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I'm going to share something with you that I don’t tell just anyone: When I first took
macroeconomics, I HATED it. No, really. Look, here's an example why: I come to class on
Monday and scribble furiously as the professor lectured. “Today we’re doing aggregate
supply, a relationship between the price level and the GDP.” Wednesday, I come to class,
and scribble furiously. “Today, we’re talking about the aggregate supply, a relationship
between the price level and the GDP.” Then Friday, I show up and scribble some more.
“Today we’re talking about aggregate supply, a relationship between price level and the
GDP.” Exam time comes around, I pull out my notes to study, and this is what I see.
Will the real aggregate supply please stand up? Which version is correct? What I came
to learn later in my academic career is that each of these views has been correct at some
point in time. After all, what is the model supposed to do? It’s supposed to help me
observe, understand, and make predictions about economic behavior. At different points
in time, if you looked out your window at the economy, you would've seen one of these
three versions of the aggregate supply.
Let's go back to late 1800s which, interestingly enough, looked a lot like the late 1900s.
The economy was operating at full capacity: factories in use, fully employed labor, production
humming along. When this is the case, that the economy is at full capacity, or full employment,
the society is at its potential GDP. Even if demand should rise, there aren't any more
resources, so you wouldn’t be able to get any more output -- just inflation. This is
why the classical model depicts the aggregate supply as a vertical line at potential (or
full employment) GDP.
The classical model fell out of favor when it no longer accurately described economic
behavior, namely, during the Great Depression. John Maynard Keynes came along and observed
that clearly, with unemployment 25% or higher for a sustained period, we were not operating
at our potential. In fact, Keynes argued that we had so much unused capacity, and so many
unused resources, that if aggregate demand were to increase, we could increase GDP without
seeing any inflation whatsoever. The Keynesian model of aggregate supply is horizontal.
Of course, for the most part, we see that increased GDP is accompanied by some inflation.
This is the intermediate model of aggregate supply. Which one is correct, Keynesian, intermediate,
or classical? Well, as I said, at some point in time, each of these viewpoints has been
correct. Really they're all smaller pieces of larger picture. At very low levels of GDP,
where there a lot of unused resources, we see the Keynesian model. At full employment,
where we’re operating at full potential, we see the classical portion. And in the middle,
where responding to increased aggregate demand means an increase in GDP and an increase in
prices, we’re in the intermediate range. Over the years, as one model falls into disfavor,
and another takes its place, invariably some academic who liked the old model will come
up with a new, more updated version to make the old model more attractive; hence new classical
economists and new Keynesian economists.
Take original classical model, for example. In the original version, the economy was always
at its potential Well of course you don't have to wait long to show that this is not
the way the world behaves. Sometimes we’re at full employment, but often we’re not.
Since it did not accurately describe the way the economy worked, the classical model fell
out of favor. Sometime later, however, the new classical model emerged: “OK, so we’re
not always our potential, but when we're not at that level, it’s only for short time
periods because economy self-adjusts over time to get back to its full-employment level.”
The story goes something like this: What if we aren't operating and natural Real GDP,
i.e., the full employment level, or our potential? If our macroeconomic equilibrium is Q*, and
Q* falls short of our potential, then Q* is less than the natural real GDP, and we have
what's called a recessionary gap. What this means is that right now, at Q*, our actual
unemployment level is higher than the natural rate of unemployment. So we currently have
a surplus of labor standing around. In a free market for anything, even if that “thing”
is labor, a surplus will correct itself as price falls. In this case, the price of labor,
or the wage, falls. As labor gets cheaper, employers hire more labor, and aggregate supply
shifts to the right. How far? Well, until the labor surplus disappears; that is, until
we are at full employment, or at our potential GDP. The weak spot in this argument is the
flexibility of wages. Will wages fall as a consequence of higher unemployment? If not,
the aggregate supply never adjusts.
And what if Q*, our equilibrium, or actual GDP, is greater than potential GDP? This is
referred to as an inflationary gap. Remember, full employment level isn't actually zero
unemployment, so it is possible to dip below this level. If our macroeconomic equilibrium
GDP is Q*, and Q* is higher than our potential, then Q* is greater than the natural real GDP.
What this means is that right now, at Q*, the actual unemployment rate is lower than
the natural rate of unemployment (also known as the full employment rate), so that we currently
have a labor shortage. Any shortage in a free market will correct itself via rising prices,
so the price of labor (or wage) will increase. As labor gets more expensive, the aggregate
supply falls. How much will it shift? Aggregate supply will stop moving when there is no longer
a labor shortage; that is, when the macroeconomic equilibrium is at our potential. TIME TO THINK:
for the self-adjusting model to work, wages and prices have to be flexible. Are wages
completely free to increase? Are they completely free to decrease?
The reason that I bring up the different schools of economic thought -- Keynesian and Classical
-- is that they have a direct impact on economic policy recommendations. For example, suppose
the economy is in a recessionary gap in you’re a Classical, or New Classical, economist -- you
believe that the economy can fix itself. What role do you recommend for the government?
Should it be active and try to help the economy along, or just leave things alone? Now, what
if you're a Keynesian, or a New Keynesian economist? You do not believe that the economy
will self-adjust. If there's a recessionary gap, the economy will remain stuck in a recessionary
gap. What role do you recommend for the government: hands-on, or non-interventionist?
NEXT TIME: Fiscal policy TRANSCRIPT (MACRO) EPISODE 25: MACROECONOMIC
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