too much money chasing too few goods”
» Logic: General rise in price level is because
demand always exceeds the supply at
existing prices
» Real factors: Increase in Government
expenditure with no change in tax receipts
and vice versa
» Monetary factors: Decrease in demand or
increase in supply of money
42

43. Inflation in AD-AS Framework
» Cost-Push Inflation
» Inflation originates from the supply side
» Wage-Push Inflation
» Profit-Push Inflation
» Supply-shock Inflation
43

44. Introduction to Phillips Curve
» Phillips curve establishes a relationship between
rate of wage increase and rate of unemployment
» What happens to unemployment when wage
rates increase?
» Modified Phillips Curve measures inflation and
unemployment
» Example: If money-wage rates are increasing by
5% and labor productivity is increasing by 2%,
then inflation is?
44

45. Introduction to Phillips Curve
» Justification for downward slope: Organized
labor‟s effort to increase wages unmatched with
the increase in labor productivity
» Degree to which organized labor can obtain a
wage increase depends on?
» Phillips curve indicates a trade-off between
inflation and unemployment
» Indicates policy makers flexibility
» “Stagflation” where both increase
simultaneously
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46. Inflation in India
» Problem of inflation exists right from the first
Five Year Plan
» Observed that whenever inflation has been high,
agricultural production was the cause
» Inflation in India could be attributed to the
excess of money supply and bottlenecks in
supply of goods and services
» Is there one reason explaining the inflation
rates in India?
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47. Factors driving inflation
» Demand-Pull:
» Government Expenditure
» Hoarding, black-marketing activities
» Population explosion?
» Cost-Push factors:
» Violent fluctuations in output
» Upward revision of administered prices
» Oil shocks and global inflation
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48. Questions???

49. Have a happy Sunday!