INDEX

INTRODUCTION ...................................................................................... 2

FACTOR AFFECTING DEMAND AND SUPPLY OF LABOUR ......... 6

LABOR MARKET EQUILIBRIUM AND WAGE DETERMINANTS 15

LABOR MARKET ................................................................................... 28

ELASTICITY OF LABOUR DEMAND ................................................. 32

AGGREGATE DEMAND AND AGGREGATE SUPPLY WITH

FLEXIBLE PRICE LEVEL ..................................................................... 37

DEMAND AND SUPPLY CURVE OF LABOUR ................................. 58

CONCLUSION......................................................................................... 65

BIBLIOGRAPHY..................................................................................... 68

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 INTRODUCTION
In most macroeconomic models, aggregate demand and aggregate supply interact
to determine the short-run performance of the economy, but when it comes to
the long-run analysis of economic growth, aggregate demand usually makes its
exit and aggregate supply rules the roost. Mainstream growth theory both in its
earlier—neoclassical (Solow, 1956)—form, and its later new or endogenous
growth theory (see Barro & Sala-i-Martin, 1995, for a review) incarnation, share
this neglect of aggregate demand. These theories imply that the rate of growth of
per-capita income in long-run equilibrium depends on supply-side factors. They
do not introduce aggregate demand into the analysis at all, assuming that the
economy is always at full employment and that all saving is (identically)
invested. Thus, for mainstream macroeconomists, aggregate demand is relevant
only for the short run and in the study of cycles, but irrelevant for the study of
growth. The apparent reason for this is that the market mechanism, in the form
of flexible wages working through assets markets, or government policies, solves
the problems of unemployment and the deviation of aggregate demand from
aggregate supply in the longer run.

The neglect of aggregate demand from current mainstream growth theory is

ironic, because in Harrod’s (1939) growth model—arguably the key pioneering
contribution to modern growth theory—aggregate demand plays a central role.
Harrod distinguished clearly between saving and investment behaviour, and his
warranted rate of growth, at which saving and investment behaviour were mutu-
ally consistent, could be different from the natural rate of growth, or the rate of
growth of what we can call aggregate supply. Other growth theories in which
aggregate demand played a major role, such as those of Robinson (1962) and
Kahn (1959) were also earlier considered to be a part of growth theory (see Sen,
1970; Wan, 1971). Growth theories in which aggregate demand plays a role
have not disappeared entirely, however. Several heterodox economists, who can
be called post-Keynesian or structuralist, give centre stage to aggregate demand.

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 These economists have developed models of aggregate-demand determined
growth that imply that the rate of growth of the economy in the long run can be
increased by increasing aggregate demand, for instance, government spending.
However, these models, while reinstating aggregate demand, appear to jettison
aggregate supply, somewhat implausibly implying that the aggregate supply
factors, so dear to mainstream growth theorists, are irrelevant for long-run
growth.

In short, aggregate demand has disappeared from mainstream growth theory,

which focuses entirely on the supply side. Growth theories that focus on
aggregate demand, however, ignore aggregate supply considerations. All this
raises the question: is it not more sensible to have a growth theory in which both
aggregate supply and aggregate demand considerations have roles to play?

This paper attempts to take some steps in synthesizing the roles of aggregate
demand and aggregate supply in a growth model by drawing on features of the
three growth traditions—Keynesian models of aggregate-demand determined
growth, neoclassical models and new growth theory models. In doing so it
complements the contributions of others who have sought to synthesize aggregate
demand and aggregate supply in growth models: for instance, Cornwall (1972,
1977), Palley (1996, 2003) from the post-Keynesian tradition, and Martin &
Rogers (1997) and Blackburn (1999) from the new growth theory perspective.

The next section starts with a simple model of aggregate-demand determined

growth. The section following this then introduces aggregate supply consider-
ations by developing a simple model in which aggregate demand plays a role in
the short run as in neoclassical-synthesis models, but in which it is irrelevant to
the determination of the rate of long-run growth, as in neoclassical growth
models. The fourth section introduces endogenous technological change.

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 The fifth section incorporates endogenous technological change into the model
of the third section and shows how aggregate demand and aggregate supply
factors can be integrated. The penultimate section provides some additional
comments on the model, examining its generality, and its relationship with some
theoretical and empirical literature, while conclusions are reached in the final
section.

A vast literature in macroeconomics has developed microfounded models of

business cycle fluctuations. In our view, such models should be transparent and
tractable and have four key features:
(1) involuntarily unemployment happens and firms cannot sell any quantity at
the going price;
(2) cyclical fluctuations in unemployment and consumption arise and are highly
correlated with cyclical fluctuations in tightness in the labor and product
markets;
(3) some fluctuations are driven by aggregate demand shocks and some are
driven by aggregate supply shocks; and
(4) the economic equilibrium should be pairwise Pareto efficient in the sense
that no mutually advantageous trades between two agents is possible.
Although simple models eventually need to be extended into large-scale
calibrated dynamic stochastic general equilibrium models, the transparence and
tractability afforded by a simple model is valuable to develop our understanding
of the macroeconomic mechanisms at play over the business cycle.

Thus, in this paper, we propose a transparent and tractable business cycle model
that possesses these four features. The key assumption we make is that there are
trade frictions in the product and labor markets. We represent these frictions
using a search-and-matching structure. The general equilibrium of this model
can be represented as the intersection of an aggregate supply and an aggregate
demand that respond to a broad range of macroeconomic shocks. We use the
model to study business cycle fluctuations in consumption and unemployment.

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 It is well known that in search-and-matching models, prices are indeterminate
because they are set in situations of bilateral monopoly [Hall, 2005; Howitt and
McAfee, 1987]. Indeed by the time a match is realized, search costs are sunk and
there is a surplus to share; therefore, there is a band of potential prices acceptable
to both seller and buyer. To resolve this indeterminacy, we do not offer a theory of
price deter- mination but instead consider reduced-form price schedules that may
depend on economic circumstances and can be calibrated to match empirical
price behavior. While it is possible to add a microfounded the- ory of price
determination to our model, this is not necessary for our analysis, and is
therefore left for future research. Our model disconnects the analysis of
fluctuations in quantity and tightness from the price-setting mechanism, which
greatly simplifies the analysis relative to other macroeconomic models. In our
model, tightness plays the role of a price: it equilibrates supply and demand.
When the economy is slack, quantities respond strongly to tightness. Conversely,
when the economy is at capacity, quantities do not respond any more to
tightness. This is because, with a typical matching function, the number of
trades made by a seller is an isoelastic, increasing, and concave function of
market tightness.

Thus, in bad times, shocks translate into large quantity responses when prices
are rigid. Although our model proposes a significant conceptual departure from
the Real Business Cycle model, it is mathematically similar to a Real Business
Cycle model in which prices are replaced by tightnesses. In both models, there
are two endogenous variables—a quantity and a price—in each market. These
variables are determined in equilibrium by the equality of supply and demand.
Our model remains an equilibrium model which avoids the pairwise Pareto
inefficiencies that arise in many New Keynesian models. We discuss existing
business cycle models and their properties in Section 2.1. We also explain how
our framework relates to these models and the value added by our approach.

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FACTOR AFFECTING DEMAND AND SUPPLY OF
LABOUR

Factors that Affect Aggregate Demand

1. Net Export Effect

When domestic prices increase, then demand for imports increases (since domestic
goods become relatively expensive) and demand for export decreases.

2. Real Balances
When inflation increases, real spending decreases as the value of money decreases.
This change in inflation shifts Aggregate Demand to the left/decreases.

3. Interest Rate Effect

Real Interest is the nominal interest rate adjusted to the inflation rate. When inflation
increases, nominal interest rates increase to maintain real interest rates. Lower real
interest rates will lower the costs of major products such as cars, large appliances, and
houses; they will increase business capital project spending because long-term costs
of investment projects are reduced.

4. Inflation Expectations
If consumers expect inflation to go up in the future, they will tend to buy now causing
aggregate demand to increase or shift to the right.

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Factors that Affect Aggregate Supply

1. Supply Shocks
Adverse supply shocks shift AS to the left, i.e., a decrease in the AS curve. Usually, a
huge rise in oil prices can cause a supply shock. Natural catastrophes or hikes in taxes
can also shift AS to the left. It is either a leftward shift in the short run AS curve (the
one on the left) or by the leftward shift in the vertical long-run AS curve. However,
the long run AS curve is best suited for natural disasters or setbacks in the economy,
such as corrupt governments.

2. Resource Price Changes

Changes in the short run resource prices can alter the Short Run Aggregate Supply
curve. Unless the price changes reflect differences in long-term supply, the Long Run
Aggregate Supply is not affected.

3. Changes in Expectations for Inflation

If suppliers expect goods to sell at much higher prices in the future, they will be less
willing to sell in the current period. As a result, the Short Run Aggregate Supply will
shift to the left.

4. Capacity Increase
A rightward or an increase in AS implies an increase in the productive capacity of the
economy. You can think of this as an outward shift in the production
possibility curve. An increase in the quality and quantity of the factors of production
or technological advancements or any increase in productivity can cause an outward
shift.
Governments can influence AS through Supply Side policies and improvements in
health and education services. This result can be better imagined by an increase in the
Long Run AS. An increase in natural resources can also shift the AS curve to the
right.

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Aggregate Demand and Economic Growth
To examine perhaps the simplest of aggregate demand-driven growth models,
assume that: saving is a fraction s of real income and output Y so that the ratio of
saving S to capital stock K is given by

S/K = s u, (1)

where u = Y/K is a measure of capacity utilization; and that the ratio of investment
to capital stock is a positive function of capacity utilization, so that, adopting a
simple linear form,

I/K =    u (1)

where is the autonomous component of investment, and > 0 shows the

response of the investment rate to changes in capacity utilization. Assuming that
there is no government fiscal activity and that the economy is closed, goods
market equilib- rium is achieved through variations in Y, and hence u, in the
standard Keynesian manner, which implies that

u   /(s   ) (3)

Abstracting from depreciation, the growth rate of capital, is given by g = I/K,

where

g  s  /(s   ) (4)

Abstracting from technological change, the growth rate of output y (with output
given by Y = uK), is also given by g since u is determined by (3). Three
comments about this model are in order.

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 First, if we assume that the rate of growth of labour supply is exogenously given
by n, there is no reason why the rate of growth of labour demand is equal to this
rate of growth of labour supply. With labour productivity fixed and given at A,
the rate of growth of labour demand is equal to the rate of growth of output y,
which is equal to g and determined in equation (4) quite independently of n.
This implies that unemployment will rise (if g < n) or fall (if g > n) indefinitely
over time.

Second, growth is driven entirely by demand-side factors. The rate of growth of

output (and per capita output, if the rate of growth of population and the labour
force is assumed to be constant at the rate n), is determined by the parameters
such as , which represent autonomous investment (and, which in a model with
govern- ment policy can be more generally determined by monetary and fiscal
policies), and s, and not by supply side factors. A rise in s, usually considered
a supply-side factor in new growth theory models, implies a fall in the rate of
growth of output and per capita output, as a result of the paradox of thrift. A rise
in n, also a supply- side factor, leaves the rate of growth of output unchanged,
and reduces the rate of growth of per capita output.

Third, this basic model has been extended in a number of directions to incorpo-
rate several features left out of this simple model, including income distribution,
differential saving propensities from wages and profits, inflation, financial

variables, open economy features and debt of various kinds.6 One feature
relevant for present purposes is technological change. If we assume that that
labour productivity A grows at the constant rate a over time, the rate of growth of
employ- ment is given by l = y/a. There is, again, no reason why this l is going
to be equal to n, and hence for the unemployment rate to be constant in long-run
equilibrium. Note also that if there is an increase in the rate of technological
change, so that a rises, unemployment will merely rise at a faster rate, leaving
the rate of growth of output and per capita output unchanged.

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 Several criticisms have been made of this model. One is that it allows the rate of
capacity utilization u to be endogenous even at long-run growth equilibrium,
rather than requiring it to converge to some desired or planned level, which may
be considered to be a requirement of long-run equilibrium. Against this
criticism, however, it can be argued that there may exist no unique desired level
of capacity utilization, but perhaps a range within which investment behaviour
may be stable. Moreover, it can be shown that if there is a unique desired level
of capacity utilization, but one that is endogenous to take into account the
strategic behaviour of oligopolistic firms (see Lavoie, 1995), then a long-run
equilibrium in which the rate of capacity utilization adjusts to this endogenous
level of desired excess capac- ity, is entirely consistent with the model of the text
(as shown in Dutt, 1997). We therefore leave this criticism aside, not only
because of these defenses, but also because the main interest of this paper is to
address the roles of aggregate demand and supply. Even if we assume that there
is a mechanism that takes the economy to full capacity utilization in the long run,
the long-run equilibrium growth rate of the economy would still be determined
by aggregate demand and not aggregate supply.

We therefore turn to another criticism of the model, that is, it does not require
the unemployment rate to arrive at some equilibrium level in long-run equilib-
rium. As noted earlier, the model implies that there is nothing to ensure that the
unemployment rate does not rise or fall indefinitely at long-run equilibrium. The
model may be considered to be problematic, both because one does not observe
indefinite increases or decreases in the unemployment rate in reality and also
because it seems theoretically implausible to have a long-run equilibrium in
which the rate of unemployment does not arrive at some equilibrium value. We
now turn to models that introduce such a requirement.

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 Aggregate Supply and Growth
Models of aggregate supply-determined growth can be developed by completely
ignoring aggregate demand right from the start. This, indeed, has been the strategy
adopted in neoclassical and new growth theory models. Because the purpose of
this paper is to draw on both the aggregate demand and aggregate supply
approaches to growth, we cannot follow this route, however. Instead, following
the neoclassical-synthesis model, we introduce aggregate demand considerations
in the short run, only to render them irrelevant in the long run.

In the standard textbook neoclassical-synthesis Keynesian model there is wage

rigidity and unemployment in the short run and wage flexibility and full employ-
ment, or at least unemployment at the natural rate, in the long run. In the short run,
with a degree of wage rigidity, the labour market does not clear, and output can
grow at a rate that does not make the growth of labour demand equal to the
growth of labour supply. However, in the longer run, with wage flexibility, this
condition cannot persist, and growth can only occur such that the demand and
supply of labour grow at the same rate. This treatment of the short and longer runs,
of course, is not found only in textbook models, but also in the new consensus
and new neoclassical synthesis models thaat introduce explicit longer-run
dynamics and a more complex treatment of monetary policy, such as those of
Clarida et al. (1999), Meyer (2001) and Woodford (2003).

A simple interpretation of neoclassical synthesis Keynesian models allows

deviations between labour demand and labour supply growth to occur in the short
run, but makes components of aggregate demand adjust to deviations between the
two growth rates in the long run.

For the short run, therefore, our model can allow demand-determined growth as
in our model of the previous section, which takes saving and investment to be
determined by equations (1) and (2). In short-run equilibrium the goods market
clears through adjustments in output, so that capacity utilization and the rate of
capital accumulation are determined by equations (3) and (4), as before.

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 In the long run, however, we assume that

ˆ  [l  n] (5)

where l is the rate of growth of employment and > 0 is a speed of adjustment

parameter, and where from now on the ‘hat’ denotes the rate of growth. As
noted earlier, two mechanisms can explain this adjustment, which shows how a
faster rate of labour supply than labour demand, which increases the
unemployment rate, increases the autonomous investment rate. First, an increase
in the unem- ployment rate reduces wages and prices, increases real money
supply, reduces the interest rate and increases investment. Second, a rise in the
unemployment rate induces expansionary monetary and fiscal policies, which
increase the investment rate. These mechanisms are not explicitly incorporated
in the model for simplicity, which does not contain the interest rate or fiscal

policy, but can be modified to do so.10

Assuming that the productivity of labour is constant, the rate of growth of
output, y = l. From the definition of u, we have

y  uˆ  g (6)

Differentiating equation (3) and substituting from equation (6) into (5) we obtain

 ˆ  [ /(1   )][n  s /(s  )] (7)

This equation of motion for the model implies that the long-run equilibrium rate
of growth of the model, at which ˆ = 0, is given by

g  n, (8)

and is stable.11 In long-run equilibrium, since g = y = l, the rate of

unemployment is constant, and output grows at the rate of growth of labour
supply, implying no growth in per capita income.

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 If we introduce technological change, reflected in a constant rate of labour
productivity growth, a, y = l + a, equation (7) must be modified to

ˆ  [ /(1   )][(n  a)  s /(s   )] (7' )

In long-run equilibrium—which is again stable—the unemployment rate

becomes constant and we have y = g = n+a. The rate of growth of per capita
income is a, as in the Solovian neoclassical growth model with exogenous
technological change.

One distinction between this model and the standard neoclassical synthesis
model is that its long-run equilibrium rate of unemployment is some constant,
rather than at a particular exogenously specified full employment rate. The
reason why this model does not result in an exogenously-specified unique unem-
ployment rate is that it assumes that investment changes as a result of changes
in—and not levels of—the unemployment rate. Dependence on changes can be
explained by what has been called hysteresis in labour markets.

A high level of unemployment need not exert downward pressure on wages and
lead to increases in investment because outsiders in the wage negotiation process
may have no influence on wage bargains, and because workers who lose their
skills are not relevant to the wage determination process. It is only when
unemploy- ment increases that wages will tend to fall, because it takes time to
lose skills or become outsiders and this exerts downward wage pressures. Fiscal
and mone- tary policy may also change only when there are changes in the
unemployment rate, with policy makers getting used to any level of
unemployment by calling it the natural rate of unemployment consistent with
price stability. We will return to this issue later.

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 Before we conclude our discussion of growth models determined by aggregate
supply, we point out that the property of the models that makes the economy
grow at the rate determined by aggregate supply is that components of aggregate
demand change in response to labour market conditions. For the market-medi-
ated adjustment, this requires both that wages and prices are flexible in the long
run, and that changes in the price level lead to increases in investment spending
(as a result of, for instance, changes in the interest rate or, alternatively, the real
balance or wealth effects). That such an adjustment may be aborted by a variety
of factors, including wage and price rigidity, the endogeneity of credit money,
uncertainty that prevents investment from responding to a reduction in the rate
of interest rate, and debt deflation, has been pointed out by Keynes (1936) and
many Keynesian and post-Keynesian economists (see Dutt & Amadeo, 1990).

Furthermore, the government policy argument may also be aborted by the

unwillingness—for instance, for political reasons (see Kalecki, 1943)—or the
inability (as suggested by the recent experience of Japan, for instance) of
govern- ments to adjust aggregate demand to aggregate supply. These problems
may well interfere with the economy converging to positions of full employment
or a constant unemployment rate. In this case, it is possible for the economy to
grow—for considerable lengths of time—with a rate of growth of output deter-
mined by aggregate demand, as in the model of the previous section.

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LABOR MARKET EQUILIBRIUM AND WAGE
DETERMINANTS

In order to find the equilibrium quantity and price of labor, economists generally
make several assumptions:

 The marginal product of labor (MPL) is decreasing;

 Firms are price-takers in the goods market (cannot affect the price of output) as
well as in the labor market (cannot affect the wage rate);

 The supply of labor is elastic and increases with the wage rate (upward sloping
supply); and

 Firms are profit-maximizers.

The marginal revenue product of labor (MRPL) is equal to the MPL multiplied by the
price of output. The MRPL represents the additional revenue that a firm can expect to
gain from employing one additional unit of labor – it is the marginal benefit to the
firm from labor. Under the above assumptions, the MRPL is decreasing as the
quantity of labor increases, and firms can increase profit by hiring more labor if the
MRPL is greater than the marginal cost of that additional unit of labor – the wage
rate. Thus, firms will hire more labor when the MRPL is greater than the wage rate,
and stop hiring as soon as the two values are equal. The point at which the MRPL
equals the prevailing wage rate is the labor market equilibrium.

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Optimizing Capital And Labor

In the long run, firms maximize profit by choosing the optimal combination of labor
and capital to produce a given amount of output. It’s possible that an automobile
company could manufacture 1,000 cars using only expensive, technologically
advanced robots and machinery (capital) that do not require any human participation.
It’s also possible that the company could produce the same number of vehicles using
only employee work (labor), without any assistance from machines or technology. For
most industries, however, relying solely on capital or solely on labor is more
expensive than using some combination of the two.

Firms use the marginal decision rule in order to decide what combination of labor,
capital, and other factors of production to use in the creation of output. The marginal
decision rule says that a firm will shift spending among factors of production as long
as the marginal benefit of such a shift exceeds the marginal cost. Imagine that a firm
must decide whether to spend an additional dollar on labor. To determine the marginal
benefit of that dollar, we divide the marginal product of labor (MP L) by it’s price (the
wage rate, PL): MPL/PL. If capital and labor are the only factors of production, then
spending an additional $1 on labor while holding the total cost constant means taking
$1 out of capital. The cost of that action will be the output lost from cutting back on
capital, which is the ratio of the marginal product of capital (MPK) to the price of
capital (the rental rate, PK). Thus, the cost of cutting back on capital is MPK/PK.

If the marginal benefit of additional labor, MPL/PL, exceeds the marginal cost,
MPK/PK, then the firm will be better off by spending more on labor and less on
capital. On the other hand, if MPK/PK is greater than MPL/PL, the firm will be better
off spending more on capital and less on labor. The equilibrium – the point at which
the firm is producing the maximum amount of output at a given cost – occurs where
MPL/PL=MPK/PK.

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The Wage Rate
The wage rate is determined by the intersection of supply of and demand for labor.

When labor is an input to production, firms hire workers. Firms are demand labor and
workers provide it at a price called the wage rate. Colloquially, “wages” refer to just
the dollar amount paid to a worker, but in economics, it refers to total compensation
(i.e. it includes benefits).

The marginal benefit of hiring an additional unit of labor is called the marginal
product of labor: it is the additional revenue generated from the last unit of labor. In
theory, as with other inputs to production, firms will hire workers until the wage rate
(marginal cost) equals the marginal revenue product of labor (marginal benefit).

Changes in Supply and Demand

In competitive markets, the demand curve for labor is the same as the marginal
revenue curve. Thus, shifts in the demand for labor are a function of changes in the
marginal product of labor. This can occur for a number of reasons. First of all, you
can imagine that a new product or company is created that represents new demand for
labor of a certain type. There are also three main factors that would shift the labor
demand curve:

1. Technology which affects the output of a unit of labor.

2. Changes in the price of the output which affect the value of the unit of labor.

3. Changes in the price of labor relative to other factors of production.

In the long run, the supply of labor is a function of the population. A decrease in the
supply of labor will typically cause an increase in the wage rate. The fact that a
reduction in supply tends to strengthen wages explains why unions and other
professional associations have often sought to limit the number of workers in their
particular industry. Physicians, for example, have a financial incentive to enforce
rigorous training, licensing, and certification requirements in order to limit the
number of practitioners and keep the labor supply low.

17 | P a g e
Compensation Differentials
Some differences in wage rates across places, occupations, and demographic groups
can be explained by compensation differentials.

According to the basic theory of the labor market, there ought to be one equilibrium
wage rate that applies to all workers across industries and countries. Of course this is
not the case; doctors typically make more per hour than retail clerks, and workers in
the United States typically earn a higher wage than workers in India. These wage
differences are called compensation differentials and can be explained by many
factors, such as differences in the skills of the workers, the country or geographical
area in which jobs are performed, or the characteristics of the jobs themselves.

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Education Differentials

One common source of differences in wage rates is human capital. More skilled and
educated workers tend to have higher wages because their marginal product of labor
tends to be higher. Additionally, the differential pay for more education tends to
compensate workers for the time, effort, and foregone wages from obtaining the
necessary training. If all jobs paid the same rate, for example, fewer people would go
through the expense and effort of law school. The compensation differential ensures
that individuals are willing to invest in their own human capital.

Geographic Compensation Differentials

If a certain part of a country is a particularly attractive area to live in and if labor

mobility is perfect, then more and more workers will move to that area, which in turn
will increase the supply of labor and depress wages. If the attractiveness of that area
compared to other areas does not change, the wage rate will be set at such a rate that
workers will be indifferent between living in areas that are more attractive but with a
lower wage and living in areas which are more attractive with a higher wage. In this
way, a sustained equilibrium with different wage rates across different areas can
occur.

Discrimination and Compensation Differentials

In the United States, minorities and women make lower wages on average than
Caucasian men. Some of this is due to historical trends affecting these groups that
result in less human capital or a concentration in certain lower-paying occupations.
Another source of differing wage rates, however, is discrimination. Several studies
have shown that, in the United States, several minority groups (including black men
and women, Hispanic men and women, and white women) suffer from decreased
wage earning for the same job with the same performance levels and responsibilities
as white males.

19 | P a g e
Compensating Differential

Not to be confused with a compensation differential, a compensating differential is a

term used in labor economics to analyze the relation between the wage rate and the
unpleasantness, risk, or other undesirable attributes of a particular job. It is defined as
the additional amount of income that a given worker must be offered in order to
motivate them to accept a given undesirable job, relative to other jobs that worker
could perform. One can also speak of the compensating differential for an especially
desirable job, or one that provides special benefits, but in this case the differential
would be negative: that is, a given worker would be willing to accept a lower wage
for an especially desirable job, relative to other jobs..

Performance and Pay

Theoretically there is a direct connection between job performance and pay, but in
reality other factors often distort this relationship.

According to economic theory, workers’ wages are equal to the marginal revenue
product of their labor. If one employee is very productive he or she will have a high
marginal revenue product: one additional hour of their work will produce a significant
increase in output. It follows that more productive employees should have higher
wages than less productive employees. Imagine if this were not true: a firm decides to
pay a highly productive worker less than the marginal revenue product of his labor.
Any other firm could make a profit by offering a higher salary to attract the
productive employee to their company, and the worker’s wage would rise.
Theoretically, therefore, there is a direct relationship between job performance and
pay.

We know that this is not always the case in reality. Wages are determined not only by
one’s productivity, but also by seniority, networking, ambition, and luck. It is very
rare for an entry-level worker to make the same wage as an experienced member of
the same profession regardless of their relative levels of productivity because the
older worker has had time to receive pay raises and promotions for which the younger
employee is simply not eligible.

20 | P a g e
Discrimination is sometimes responsible for members of minority racial or gender
groups receiving wages that are less than wages for the majority group even when
productivity levels are the same. Finally, outside forces, such as unions or government
regulations, can distort pay rates.

Linking Performance and Pay

Some of the disconnect between performance and pay can be addressed with alternate
pay schemes. While a salary or hourly pay does not directly take into account the
quality of work, performance-related pay compensates workers with higher levels of
productivity directly. One example is commission-based pay. In this type of pay
scheme, workers receive some percentage of the profit that they generate for their
company. This may be paid on top of a baseline salary or may be the only form of
compensation. This type of system is very common among car salespeople and
insurance brokers.

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Another alternative is piece-work, in which employees are paid a fixed rate for every
unit produced or action performed, regardless of the time it takes. This is common in
settings where it is easy to measure the output of piece work, such as when a garment
worker is paid per each piece of cloth sewn or a telemarketer is paid for every call
placed.

Marginal Revenue Productivity and Wages

In a perfectly competitive market, the wage rate is equal to the marginal revenue
product of labor.

Just as in any market, the price of labor, the wage rate, is determined by the
intersection of supply and demand. When the supply of labor increases the
equilibrium price falls, and when the demand for labor increases the equilibrium price
rises. In the long run the supply of labor is a simple function of the size of the
population, so in order to understand changes in wage rates we focus on the demand
for labor.

To determine demand in the labor market we must find the marginal revenue product
of labor (MRPL), which is based on the marginal productivity of labor (MPL) and the
price of output. Conceptually, the MRPL represents the additional revenue that the
firm can generate by adding one additional unit of labor (recall that MPL is the
additional output from the additional unit of labor). Thus, MRPL is simply the
product of MPL and the price of the output.

The MPL is generally decreasing: adding a 100th unit of labor will not increase output
as much as adding a 99th. Since competitive industries are price takers and cannot
change the price of output by changing their level of production, the MRPL curve will
have the same downward slope as the MPL curve.

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From the perspective of the firm, the MRPL is the marginal benefit to the firm of
hiring an additional unit of labor. We know that a profit-maximizing firm will
increase its factors of production until their marginal benefit is equal to the marginal
cost. Therefore, firms will continue to add labor (hire workers) until the MRPL equals
the wage rate. Thus, workers earn a wage equal to the marginal revenue product of
their labor. For example, in a perfectly competitive market, an employee who earns
$20/hour has a marginal productivity that is worth exactly $20.

Changes in Equilibrium for Shifts in Market Supply and Market

Demand
A shift in the supply or demand of labor will cause a change in the market
equilibrium.

As in all competitive markets, the equilibrium price and quantity of labor is

determined by supply and demand.

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Labor Supply

Labour supply curves are derived from the ‘labor-leisure’ trade-off. More hours
worked earn higher incomes but necessitate a cut in the amount of other things
workers enjoy such as going to movies, hanging out with friends, or sleeping. The
opportunity cost of working is leisure time and vis versa. Considering this tradeoff,
workers collectively offer a set of labor to the market which economists call the
supply of labor.

To see how changes in wages affect the supply of labor, suppose wages rise. This
increases the cost of leisure and causes the supply of labor to rise – this is
the substitution effect, which states that as the relative price of one good increases,
consumption of that good will decrease. However, there is also an income effect – an
increased wage means higher income, and since leisure is a normal good, the quantity
of leisure demanded will go up. In general, at low wage levels the substitution effect
dominates the income effect and higher wages cause an increase in the supply of
labor. At high incomes, however, the negative income effect could offset the positive
substitution effect and higher wage levels could actually cause labor to decrease. A
worker making $800/hour who receives a raise to $1200/hour may not have much use
for the extra money and may choose to work less while maintaining the same standard
of living, for example. This creates a supply curve that bends backwards, initially
increasing with the wage rate but later decreasing.

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People supply labor in order to increase their utility —just as they demand goods and
services in order to increase their utility. The supply curve for labor will shift in
response to changes in the same factors that shift demand for goods and services.
These include changes in preferences, changes in income, changes in population, and
changes in expectations. A change in preferences that causes people to prefer more
leisure, for example, will shift the supply curve to the left, creating a lower level of
employment and a higher wage rate.

Labor Demand

An increase in the demand for labor will increase both the level of employment and
the wage rate. We have already seen that the demand for labor is based on the
marginal product of labor and the price of output. Thus, any factor that affects
productivity or output prices will also shift labor demand. Some of these factors
include:

 Available technology (marginal productivity of labor)

 The skills or education of the workforce (marginal productivity of labor)

 Level of physical capital (marginal productivity of labor)

 Price of physical capital (price of output)

 Price of substitute or complement goods (price of output)

 Consumer preferences (price of output)

All of the above may cause the demand for labor to shift and change the equilibrium
quantity and price of labor.

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Labor Union Impacts on Equilibrium

Unions are organizations of workers that seek to improve working conditions and
raise the equilibrium wage rate.

A labor union is an organization of workers who have banded together to achieve

common goals. The primary activity of the union is to bargain with the employer on
behalf of union members and negotiate labor contracts. The most common purpose of
associations or unions is maintaining or improving the conditions of employment,
which may include the negotiation of wages, work rules, complaint procedures,
promotions, benefits, workplace safety, and policies.

In order to achieve these goals unions engage in collective bargaining: the process of
negotiation between a company’s management and a labor union. When collective
bargaining fails, union members may go on strike, refusing to work until a firm
addresses the workers’ grievances.

Union Impacts on Equilibrium

Fundamentally, unions seek higher wages for its member workers (though, here
“wages” encompases all types of compensation, not just cash paid to the workers by
the employer).

The effect of unions on the labor market equilibrium can be analyzed like any other
price increase. If employers (those who demand labor) have an inelastic demand for
labor, the increase in wages (the price of labor) will not translate into a drop in
employment (quantity of labor supplied). If, however, their demand is elastic,
employers will simply respond to union demands for higher wages by hiring fewer
workers.

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However, the reality of unions is more complex. As an organized body, unions are
also active in the political realm. They can lobby for legislation that will affect the
market not only for labor, but also for the goods they produce. For example, unions
may advocate for trade restrictions to protect the markets in which they work from
foreign competition. By preventing domestic firms from having to compete with
unrestricted foreign firms, they can ensure that consumers do not have lower cost
alternatives which would drive employers who pay a higher union wage out of
business.

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LABOR MARKET

What Is the Labor Market?

The labor market, also known as the job market, refers to the supply and demand for
labor in which employees provide the supply and employers the demand. It is a major
component of any economy and is intricately tied in with markets for capital,
goods and services.

BREAKING DOWN Labor Market

At the macroeconomic level, supply and demand are influenced by domestic and
international market dynamics, as well as factors such as immigration, the age of the
population and education levels. Relevant measures include unemployment,
productivity, participation rates, total income and gross domestic product (GDP).

At the microeconomic level, individual firms interact with employees, hiring them,
firing them and raising or cutting wages and hours. The relationship between supply
and demand influences the hours the employee works and compensation she receives
in wages, salary and benefits.

The U.S. Labor Market

The macroeconomic view of the labor market can be difficult to capture, but a few
data points can give investors, economists and policymakers an idea of its health. The
first is unemployment. During times of economic stress, the demand for labor lags
behind supply, driving unemployment up. High rates of unemployment exacerbate
economic stagnation, contribute to social upheaval and deprive large numbers of
people the opportunity to lead fulfilling lives.

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In the U.S., unemployment was around 4% to 5% before the financial crisis, when
large numbers of businesses failed, many people lost their homes, and demand for
goods and services — and the labor to produce them — plummeted. Unemployment
reached 10% in 2009 but declined more or less steadily to 4.9% in January 2016.

Labor productivity is another important gauge of the labor market and broader
economic health, measuring the output produced per hour of labor. Productivity has
risen in many economies, the U.S. included, in recent years due to advancements in
technology and other improvements in efficiency.

In the U.S., however, growth in output per hour has not translated into similar growth
in income per hour. Workers are creating more goods and services per unit of time,
but not earning more compensation. Growth in the employment cost index averaged
under 0.7% per year from 2001-2015, while growth in productivity exceeded 2%.

The Labor Market in Macroeconomic Theory

According to macroeconomic theory, the fact that wage growth lags productivity
growth indicates that supply of labor has outpaced demand. When that happens, there
is downward pressure on wages, as workers compete for a scarce number of jobs and
employers have their pick of the litter. Conversely, if demand outpaces supply, there
is upward pressure on wages, as workers have more bargaining power and are more
likely to be able to switch to a higher paying job, while employers must compete for
scarce labor.

Some factors can influence labor supply and demand. For example, an increase in
immigration to a country can grow the labor supply and potentially depress wages,
particularly if newly arrived workers are willing to accept lower pay. An aging
population can deplete the supply of labor and potentially drive up wages.

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These factors don't always have such straightforward consequences, though. A
country with an aging population will see demand for many goods and services
decline, while demand for healthcare increases. Not every worker who loses his job
can simply move into healthcare work, particularly if the jobs in demand are highly
skilled and specialized, such as doctors. For this reason, demand can exceed supply in
certain sectors, even if supply exceeds demand in the labor market as a whole.

Factors influencing supply and demand don't work in isolation, either. If it weren't for
immigration, the U.S. would be a much older, and probably less dynamic society, so
while an influx of unskilled workers might have exerted downward pressure on
wages, it likely offset declines in demand.

Other factors influencing contemporary labor markets, and the U.S. labor market in
particular, include: the threat of automation as computer programs gain the ability to
do more complex tasks; the effects of globalization as enhanced communication and
better transport links allow work to be moved across borders; the price, quality and
availability of education; and a whole array of policies such as the minimum wage.

The Labor Market in Microeconomic Theory

Microeconomic theory analyzes labor supply and demand at the level of the
individual firm and worker. Supply, or the hours an employee is willing to work,
initially increases as wage increases. No workers will work voluntarily for nothing
(unpaid interns are, in theory, working to gain experience and increase their
desirability to other employers) and more people are willing to work for $20 an hour
than $5 an hour.

Gains in supply may accelerate as wages increase, since the opportunity cost of not
working additional hours grows. But supply may then decrease at a certain wage
level: The difference between $1,000 an hour and $1050 is hardly noticeable, and the
highly-paid worker who's presented with the option of working an extra hour or
spending her money on leisure activities may well opt for the latter.

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Demand at the microeconomic level depends on two factors, marginal cost and
marginal revenue product. If the marginal cost of hiring an additional employee, or
having existing employees work more hours, exceeds the marginal revenue product, it
will cut into earnings, and the firm would theoretically reject that option. If the
opposite is true, it makes rational sense to take on more labor.

Neoclassical microeconomic theories of labor supply and demand have received

criticism on some fronts. Most contentious is the assumption of "rational" choice —
maximizing money while minimizing work — which to critics is not only cynical but
not always supported by the evidence. Homo sapiens, unlike Homo economicus, may
have all sorts of motivations for making specific choices. The existence of some
professions in the arts and non-profit sector undermines the notion of maximizing
utility. Defenders of neoclassical theory counter that their predictions may have little
bearing on a given individual, but are useful when taking large numbers of workers in
aggregate.

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ELASTICITY OF LABOUR DEMAND

The following points highlight the four major determinants of the elasticity of labour
demand. The determinants are: 1. The Availability of Good Substitutes 2. Elasticity of
Demand for the Products of Unionized Firms 3. The Proportion of Labour Cost in
Total Cost 4. The Elasticity of Supply of Substitute Inputs.

Determinant # 1. The Availability of Good Substitutes:

When it is difficult to substitute other factors such as capital for unionized labour to
produce a commodity, the bargaining power of union is strengthened.

As Grawtney and Stroup have put it, “Since non-union labour is a good substitute
for union labour, the power of unions to exclude non union labour is an
important determinant of union strength. Unless a union can prevent non-union
employees from entering an occupation and cutting wages below the union level,
it will be unable to raise wages significantly above the free-entry level.”

However, availability of capital in the form of machines that are close substitutes for
labour will reduce the bargaining power of trade unions considerably. A rise in wages
will induce employers to mechanize. A substantial wage increase can thus lead to a
shortfall in the demand for unionized labour.

While highlighting the importance of substitute inputs economists often make a

comparison of the experiences of elevator operators and airline pilots. It is normally
observed that when elevator operators of many multi-storeyed buildings form unions
and negotiate substantial wage increases, their gains are short-lived.

Residents of such houses turn to automated elevators and the employment of elevator
operators fall suddenly. In contrast, airplane pilots are able to maintain wages above
the free-market levels without much substitution in production. While people do not
normally object to riding an automated elevator, they are unlikely to tolerate an
automated aircraft.

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Determinant # 2. Elasticity of Demand for the Products of Unionized
Firms:
If the demand for the good produced by union labour is inelastic, the output produced
by unionized firm will not fall much if the union pushes up wages (and costs). Thus if
a union is going to have a significant impact on wages, its workers must produce a
good for which demand is inelastic (such as bread).

Determinant # 3. The Proportion of Labour Cost in Total Cost:

If the wage bill of the unionized labour is a very small proportion of total production
cost, demand for minimised labour will tend to be relatively inelastic.

For example, since the wages of carpenters and airplane pilots are a very small
proportion of the total cost of production in the housing and air travel industries,
respectively, a doubling or even tripling of the wages of carpenters or airline pilots
would result in only a 1% or 2% increase in the cost of housing or air travel.

Thus a substantial increase in the price of such factors is likely to have little, if any,
impact on product price, output, and employment. This factor has been called by
Milton Friedman ‘the importance of being unimportant’ because it is an important
determinant of the strength of the union.

Determinant # 4. The Elasticity of Supply of Substitute Inputs:

We have just noted that if wage rates in the unionized sector are pushed upward, firms
will look for substitute inputs. Consequently the demand for such inputs will increase.
If the supply of such substitutes (such as non-union labour) is inelastic, however, their
price will rise sharply in response to an increase in demand.

The higher price will reduce the attractiveness of the substitutes. An inelastic supply
of substitutes will thus strengthen the bargaining power of the union by making the
demand for union labour more inelastic.

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Determinants of Elasticity of Demand for Labour
Some of the main determinants of elasticity of demand for labour are as follows:

i. The proportion of labour costs in total costs:

If labour costs form a large proportion of total costs, a change in wages would have a
significant impact on costs and hence demand would be elastic.

ii. The ease with which labour can be substituted by capital:

If it is easy to replace workers with machines, demand would again be elastic.

iii. The elasticity of demand for the product produced:

A rise in wages increases costs of production which, in turn, raise the price of the
product. This causes demand for the product to contract and demand for labour to fall.
The more elastic the demand for the product is, the greater the fall in demand for it
and hence for workers – making demand for labour elastic.

iv. The time period:

Demand for labour is usually more elastic in the long run as there is more time for
firms to change their methods of production.

v. The qualifications and skills required:

The more qualifications and skills needed, the more inelastic supply will be. For
instance, a large increase in the wage paid to brain surgeons will not have much effect
on the supply of labour. This is especially true in the short run, as it will take years to
gain the requisite qualifications and experience.

vi. The length of training period:

A long period of training may put some people off the occupation. It will also mean
that there will be a delay before those who are willing to take it up are fully qualified
to join the labour force. Both effects make the supply of labour inelastic.

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vii. The level of employment:
If most workers are employed already, the supply of labour to any particular
occupation is likely to be inelastic. An employer may have to raise the wage rate quite
significantly to attract more workers and encourage the workers employed in other
occupations to switch jobs.

viii. The mobility of labour:

The easier workers find it to change jobs or to move from one area to another, the
easier it will be for an employer to recruit more labour by raising the wage rate. Thus,
higher mobility makes the supply elastic.

ix. The degree of vocation:

The stronger the attachment of workers to their jobs, the more inelastic supply tends
to be in case of a decrease in wage rate.

x. The time period:

As with demand, supply of labour tends to become more elastic over time. This is
because it gives workers more time to notice wage changes and to gain any
qualifications or undertake any training needed for a new job.

Wage elasticity of supply

Wage elasticity of supply is the grade of influence on the supply of labor caused by a
change of wages. This change could either be a fall in wages, or an increase of wages.

To find out how strongly the supply of labor reacts on a shift in income, one could
work out the wage elasticity of supply, and so, see if a certain change in salary would
influence the supply of labor.

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To work out the wage elasticity of supply one uses the following formula:

Change of supply of labor in % / Change of salary in %

Should it be the case that the outcome of the formula with certain data is higher than
1, then the supply of labor concerned is called ‘salary with an elastic demand’,
meaning that a certain change in salary has a rather strong influence on a certain
supply of labor.

In most cases, the supply of labor has a fairly inelastic demand, which means that a
change in salary has a relatively small impact on the supply of labor, this often
depends on different professions. For example, if the wage of a doctor increases, there
will not immediately be a very big raise in doctors, since the duration of medical
studies is rather long. On the other hand, it does not take long to achieve qualification
to practice a profession like window cleaner or doorman. Therefore, the short-term
wage elasticity of supply will be higher than for example a doctors’; as soon as there
would be a significantly high raise in salary for window cleaners, the supply of labor
in the labor sector of window cleaners will increase quickly; it does not take long to
become a window cleaner.

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AGGREGATE DEMAND AND AGGREGATE SUPPLY
WITH FLEXIBLE PRICE LEVEL

Aggregate Demand and Aggregate Supply with Flexible Price Level!

Before analyzing the causes of inflation we need to explain aggregate demand-
aggregate supply model with flexible price level.

Keynes in his income-expenditure analysis of income and employment assumed that

price level remained constant. Concerned as he was with the unemployment problem
of the economy under the grip of depression characterized by demand deficiency and
excess capacity in the economy he validly assumed the price level to remain constant.

But during the Second World War and after, the problem of inflation, that is,
continuous rise in general price level, was faced by many capitalist advanced
countries. During this period Keynes himself explained inflation in terms of his
inflationary gap which arises due to excess demand when the economy is working at
its full capacity with full employment of workers.

Behind his analysis of inflation were aggregate demand and aggregate supply with
flexible price level though he did not explicitly use the concepts of aggregate demand
and aggregate supply curves with flexible price level. After Keynes it is with the
concepts of aggregate demand and aggregate supply curves with flexible price level
that inflation has been explained. It is therefore useful to explain these concepts
before analyzing the problem of inflation.

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Aggregate Demand (AD):
Let us first explain aggregate demand. Aggregate demand is the total desired quantity
of goods and services that are bought by consumer households, private investors,
government and foreigners at each possible price level, other things being held
constant. Thus aggregate demand is not any quantity demanded at a particular price
level but is a schedule of total output demanded at various price levels and is
represented by a curve.

Thus aggregate demand has four components: consumption demand, private

investment demand, Government purchases of goods and services and net exports.
Thus, aggregate demand curve depicts the total output of goods and services which
households, firms, and Government are willing to buy at each possible price level.

Thus aggregate demand curve shows the relationship between the total quantity
demanded of goods and services and general price level. It is worth noting that
aggregate demand curve (AD) differs from the ordinary demand curve of an
individual commodity with which we are concerned in microeconomics though both
slope downward to the right.

In case of a demand curve of an individual commodity when price of a commodity

rises, it will tend to be substituted by other commodities which are its close substitutes
resulting in fall in the quantity demanded of the commodity at a higher price. Thus,
the slope of demand curve of an individual commodity depends mainly on the
possibility of substitution between the commodities.

On the other hand, as we shall see below, the slope of aggregate demand curve
depends on factors totally different from those that cause demand curve of an
individual commodity to slope downward. We have drawn an AD curve in Figure
22.1 where on the horizontal axis we measure level of aggregate output and on the
vertical axis we measure the general price level. As will be seen from Figure 22.1,
aggregate demand curve AD slopes downward to the right.

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It is important to note that the AD-AS model is unlike that of market demand- supply
model of microeconomic theory. When we consider demand and supply in a
particular market, say for cotton cloth, rise in its price will cause increase in its
quantity supplied but in doing so resources will be withdrawn from other goods.

Such reallocation of resources between products and consequently rise in output of

one product and fall in that of the other is not considered in macroeconomics where
we are concerned with determination of aggregate output and total employment of
resources in the economy as a whole.

Similarly, in macroeconomic model of aggregate demand and aggregate supply we

study the determination of general price level which does not explain the relative
prices of various products. We explain below in detail the concepts of aggregate
demand (AD) and aggregate supply (AS) curves and their likely shape and factors
determining them. We will also discuss some important controversial issues of
macroeconomics with this AD-AS model.

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Why does Aggregate Demand Curve Slope Downward?
Like the demand curve for an individual commodity, aggregate demand curve slopes
downward but for different reasons. There are three factors responsible for
downward-sloping aggregate demand curve.

First, as the general price level falls, the real value or purchasing power of money
balances and monetary assets with the public increases. This makes the people feel
better off or richer which induces them to increase their consumption which is an
important component of aggregate demand. This is called real balance effect.

Second, with the fall in general price level, transactions demand for money falls
which causes interest rate to fall. At a lower interest rate investment demand increases
which also operates to bring about rise in aggregate demand at a lower general price
level. This is called interest rate effect.

Thirdly, the fall in general price level makes exports of a country relatively cheaper
leading to an increase in export demand for domestic goods produced in the economy.
Besides, due to cheaper domestic goods as a result of fall in general price level, the
people buy domestic goods instead of imported ones which reduces imports of a
country. This causes net exports of the country to rise and leads to the increase in
aggregate demand at a lower price level. This is known as foreign trade effect.

Shifts in Aggregate Demand Curve:

Now, which factors cause aggregate demand curve to shift? We have drawn above
aggregate demand curve AD in Fig. 22.1 keeping non-price factors such as
government expenditure, taxes, autonomous investment, money supply as remaining
fixed or constant. When there is change in any of these non-price factors, aggregate
demand curve AD will shift.

For example, if there is increase in government expenditure without being matched by

increase in taxes, aggregate demand curve will shift to the right indicating that at each
price there will be more aggregate demand. Likewise, if RBI increases money supply
in the economy, this will raise demand of the people for goods and services and cause
a shift in aggregate demand curve to the right.

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Aggregate Supply:
Aggregate supply is the total output of goods and services that firms want to produce
at each possible price level. Thus, like aggregate demand, aggregate supply is the
whole schedule of total quantities of aggregate output that firms in the economy are
willing to produce at each possible price level and can be represented by an aggregate
supply curve.

It is worth noting that aggregate supply is the outcome of the decisions of all
producers in the economy to hire workers and buy other inputs for production of
goods and services for selling them to consumers, other producers, government as
well as for exporting them to other countries.

It may be noted while drawing aggregate supply curve that depicts relationship been
quantities of aggregate output that are produced for sale in the market by the firms in
the economy at various price levels, all other factors that affect aggregate supply
being held constant.

There is a lot of disagreement among economists about the shape of aggregate supply
curve. The classical economists assumed that there normally prevailed full-
employment of resources in the economy. According to them, if at any time there is
deviation from this full-employment level, the wages, interest and prices quickly and
automatically adjust and change to restore equilibrium at the full-employment level.

Thus, in the classical theory, the aggregate supply curve of output is perfectly
inelastic (i.e. a vertical straight line) at the output level corresponding to full-
employment level of resources. This aggregate supply curve relating aggregate supply
with price level of the classical theory of income and employment is shown in Figure
22.2 by a vertical AS curve.

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On the other hand, Keynes considered the situation of economic depression when the
economy was operating before the level of full employment of resources. He further
believed that in such a situation money wage rates were sticky i.e. remained constant.
He further assumed that average and margined products of labour remain constant
when more of it is employed following the increase in aggregate demand.

With these assumptions, more aggregate output is produced and supplied at the given
price level in response to increase in aggregate demand. But when full employment of
labour and capital stock is attained and aggregate demand further increases, aggregate
supply curve being unable to increase any more, it is the price level that will rise in
response to the increase in aggregate demand Keynes’ aggregate supply curve
depicting the relationship between price level and the aggregate production (supply)
during the period of depression and involuntary unemployment when there is a lot of
excess capacity in the economy is shown in Figure 22.3 where it will be seen that
aggregate supply is a horizontal straight line (i.e. perfectly elastic) up to full-
employment output Yf showing thereby that more is produced and supplied at the
same price level OP but corresponding to full-employment level point Yf it becomes
vertical.

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It may however be noted that Keynes recognized that as the aggregate supply
approaches close to the full-employment level, the cost of output per unit tends to rise
due to the rise in wage rate and also due to diminishing returns to extra factors
employed. But, according to Keynes, the rise in price at full-employment level before
full employment or less than capacity output will not be much.

It is evident from above that shape of aggregate supply curve has been a highly
controversial issue. However, there is now a general consensus among modern
economists that when the economy is working substantially below capacity, that is, at
times of depression or severe recession, more can be produced without much rise in
marginal cost of production and therefore the aggregate supply curve is nearly flat.

This first range is therefore called horizontal range. With the given stock of capital
(i.e. plant and equipment) when output is expanded beyond this range the diminishing
returns and rising marginal costs occur which ultimately cause the aggregate supply
curve to slope upward gently.

Thus there is a part of gently rising short-run aggregate supply curve which represents
intermediate range of short-run aggregate supply curve. But as the firms in the
economy approach near their capacity output, their marginal costs sharply rise which
causes sharply rising aggregate supply curve. Beyond the level of capacity output, that
is, when the given resources of the economy are fully employed, aggregate supply
curve (AS becomes a highly steep curve).

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Thus the short-run aggregate supply curve has segments or ranges:
(1) The horizontal range,

(2) The intermediate upward-sloping range, and

(3) The highly steep range.

This aggregate supply curve having three distinct segments is shown in Figure 22.4.

Shifts in Short-Run Aggregate Supply Curve:

In explaining the upward-sloping nature of short-run aggregate supply we stated that
aggregate supply curve depicts the relationship between price level and aggregate
output (i.e., real GDP), other factors such as wages, input prices, technology and
indirect taxes that determine aggregate supply being held constant. Now, it is the
changes in these other determining factors that cause a shift in the aggregate supply
curve. We explain below the factors that cause a shift in aggregate supply curve.

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Changes in Wage Rate:
Change in wage rate of workers is an important factor that causes a shift in short-run
aggregate supply curve. For example, when wage rate of workers increases, it causes
a leftward shift in short-run aggregate supply curve. This is because increase in wages
raises cost per unit of output. With a given price of output, higher wage rate means
profit per unit of output will decline. As production becomes less profitable, it is
likely that the firms will cut back on production and supply less output. Now when
wage rate of workers increases, it causes a leftward shift in short-run aggregate supply
curve as shown in Fig. 22.5.

Prices of Inputs:
Changes in prices of other inputs such as energy (for example, crude oil) and raw
materials also bring about a shift in short-run aggregate supply curve. It is well known
that increase in price of crude oil by OPEC in 1973 and again in 1979 affected
aggregate supply by raising cost per unit of production. This caused a leftward shift in
short-run aggregate supply curve as shown in Fig. 22.5 This leftward shift in the
aggregate supply curve implies that at any given price level less output is supplied
than before.

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On the other hand, when price of crude oil falls as has happened at several occasions
in the past, aggregate supply curve shifts to the right as is shown in Fig. 22.6
indicating that at any given price level more output will be produced and supplied
than before.

Change in Technology. The change in technology is another important factor that

causes a shift in aggregate supply curve. When there is improvement in technology,
productivity of factors rises causing a fall in the unit cost of production. This brings
about a rightward shift in aggregate supply curve showing that at any given price level
more will be produced and supplied than before.

Business Taxes and Subsidies:

Increase in rates of business taxes such as excise duty, sales tax, customs duties raise
per unit cost of production just as rise in wage rate. (Note that tax is considered as
cost of production as it raises the supply price of output.) Thus, by levying business
taxes or increasing their rates causes a leftward shift in the aggregate supply curve.

On the other hand, lowering of taxes as happened during the recent global slowdown
(2007-09), caused by bursting of sub-prime housing loans bubble in United States,
will cause a shift in the aggregate supply curve to the right. Provision of subsidies on
products of various industries also causes a shift in the aggregate supply curve to the
right.

46 | P a g e
Available Supply of Resources:
Lastly, a very important factor determining the position of aggregate supply curve is
the available quantity of resources. When the available supplies of resources such as
labour and capital increase, the short-run aggregate supply curve will shift to the right.
As labour force grows and supply of capital is increased through investment, the
short-run aggregate supply curve will shift to the right implying that more output will
be produced for sale at any given price level.

Long-Run Aggregate Supply Curve:

In our above analysis we have explained the short-run aggregate supply curve with a
variable price level. In the modern macroeconomic analysis the distinction is drawn
between the long-run and short-run aggregate supply curve. Since classical
economists who were concerned with determination of national income and
employment in the long run, they considered the long-run aggregate supply.

The long-run aggregate supply is determined by three real factors such as availability
of labour, the quantity of capital stock and the state of technology. In the long run
price level is variable and the aggregate supply curve is vertical. On the other hand,
Keynes considered the short-run aggregate supply which is perfectly elastic at the
fixed price level in the period of depression.

However, in the modem or new Keynesian macroeconomics short-run aggregate

supply curve slopes upward. Further, this short-run aggregate supply fluctuates over
the course of a business cycle, that is, in different phases of the business cycle. The
level of employment fluctuates around full-employment level and GDP fluctuates
around the potential GDP.

Note that the quantity of real GDP when there is full employment of labour or, in
other words, when unemployment is at its natural rate is known as potential GDP.
Potential GDP depends on the given labour force and capital stock when they are fully
employed or used, given the state of technology. We explain below in detail the
concept of long-run aggregate supply and short-run aggregate supply.

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Long-run Aggregate Supply:
The long-run aggregate supply of output or real GDP depends on three factors:
(1) The quantity of available labour,

(2) The stock of capital and

(3) The state of technology.

The aggregate production function which describes the influence of these three
factors is written as:
Y = F(L, K, T)

where Y is the quantity of aggregate output or real GDP, L is the quantity of labour, K
is the stock of capital and T is the state of technology. At any given time, the stock of
capital and state of technology are given and fixed. Though at any time population of
a country is fixed but the quantity of labour is variable; it depends on the preferences
between work and leisure of the people on the one hand and the decisions of the firms
about the demand for labour on the other.

People supply labour only if wage rate which is reward for their work effort is
sufficient to overcome their preference for leisure. The higher the wage rate, the
greater is the quantity of labour supplied. On the other hand, the firms demand labour
if it is profitable to use it for production.

The lower the wage rate, which is the cost of labour, the greater is the quantity of
labour used. The equilibrium wage rate and the quantity of labour employed are
determined by labour market equilibrium. The labour market is in equilibrium at the
wage rate at which the quantity of labour demanded equals the quantity of labour
supplied.

At this equilibrium wage rate, all those who are willing to supply their labour are is
fact demanded and employed. Therefore, at this equilibrium wage rate, full
employment of labour is said to prevail.

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However, even at full employment, there are always some workers searching for jobs
and some firms are looking for workers to offer them employment. This is because of
two factors, frictional and structural. Every week some workers leave their old jobs
and search for new better jobs more suited to their skills and ability. But due to lack of
information, it takes time to find the new jobs even though these are available.

This represents what is called frictional unemployment. Second, every week or month
some industries are declining due to technological changes in technology or
preferences of the people for goods while others are expanding.

In this case while some people are laid off from the declining industries but some time
is required before they acquire new skills and training needed for employment in the
expanding industries. Therefore, for some time they remain unemployed though job
vacancies for them exist. This second type of unemployment is called structural
unemployment.

Thus, at any time some frictional and structural unemployment inevitably exist in a
free market economy. Therefore, in modern macroeconomics, the amount of frictional
and structural unemployment is called the natural rate of unemployment. Around 4 to
5 per cent of labour force in the developed free-market economies represents the
natural rate of unemployment.

And full employment is said to exist in spite of the existence of frictional and
structural unemployment. The quantity of real GDP produced and supplied when
there is full employment (that is, when there exists only natural rate of
unemployment) is called potential GDP. It may be noted again that potential GDP
depends on full employment of labour, the full use of the existing stock of capital and
the available technology.
The long-run aggregate supply describes the relationship between the quantity of real
GDP and the price level in the long run when real GDP equals potential GDP. The
long-run aggregate supply curve is a vertical line (at potential GDP level as shown by
LAS in Figure 22.7.

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The long-run aggregate supply is vertical because potential GDP does not vary with
price level, that is, it is independent of the price level. The reason for the
independence of potential GDP from the price level is that the movement along the
long-run aggregate supply curve involves not only the change in price level of goods
but also prices of factor inputs such as wages of labour etc.

For example, when there is 5 per cent decrease in the prices of goods and services,
this is matched by the same (i.e. 5 per cent) decline in wage rate and other factor
prices so that relative prices and real wage rate remain unchanged. This explains why
it is profitable to produce the same quantity of real GDP at lower price level of goods
and services.

When price level of goods and services falls, the cost also falls as wage rate and other
factor prices fall by the same percentage. Therefore, aggregate supply of output (i.e.
real GDP) in the long run also remains constant at potential GDP level.

It is evident from above that long-run aggregate supply curve is the same as the
classical aggregate supply curve.

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Changes in Long-Run Aggregate Supply Curve:

Long-run aggregate supply curve is a vertical straight line at the level of potential
GDP. Changes in price level bring about a movement along the long-run aggregate
supply, but the quantity of aggregate supply remains fixed at the level of potential
GDP. It is changes in potential GDP that causes a shift in the long-run aggregate
supply curve.
The following factors cause a change in potential GDP resulting in a shift in the
long-run aggregate supply curve:
1. The change in the full-employment quantity of labour.

2. Change in the stock of capital.

3. Progress in technology.

Increase in Labour Force:

Labour is an important resource of production. Over time, given the capital stock and
the state of technology potential GDP will increase as full-employment quantity of
labour force increases. Therefore, the increase in the full-employment quantity of
labour force causes a shift in the long-run aggregate supply curve to the right as
shown in Figure 22.8.

It may be noted that changes in labour employment over the business cycle cause
fluctuations in real GDP. But these changes in real GDP that take place over the
business cycle are not changes in potential GDP. Changes in potential GDP occur due
to changes in labour force and stock of capital, and improvement in technology.

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Growth in the Stock of Capital:

The stock of capital in an economy determines the productive capacity of the

economy. The larger the stock of capital in the economy, the more productive is the
labour force of the economy and the greater is its potential GDP. The higher per
capita output and potential GDP of the American economy as compared to those of
the Indian economy are mainly due to the greater stock of capital in the United States.

Note that in the capital stock the modern economists include not only physical capital
but also human capital. Human capital means the acquired skills, education and
training of the workers. Like the increase in labour force, growth in capital stock also
brings about increase in potential GDP and causes a shift in the long-run aggregate
supply curve (LAS) to the right.

Progress in Technology:
Progress in technology enables firms to produce more from the given resources.
Empirical research studies have shown that technological progress is by far the most
important source of increase in GDP over the past two centuries. It is due to advances
in technology that a modern worker, both in industry and agriculture, produces many
times more output than the worker in the olden times. Thus, even with the fixed
quantities of labour and capital, progress in technology raises potential GDP and
causes shift in the long-run aggregate supply curve to the right.

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We have shown long-run aggregate supply curve LAS and short-run aggregate supply
curve together in Fig. 22.9. It will be seen that short-run aggregate supply curve at
potential GDP level and beyond potential GDP level Y1, it becomes highly steep.

Determination of GDP and Price Level: As-Ad Model:

Having explained the concepts of aggregate demand and aggregate supply with
variable price level, now we shall explain how macroeconomic equilibrium is reached
between the aggregate supply and aggregate demand to determine the amount of real
GDP and the price level.

As there is difference between the long-run and the short run aggregate supply curves,
the long-run equilibrium differs from the short-run macroeconomic equilibrium.
While long-run equilibrium is the state towards which the economy is moving, short-
run equilibrium is the actual state of the economy in the short run as it fluctuates
around potential GDP.

The purpose of AS-AD model is to explain how the changes in various factors, fiscal
and monetary policies bring about changes in real GDP and the general price level,
that is, inflation. We explain below both the short-run and long-run macroeconomic
equilibrium.

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Short-run Macroeconomic Equilibrium:
Short-run macroeconomic equilibrium occurs at the price level at which aggregate
output demanded equals aggregate supply of output. That is, short-run equilibrium is
reached at the price level at which aggregate demand curve AD intersects the short-
run aggregate supply curve SAS.

This is shown in Fig. 22.10 where AD is the aggregate demand curve and SAS is the
short-run aggregate supply curve. It will be seen that the short-run macroeconomic
equilibrium occurs at point E at which the price level is P0 and the real GDP is Y0.
If price level is different from P0, the economy will not be in equilibrium. Suppose,
for example, price level is P2, the quantity P2A of the real GDP demanded at P2 is less
than the quantity P2 B of real GDP supplied. This means the firms will not be able to
sell all their output.
As a result, unintended inventories well pile up and firms will cut both production and
prices. The process of cutting production and prices will continue until the
equilibrium price level PQ is reached and real GDP produced and sold is Y0.

Now suppose that price level is P1. It will be seen from Fig. 22.10 that at price level
P1 the quantity of aggregate output demanded (P1D) exceeds the aggregate supply
(P1C). Thus at the price level P1, the people will not be able to get all the goods and
resources they want to buy.

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As a result, inventories of goods with the firms will decrease below the desired level.
This will induce firms to increase production and raise prices. The production and
price level will rise until price level P0 is reached and real GDP produced is Y0 which
meets the demands of the people fully at the price level P0. Thus, the price level
P0 and real GDP equal to Y0 represent the short-run macroeconomic equilibrium.
It is worthwhile to note that in the short run the money wage rate is fixed. It does not
adjust to bring macro-equilibrium at full-employment level of real GDP. Thus, in the
short run macro- equilibrium can be attained with real GDP less than or greater than
potential GDP (i.e. the level of GDP at which there is full employment of labour)
depending on the level of aggregate demand. It is only in the long run when money
wage rate adjusts that equilibrium is restored at potential GDP.

It is worth noting that, as Keynes emphasized, the equilibrium between aggregate

demand and aggregate supply may not necessarily be at full-employment level.
Besides, when the economy is working at the level of full productive capacity, the
increase in aggregate demand will lead to inflation in the economy.

Shift in Short-run Aggregate Supply Curve and Stagflation:

Let us now turn to examine the effect of changes in aggregate supply, aggregate
demand remaining constant. With the advent of supply-side economics and new
classical macroeconomics embodying rational expectations in recent years economists
are increasingly concerned with shifts in aggregate supply curve.

Important factors that cause a shift in supply are changes in factor-prices and
availability of resources, change in productivity and expectations about future
inflation. Institutional factors such as Government regulations that affect resource use
efficiency also cause shift in aggregate supply curve.

An important cause of shift in aggregate supply curve is the rise in prices of resources
such as large increase in oil price by OPEC in 1973-74 and again in 1979-80. The rise
in oil prices causes the aggregate supply curve to shift to the left as shown in Figure
22.11 where due to the higher per unit resource cost aggregate supply curve has
shifted leftward from SAS0 to SAS1.

55 | P a g e
The aggregate demand curve AD remaining constant, with the leftward shift in
aggregate supply curve from AS0 to AS1 leads to the new macroeconomic equilibrium
being established at T, at which price level is higher and aggregate output smaller
than before.

The emergence of rise in price level or inflation due to the leftward shift in aggregate
supply curve is called cost-push inflation. There is an important difference between
demand-pull inflation cost-push inflation. Whereas in case of demand-pull inflation,
price rises along with rise in GDP, in case of cost-push inflation price level rises but
GDP declines.

Thus, in Fig. 22.11 leftward shift in the SAS curve leads to rise in the price level from
P0 to while national output falls from Y0 to Y1. When both inflation and recession
occur simultaneously, economists call this situation as stagflation. We thus see that
increase in costs or resource prices are both inflationary and recessionary.
It may be noted that stagflation is also said to occur when instead of absolute fall in
aggregate output there is slowdown in economic growth rate when inflation rate
remains steadily high and also unemployment levels are quite high. It is evident from
above that stagflation occurs as a result of supply shock, that is, rise in price of
essential inputs such as crude oil which causes a shift in the short-run aggregate
supply curve to the left.

56 | P a g e
Given the aggregate demand curve, the new equilibrium is reached at a higher price
level (i.e., inflation) and at the same time reduced aggregate output (i.e., GDP) which
generates unemployment in the economy.

We have explained above stagflation as a result of sharp rise in price of crude oil
effected by restriction of oil output by collusive agreement of OPEC. In India
stagflation can arise when there is decline in agricultural output due to failure of
monsoon.
The decline in agricultural output causes food inflation which in turn leads to rise in
wages of workers which causes a shift in the short-run aggregate supply curve to the
left. Besides, drastic decline in agricultural output also leads to the rise in prices of
raw materials provided by agricultural sector to industries. The rise in raw material
prices for industries shifts aggregate supply curve to the left causing both inflation
and reduction in output.

57 | P a g e
DEMAND AND SUPPLY CURVE OF LABOUR

Demand for Labour:

The demand for labour is a derived demand. It is derived from demand for the
commodities it helps to produce. The greater the consumers’ demand for the product,
the greater the producers’ demand for the labour required in making it. Hence an
expected increase in the demand for a commodity will increase the demand for the
type of labour that produces this commodity.

The elasticity of demand for labour depends, therefore, on the elasticity of demand for
its output. Demand for labour will generally be inelastic if their wages form only a
small proportion of the total wages. The demand, on the other hand, will be elastic if
the demand for the commodity it produces is elastic or if cheaper substitutes are
available.

The demand for labour also depends on the prices of the co-operating factors.
Suppose the machines are costly, as is the case in India, obviously more labour will be
employed. The demand for labour will increase. Another factor that influences the
demand for labour is the technical progress. In some cases, labour and machinery are
used in a definite ratio. For instance, the introduction of automatic looms reduces the
demand for labour.

58 | P a g e
After considering all relevant factors, e.g., demand for the products, technical
conditions, and the prices of the co-operating factors, the wages are governed by one
fundamental factor, viz., marginal productivity. Just as there is a demand price of
commodities, so there is a demand price for labour.

The demand for labour, under typical circumstances of a modern community, comes
from the employer who employs labour and other factors of production for making
profits out of his business. The demand price of labour, therefore, is the wage that an
employer is willing to pay for that particular kind of labour.

Suppose an entrepreneur employs workers one by one. After a point, the law of
diminishing marginal returns will come into operation. Every additional worker
employed will add to the total net production at a decreasing rate. The employer will
naturally stop employing additional workers at the point at which the cost of
employing a worker just equals the addition made by him to the value of the total net
product.

Thus, the wages that he will pay to such a worker (the marginal unit of labour) will be
equal to the value of this additional product or marginal productivity. But since all the
workers may be assumed to be of the same grade, what is paid to the marginal worker
will be paid to all the workers employed. This is all about the demand side of labour.
Now let us consider the supply side.

59 | P a g e
Supply of Labour:

By the supply of labour, we mean the various numbers of workers of a given type of
labour which would offer themselves for employment at various wage rates.

The supply of labour may be considered from two view-points?

(a) Supply of labour to the industry and

(b) Supply of labour to the entire economy.

For an industry, the supply of labour is elastic. Hence, if a given industry wants more
labour, it can attract it from other industries by offering a higher wage. It can also
work the existing labour force over-time. This in effect will mean an increase in
supply. The supply of labour for the industry is subject to the law of supply, i.e., low
wage, small supply and high wage, large supply. Hence, the supply curve of labour
for an industry rises upwards from left to right.

60 | P a g e
The supply of labour for the entire economy depends on economic, social and
political factors or institutional factors, e.g., attitude of women towards work, working
age, school and college leaving age and possibilities of part-time employment for
students, size and composition of the population and sex distribution, attitude to
marriage, the size of the family, birth control, standard of medical facilities and
sanitation, etc.

The supply of labour may be decreased by workers refusing to work for a time. This
happens when labour is organised into trade unions. The workers may not accept
wages offered by the employer if such wages do not ensure the maintenance of a
standard of living to which they are accustomed.

But, as we shall see, it is only when higher wages are justified by higher marginal
productivity that high wages will be paid. Thus, workers with low marginal
productivity cannot demand high wages merely on the basis of their standard of
living. On the whole, we might say that, the number of potential workers being given,
the supply of labour may be defined as the schedule of units of labour at the
prevailing rates of wages.

This depends on two factors:

(a) The number of workers who are willing and able to work at different wages;

(b) The number of working hours that each Worker is willing and able to put in at
different wages.

In case the workers have no staying power and the only alternative to work is
starvation, the supply of labour in general will be perfectly inelastic. This means that
wages can he driven down. Over a short period, reduction in wages may not cause any
reduction in the supply of labour. For any industry over a long period, the supply
curve will slope upwards from left to right. In other words, supply will be somewhat
elastic in the long run.

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Backward Sloping Supply Curve of Labour:

While labour’s supply curve sloping upwards from left to right is the general rule, an
exceptional case of labour’s supply curve may also be indicated (see Fig. 31.1) When
the workers’ standard of living is low, they may be able to satisfy their wants with a
small income and when they have made that much, they may prefer leisure to work.
That is why it happens that, sometimes, increase in wages leads to a contraction of the
supply of labour. This is represented by a backward-sloping supply curve as under.

For some time this particular individual is prepared to work long hours as the wage
goes up (wage is represented on OY—axis in Fig. 31.1). But beyond OW wage, he
will reduce rather than increase his working hours.

62 | P a g e
However, this backward sloping Curve may sometimes be true of certain workers, the
supply curve of labour to industry as a whole will normally slope upwards from left to
right (as shows in Fig. 31.2)

Interaction of Demand and Supply:

We have now analysed the demand side as well as the supply side of labour. We shall
now see how their interaction determines the wage level. This is shown in Fig. 31.2

In this diagram, we have shown the wage determination of a particular type of labour
for an industry. The curve SS represents supply of labour to the industry. DD is the
demand curve for labour of that industry. Demand and supply curves intersect at E.
Therefore, the wage rate OW (= NE) will be established. The equilibrium wage rate
will change if the demand and/or supply conditions change.

Under competitive conditions, wage rate in the long run will be equal to both the
marginal revenue product and the average revenue product. If the wage rate is less
than the average revenue product, the firms would be earning supernormal profits. As
a result, new firms will enter the industry and the demand for labour will increase
which will push up the wage rate so as to be equal to average revenue product.

63 | P a g e
On the other hand, if the wage rate is above the average revenue product, the firms
will be suffering losses. As a result, some firms will leave the industry and demand
for labour will decrease which will force the wage-rate down. Fig. 31.2 shows the
long-run equilibrium of the firms under perfect competition. This diagram shows that
long-run equilibrium wage rate is OW. At wage rate OW, the firm is employing ON
number of labour. This OW rate is equal to marginal revenue product (MRP) and
average revenue product (ARP) at point E. The point E is the equilibrium position of
the firm in the long run.

We have so far concerned ourselves with the problem of how wages in general are
determined. But is there any general rate of wages?

If labour had been like any other commodity, it would also have been sold in the
market at the same rate. But as you know, labour is peculiar in certain respects.
Labourers differ in efficiency. They are less mobile than goods. Their supply cannot
be increased to order and it is a most painful process to reduce I hem. If a day is lost,
its labour is lost with it. For these and other reasons, a uniform rate of earnings for
workers is not possible. There is thus no prevailing rate of wages similar to the
prevailing rate of interest or prevailing price of a good.

All over the world, labour is spat up into a very large number of groups and sub-
groups, each with a different level of wages. Even within the same group, the
differences are ever so many. Consequently there cannot possibly be a general rate of
wages. All that can be done is to and out an average rate which can be discovered by
dividing the total amount paid to a given group of workers by the total number of
workers in it. The fact is that the wages differ from occupation to occupation. Wages
are relative.

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 CONCLUSION

This paper has developed a simple model with endogenous technological change
in which aggregate demand and aggregate supply both have a role to play and in
which long-run growth can be affected by aggregate demand.

The model can be thought of as synthesizing the roles of aggregate demand and
aggregate supply. The importance of aggregate demand forces in obvious:
aggre- gate demand (in the sense of exogenous changes in investment demand or
changes in government policy) affects the long-run rate of growth. The role of
aggregate supply can be seen from the fact that if technology is not sufficiently
responsive to aggregate demand changes, as shown by a low technology
parameter in the model developed here, the impact of aggregate demand
expansion will be limited or completely nullified.

The model can also be thought of as synthesizing the contributions of three

strands of growth theory, that is, neoclassical, new growth, and Keynesian
growth theory. As implicitly done in neoclassical growth theory, there are forces
that push the actual growth rate of economy towards the natural rate of growth of
the economy determined by labour supply growth, as captured by the equation
for investment dynamics. As explicitly done in new growth theory, technological
change is endogenized, and this plays a vital role in allowing aggregate demand
to affect economic growth in the long run. Following Keynesian growth theory,
aggregate demand is explicitly introduced into the model and has a long-run
effect on growth.

65 | P a g e
 The main theoretical implication of the paper is to emphasize the role of
aggregate demand as a determinant of long-run growth. It is only with extreme
assumptions about the nature of technological change that aggregate demand has
no effect in determining long-run growth. Thus, the almost complete neglect of
aggregate demand in mainstream growth theory is unwarranted. While this
neglect was explicitly acknowledged by early neoclassical growth theorists like
Solow (1956), new growth theory has ignored it by default. To the extent
aggregate demand is an important determinant of long-run growth, we can rely
on many of the results of post-Keynesian and structuralist growth theories,
which have been ignored in mainstream growth theory, in understanding growth:
for instance, it is possible for income distributional improvements to increase the
rate of economic growth, as well as for expansionary fiscal and monetary policy
to have a positive effect on growth. Moreover, there can be no sharp division
between short-run and long-run macroeconomics: for instance, financial crises
can have adverse long run consequences.

Because the model of this paper suggests that the long-run growth rate of
the economy depends on the dynamic path of the economy, our analysis has the
further implication that history and its study should complement theory in the
analysis of growth.

The model, especially given its empirical plausibility, also implies that growth
policy will have to pay more careful role to aggregate demand. Simple-minded
efforts to increase the saving rate and cutting government deficits to increase the
rate of economic growth will have to be rethought. The effects of such policies, by
reduc- ing aggregate demand, may well be to depress long-run growth. Moreover,
contrac- tionary fiscal and monetary stabilization policy in response to crises may
well have long-run depressive effects that may exacerbate the effects of the crisis
itself. Finally, policies to check the growth of aggregate demand during
expansion without clear signs of strong inflationary tendencies may have
unnecessary costs in terms of long- run growth rates.

66 | P a g e
 This is not to imply, however, that in reality growth can be indef- initely
increased by expanding aggregate demand: it is necessary to deal with supply-
side factors such as the responsiveness of technological change.

Our analysis suggests a number of directions for future work. First, we have used
a simple model in which technical input–output coefficients are given at a point
in time, and excess capacity is allowed to prevail even in long-run equilibrium.
Allow- ing factor substitution and endogenously determining desired capital-
output ratios may make the model more palatable to those who are troubled by
these simplifications. Second, our treatment of asset market considerations has
been of a reduced-form type, in which (for instance) labour market conditions
are taken to affect investment in the neoclassical synthesis manner without
explicitly examin- ing the asset market and the interest rate. It is possible that
incorporating asset markets explicitly can yield useful insights. Finally, our
analysis assumes a partic- ular type of endogenous technological change, without
explicit formalization of the mechanisms by which it occurs. Future work can
analyze and explore these mech- anisms more carefully, both theoretically and
empirically, and analyze whether other related ways of endogenizing
technological change will yield similar results.

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BIBLIOGRAPHY

BOOKS

 INTERNATIONAL ECONOMICS TIMES

 INTERNATIONAL LABOUR LAW
 INTERNATIONAL DEMAND & SUPPLY LAW

WEB SITES :

 www.Wikipedia.com

 www.ANSWERS.COM

 www.EXIM.com

 www.eximbankindia.in

 www.yourarticlelibrary.com

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