I am watching a video lecture by Mark Thoma, where he is presenting the AS-AD, aggregate supply-aggregate demand, model. Between the 23 and 25 minute point, he is talking about how wages decrease or increase in order for the economy to get back to the LRAS, Long-run aggregate supply, curve.
He shows that as wages decrease, the SRAS, short-run aggregate supply, curve shifts right. However, the aggregate demand curve should also shift left from lower labor share of income but he doesn't move it. In fact, according to his graph, as SRAS shifts right, aggregate demand is able to increase real GDP even though labor just got a pay cut. His explanation doesn't make sense.
Wages don't actually have to be cut in order to lower relative wages. You only need to keep inflation subdued, which lowers unit labor costs according to the equation...
effective unit labor costs = effective labor share of income * price level
ulce = els * p
p =( index of ulc*0.78)/(index of labor share*0.78)
els = ulce/p
ulce is a conversion of unit labor costs by just multiplying the index of unit labor costs by 0.78, the same adjustment made to the index of labor share of income to get effective labor share.
The AS-ED Model
Let's look at the AS-AD model from the perspective of Effective Demand. I will call this model the AS-ED Model, Aggregate Supply-Effective Demand Model. In this model, we still see SRAS and LRAS, but now we replace the aggregate demand curve with the Effective Demand curve, ED. We put real output on the x-axis and price level on the y-axis, just like the AS-AD model.
The equations for the curves are...
Inflation rate (p) for SRAS = ulce(3000 + real GDP - Potential real GDP)/(3000 * cu) - 1
Inflation rate (p) for ED = real GDP * ulce/(ED*cu*(1-u)) - 1
$3000 billion is real $$ amplitude constant for business cycle... cu=capacity utilization... ulce= effective unit labor costs... p=price level, inflation... u=unemployment rate... ED=Effective demand
In this graph, I will simply lower the variable of effective unit labor costs to show where the curves shift.
First, look at where the economy was in the 4th quarter 2012 (purple dot). It was at a real GDP of $13.665 trillion and an inflation rate of 1.8%. If inflation rises, the economy moves up the SRAS 1 curve. The place where the SRAS 1 and effective demand curves cross is the inflation limit of real GDP growth of about 5%. That is the LRAS, long-run supply curve and here real GDP will want to stop moving up the SRAS 1 curve due to the constraints of effective demand.
In the graph, unit labor costs are lowered reflecting a lower labor input cost, lower wages or just lower labor share of income. According to the equations, LRAS does not change. That is to be expected. However, the SRAS 1 curve has shifted right to SRAS 2 allowing real GDP to increase. But the inflation limit imposed by effective demand has fallen, due to the ED 1 shifting left to ED 2. We also see the aggregate is less due to the cut in wages, which should have been shown in Mark Thoma's explanation.
There is a trade-off, more room to grow real GDP, but less room to increase inflation and unit labor costs if need be. If unit labor costs were to get pushed down more we could see a deflationary environment starting as the crossing point of effective demand and the SRAS curve pushes lower.
Cost-Push Inflation
On the other hand, if real GDP does cross the LRAS curve, unit labor costs can rise adjusting both the SRAS and ED curves back to LRAS at a higher inflation rate. There we see the cost-push inflation dynamic that Mark Thoma talks about at the 58 to 61 minute point in the video.
(note: Businesses should do better in low inflation environments. They have more profit and controlled unit labor costs. But the problem is that full employment of labor and capital gets "boxed" out, and we end up with lower "natural" rates for employment and utilization of capital. (Natural refers to the limits of the LRAS curve. (see previous post for explanation)))
UPDATE: This is an explanation of how to graph the equations in the graph. Take the equations for Real GDP and Effective Demand...
Real GDP = YP + 3000 * (cu - ulce/(1+p))/(ulce/(1+p))
Effective demand = Real GDP * ulce/(1+p)/cu*(1-u)
Then just change p (price level, inflation rate). The curves for Real GDP (aggregate supply, output) and Effective demand will look as is shown in the graphs. You just need to put price level on the y-axis, then put real GDP on the x-axis for the Real GDP equation and Effective demand on the x-axis for the Effective demand equation.
Cited sources:
Thoma, Mark. Economics 470/570 - Monetary Theory and Policy - Fall 2009 - Lecture 14 - Thursday 11/19/200. Youtube.com, 4/19/2013, https://www.youtube.com/watch?v=93RI7_nvmEM
Waldman, Steve Randy. Restraining unit labor costs is a right-wing conspiracy. Interfluidity, 4/19/2013, http://www.interfluidity.com/v2/2942.html
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