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Keynesian Economics
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Dominant questions regarding Business Cycles
John Maynard Keynes
1. Dominant questions regarding business cycles
2. Keynesian economics: an introduction
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3. Wage rigidity and the efficiency wage model
1. What do we believe is the best theory of how GDP, prices, and other variables are
determined in the short run? Such a theory may allow more than one potential cause
of business cycles.
4. Employment, unemployment and efficiency wages
2. Given such a theory, which of the potential causes do we believe are actually responsible for the business cycles that all economies seem to observe?
5. Nominal price rigidity
3. What, if anything, should be done about business cycles?
6. Are prices sticky?
7. Monetary and fiscal policy in the Keynesian model
Wage Rigidity
An introduction to Keynesian economics
• In contrast to classical economists, Keynesian economists believe wages are slow to
respond to shocks. Then recessions and booms can lead to the labor force being out
of equilibrium. Hence labor market doesn’t clear – recessions lead to substantially
cyclical unemployment.
• In contrast, in classical (RBC) theory, LM curve immediately adjusts so that all three
curves intersect at same place. The LM curve adjusts because nominal prices adjust.
• For unemployment (beyond the unemployment due to costly searching and matching)
to persist the real wage must exceed the market wage.
• Keynesians argue that “prices are sticky” at least in the short run, making this shift
slow.
• This is how they are going to generate short-run non-neutrality for money.
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• Keynesian theory is essentially boiled down into the IS- LM graph with the assumption
that in the short-run, the IS and LM curves can intersect off the FE curve, and that
it is this intersection which determines Y and r.
• So why is it that you see firms firing workers rather than reducing the wage?
– minimum wage laws?
– union rules?
– efficiency wages?
The Efficiency Wage Model
The effort curve and wage determination
• Secretaries and receptionists at investment banks are paid more than secretaries and
receptionists elsewhere? Why?
• The effort curve – plotting effort against the real wage is S-shaped.
– at low levels of the real wage, workers hardly make any effort.
– adverse selection
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– moral hazard
– effort rises as the real wage rises
– as the real wage becomes very high, effort flattens out as it reaches the maximum
possible level.
– reduce the number of quits.
– feel good or loyalty story
• To maximize profit, firms choose the real wage that gets the most effort form workers
for each dollar of real wages paid.
• Think about employee crime. U.S. businesses spend approximately $12 billion a year
on security products, personnel and services.
Employment, unemployment, and efficiency wages
Efficiency wages and the FE curve
• The labor market now determines employment and unemployment, depending on how
far above the market-clearing wage is the efficiency wage.
• The difference between labor supply and labor demand is the amount of unemployment.
• The fact that there’s unemployment puts no downward pressure on the real wage,
since firms know that if they reduce the real wage, effort will decline.
• The classic example of efficiency wages: Henry Ford.
• Equilibrium employment pinned down by the labor demand curve.
• FE curve still vertical since since the full-employment level of output is unaffected by
the interest rate.
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• The labor supply curve is the same old upward sloping LS curve we have worked with
all along. The labor demand curve is now the marginal product of labor when the
effort level is determined by the efficiency wage.
• “Keynesian” FE curve now to the left of the “Classical” FE curve.
• Small shocks to labor supply have no effect on the Keynesian FE curve since they
don’t affect equilibrium employment.
• A change in productivity does affect the FE line, since it affects labor demand.
Are Prices sticky?
• Well known study by Dennis Carlton
• But remember ...
– many prices change frequently: price of stocks; mortgage rates; airline tickets.
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Average Duration of
Product Group
Price Rigidity (months)
Steel
13.0
Nonferrous metals
4.3
Petroleum
5.9
Rubber tires
8.1
Paper
8.7
Chemicals
12.8
Cement
13.2
Glass
10.2
Truck motors
5.4
Plywood
4.7
Household appliances
3.6
average (weighted)
9.9
Monetary Policy in the Keynesian Model
• First the FE line in the Keynesian model differs from the Classical model in two
respects:
• Assume firms must choose nominal prices to sell at in advance, post these prices, and
then sell to whoever wishes to buy at these prices.
– The Keynesian level of full-employment occurs where the efficiency wage line
intersects the labor demand curve, not where the labor supply curve intersects
the labor demand curve as in the Classical model.
• Over time, firms get opportunity to change price.
• At fixed prices, consumers want a certain amount of goods and firms supply it by
hiring whatever amount of labor necessary to produce that amount of labor.
– Small changes in labor supply don’t affect the FE line in the Keynesian model;
they will in the Classical model.
• We assume firms are robots and need to hire to produce enough to meet demand.
• In the “too high” case, the wage is low and the MPN is high. Firms would like to
produce a little more and sell it, but to do so would have to lower prices a little. By
assumption, they can’t.
• In the “too low” case, the wage is high and the MPN is low. Firms would like to cut
back on production since they are losing on the marginal units. By assumption, we
rule this out.
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• Note that firms will wish to change price both when it turns out they set them “too
high” and “too low.”
– On many items while the price does not change frequently key characteristics
about the product may change: delivery times, quality of service, stock outs.
– Old Soviet joke: “The price is fixed, but the weight is subject to negotiation.”
An alternative way to think about price stickiness
• Implies an “effective labor demand” function.
– internet
• An increase in Ms shifts the LM curve down.
• So output rises and the real interest rate falls.
• Since prices don’t adjust immediately, it stays there for a while and then comes back
again when prices adjust.
• Assumption is that firms meet the demand for their products by adjusting employment
– not wages or prices.
• Eventually firms raise prices, the LM curve shifts back to its original level, and general
equilibrium is restored.
• Thus money is neutral in the long run, but not in the short run.
Fiscal Policy: Decreasing current taxes, government spending is unchanged.
Fiscal Policy: Decreasing current government spending
• Keynesians reject Ricardian equivalence.
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• IS curve shifts in.
• In long run, prices adjust (downward). LM curve shifts down in IS-LM graph to
restore general equilibrium
• In long run, prices adjust (upward). LM curve shifts up in IS-LM graph to restore
general equilibrium
Keynesian Stabilization Policy
Animal Spirits
• Earlier stated there were three questions regarding business cycles.
• Suppose the country gets convinced recession is coming. Possible effects:
– What is the short run theory of the behavior of the economy? (We just did this
for the Keynesian story.)
– Increased precautionary saving. IS curve shifts in
– Increased demand for cash balances, all else equal. LM curve shifts in.
• Each of these alone causes a recession.
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– Decreased demand for capital. IS curve shifts in
• IS curve shifts out.
– What shocks are important?
– What should we do?
• Allows for “self-fulfilling prophesies.”
• Traditional Keynesian thought is that private determined shocks (such as animal
spirits) are important.
• FDR: “the only thing we have to fear is fear itself.”
• Discounted movements in the FE curve.
Policy Recommendations
• Counter-act changes due to shocks from the private sector.
– If the IS curve shifts in because of an increase in pessimism, build some roads
(increase government spending) to shift it out again.
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– Alternatively, one can increase the money supply (as in the graph below). When
the IS curve shifts back, bring the money supply back down again.
– If the LM curve shifts up because of an increase in liquidity preference, shift it
back down with an increase in the money supply.
• This type of “fine tuning” which was in its heyday in the 1960’s in the US