Economics 268                                                                            Tuesday March 23, 2004


Misperceptions Approach to AS-AD


Short-run AS:


short-run:  brief enough time period such that decision makers dont have time to fully adjust to unexpected changes.  Expectations are fixed. 


long run: decision makers fully adjust, expectations are not fixed.



Qp = potential GNP and Pe= expected price level


All along Assr expected price level equals p0.  If expectations are correct, output = potential GNP.


movements along AS keep Pe constant, but actual price level and output change.


Why is Assr upward sloping?  Consider the following example:  an unanticipated increase in net export demand.


(1)  increasing net exports shifts AD up and to the right.

(2)  since it is unanticipated, P increases and output increases

(3)  firms produce more output  since the real wage that they pay has fallen.  Workers see their nominal wage rise to W1 but do not realize that the price level has risen to P1.  They believe that the price level is still at P0. 


In the labor market



      as the price of products a firm produces increase, the firm hires more labor


      workers must anticipate the prices of all of the goods


      firms arent smarter than workers it is just that the firm needs to know less than the worker.  Firms only must know their own costs of doing business.


      as a result of incomplete information by workers, S0L is fixed (i.e. price expectations are fixed).


      nominal wage rises and employment rises


      workers supply more labor because they think that their real wage has gone up; actually their real wage has fallen since w0/p0 > w1/p1.  Firms are now willing to hire more workers than before because the real wage has fallen.


Summary of the Impact of Expectations


      Firms need to now only wages and price of their product.


      Workers need to know all the prices in the economy to know what is happening to the real wage:  stress the buying power aspect of the real wage. 


      workers have a harder time making price expectations, not because they are less intelligent but because they have to gather more information. 





Consider another example:  unanticipated fall in AD, due to say a fall in I.


1)  a fall in I Þ AD falls


2)  expectations are fixed Þ movement along AS




3) as P falls and Q falls the demand for labor falls.


4)  a workers nominal wage W falls, but the worker thinks that they are getting a reduction in their real wage since Pe = P0 which implies that they work less than before.  They do not offer as many hours of labor as they did before hand.


5)  in fact the price falls more than W, the nominal wage, so the real wage increases which means that the firms hire fewer workers. 











Reconsider our first example of an unanticipated increase in net export demand.


In the long run, expectations adjust.  Workers realize that the price level adjusts from p0 to p2 and they adjust their expectations accordingly Þ AS shifts back and to the left. 


Long-run aggregate supply is at Qp as in the classical model.




as workers change their price expectations, they realize that the real wage has fallen so they reduce the number of hours that they are willing to supply.  Thus, the nominal wage rises from W0 to W2 and the real wage returns to its previous level.  The amount of hours of labor supplied returns to LN. Note that the real wage that obtained before the unanticipated increase in net export demand is once again achieved after expectations have adjusted. 



(1)  Fully anticipated changes in AD: move from one LR equilibrium to the other directly.  There is no movement along Assr since price expectations change immediately.

(2) Self-adjustment mechanism:  if in short run Q does not equal Qp, then price expectations will adjust to return the economy to Qp. 

(3)  In the short run, unanticipated changes in AD can have an effect on P and Q

(4)  In the long run the economy self-adjusts as people adjust their expectations.


Fully anticipated changes in AD result in movement from original LR equilibrium directly to new LR equilibrium.


Changes in AS


Example 1: Inflationary Expectations workers expect rising prices, but actual P unchanged

SRAS always cuts LRAS at the price level workers expect. incorrect expectation can cause increases in prices.


The supply curve shifts by the amount of the expected change in the price level. 


      Workers expect the price level to rise from P0 to P2 which means that supply shifts from S0 to S2.

      Firms see that the actual price level changes from P0 to P1 which means that demand shifts from D0 to D1.

      The shift in demand is less than the shift in supply in the sense that the vertical distance between the supply curves exceeds the vertical distance between demand the curves.  Recall that this vertical distance represents the percentage change in the actual price level for the demand curves and the percentage change in the expected price level for the supply curves. 

      Employment falls below the natural level of employment, the nominal wage as measured on the vertical axis rises from W0 to W1 and the real wage rises as well since. 


Example 2:  Unanticipated technological improvement



What happens to real wages, nominal wages etc?  You need to graph out the labor market and beware of some confusion at this point.















Application:  Declining US Savings Rate


AD effects:  Falling savings implies that consumption rises. 


Recall from our discussion of the loanable funds market that we can derive the equilibrium condition for the supply and demand for loanable funds via the following procedure.  Starting with the total real output in the economy, GDP = C + I + G + (X - M) and the fact that.  We note that GDP = Total Income, so we may write that  C + S + T = C + I + G + (X - M).  Rearranging gives us a relationship between investment and saving I = S + (T - G) + (M - X).  Here we may break the terms which make up savings into three: private saving, government saving, and foreign saving.  Thus, investment = (private saving) + (government saving) +  (foreign saving) or




Holding (G-T) constant, if US savings, S, falls then either I must fall or (M-X) must rise to maintain equality in the above equation.  That is,



to restore equality, i.e., .


A fall in savings implies that people consume more and this rise in consumption means that imports rise:  people buy more goods from overseas and firms import more foreign capital. Economist Martin Feldstein predicted that the US would run a trade deficit if we had government deficits and the economic policies of the Reagan administration (to read more on this topic see Paul Krugmans Peddling Prosperity).  If we are running a government deficit and are unwilling to change (G-T), then if US investment is not to fall firms must import foreign financial capital.  So firms issued bonds and financial instruments which foreigners purchased.  That is the same as saying that the foreigners loaned the US financial capital and the source of the funds was their savings.

What would happen if the US could not borrow from abroad?

AD shifts because I falls and X-M falls. 

What happens to AS?

decrease in investment implies a decrease in the capital stock over time.