Download Chapter 12

Chapter 12
Keynesian
Business Cycle
Theory: Sticky
Wages and Prices
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Chapter 12 Topics
• Construction of the Keynesian sticky wage
model: labor market, aggregate supply, IS and
LM curves, aggregate demand.
• Nonneutrality of money when wages are sticky.
• The Role of Government in the sticky wage
model.
• A Keynesian sticky price model.
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12-2
Figure 12.1 The Labor Market in
the Keynesian Sticky Wage Model
• The wage is
sticky and so can
be different, w*,
from the
equilibrium level.
• The result is
unemployment,
N**-N*
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12-3
Figure 12.2 The Labor Market in the
Keynesian Sticky Wage Model When
There Is Excess Demand
• When the wage is also
upward sticky, hence
does not adjust upwards
when market forces
require so, there is no
employment
• Employment is equal to
N** by a rationing rule
that nor firms nor
workers are forced to
demand or supply more
labor than desired
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12-4
Figure 12.3 Construction of the
Aggregate Supply Curve
• The wage is sticky
• An increase in prices
leads to a lower real
wage
• Firms hire more labor
• Produce more
• Thus Y increases in P:
an upward sloping AS
curve
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12-5
Figure 12.4 The Effect of an
Increase in W or a Decrease in z
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12-6
Figure 12.5 The IS Curve
• The IS curve is just the
Yd curve from previous
chapters
• A lower interest rate
increases investment
demand and shifts
consumption to the
current period
• Both raise output
demand
• Mechanism in IS/LM
model is equal
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12-7
Figure 12.6 Money Demand,
Money Supply, and the LM Curve
• The LM curve is
determined by
equilibrium in the
money market
• Money market
equilibrium is as in
chapter 10: it rises
in Y and declines
in r
• A higher income raises money demand for a given interest rate
• To restore money market equilibrium, the interest rate has to rise as
well: an upward sloping LM curve
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Figure 12.7 Determination of r
and Y Given P
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12-9
Figure 12.8 The Effect of an Increase
in the Money Supply on the LM Curve
•
•
•
•
An increase in Ms leads to Ms>PL
To restore money market equilibrium, Md should go up
This requires a lower interest rate, hence for given Y, r is lower
Think of how CB conducts monetary expansion: buying government
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© 2008 raises
Pearson Addison-Wesley.
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bonds
Ms, increases
price of bonds and decreases interest rate
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Figure 12.9 The Effect of an Increase
in the Price Level on the LM Curve
• A higher price level P, raises real money demand, P*L
• Hence, P*L>Ms. For given Y, interest rate has to go up to reduce
money demand: LM curve shifts inwards
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12-11
Figure 12.10 A Positive Shift in Money
Demand Shifts the LM Curve to the
Left
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12-12
Figure 12.11 The Aggregate
Demand Curve
• The AD curve is a relation
between output Y and the price
level P through the demand side
of the economy
• A higher price level, shifts the
LM curve inwards, the interest
rate rises for given output Y
• Shifting along the IS curve,
output declines
• Hence a downward sloping AD
curve
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12-13
Figure 12.12 A Shift to the Right in the IS
Curve Shifts the AD Curve to the Right
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12-14
Figure 12.13 A Shift to the Right in the
LM Curve Shifts the AD Curve to the
Right
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12-15
Figure 12.14 The Keynesian
Sticky Wage Model
• The full sticky wage model is a
combination of:
• Financial and spending
equilibrium, the IS/LM diagram
• Goods market equilibrium, the
AS/AD diagram
• Labor market equilibrium, the
Nd/Ns diagram
• Logic runs top down, goods
market equilibrium determines
labor demand Nd, which
determines unemployment
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12-16
An Increase in the Money
Supply
• The LM curve and AD curve shift to the right.
• The real interest rate falls, the price level rises,
the real wage falls, firms hire more labor, real
output increases, consumption rises, investment
rises.
• Money is not neutral in the short run when
nominal wages are sticky.
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12-17
Figure 12.15 An Increase in the
Money Supply in the Sticky Wage
Model
• The LM curve and AD curve shift to the
right.
• The real interest rate falls, the price level
rises, the real wage falls, firms hire more
labor, real output increases, consumption
rises, investment rises.
• Money is not neutral in the short run
when nominal wages are sticky.
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12-18
Table 12.1 Data vs. Predictions of the
Keynesian Sticky Wage Model with
Monetary Shocks
• The real wage is countercyclical, because the price level goes up
due to the increase in aggregate demand, whereas wages are sticky
• Employment goes up with the shift along the Nd curve and
therefore average labor productivity goes down
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12-19
Figure 12.16 Percentage Deviations
from Trend in the Money Supply and Real
GDP for the Period 1959–2006
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12-20
Figure 12.18 An Increase in the Demand
for Investment Goods in the Sticky Wage
Model
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12-21
Table 12.2 Data vs. Predictions of the
Keynesian Sticky Wage Model with
Investment Shocks
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12-22
Figure 12.19 Long-Run
Adjustment of the Nominal Wage
• With unemployment, the nominal wage
will go down in the long run
• As a result labor demand goes up and the
AS curve shifts out
• The price level goes down from P1 to P2
• Therefore the LM curve shifts out, the real
interest rate goes down
• This cause the Ns curve to shift in
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12-23
The Role of Government Policy
in the Sticky Wage Model
• Keynesian unemployment will be eliminated and
economic efficiency restored in the long run when
nominal wages adjust to equate supply and demand in
the labor market.
• In the short run, efficiency can be restored through
appropriate monetary or fiscal policy in the sticky wage
model.
• Monetary or fiscal policy needs to act quickly enough,
and given the right information, to have the predicted
effects.
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12-24
Figure 12.20 Stabilization Policy in the
Sticky Wage Model–Monetary Policy
• Monetary policy shifts the LM curve out
• As a result, the AD curve shifts out as well
• Because of the price increase, the LM
curve shifts partly back
• The economy moves down along the Nd
curve to a higher level of employment
• The Ns curve shifts in because of the lower
interest rate
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12-25
Figure 12.21 Stabilization Policy in the
Sticky Wage Model–Fiscal Policy
• Fiscal policy shifts the IS curve out
• As a result the AD curve shifts out as well
• The LM curve shifts in, because of the
higher price level
• The economy moves down along the Nd
curve
• The Ns curve shifts out now, because of the
higher interest rate
• Difference with monetary policy is that
interest rate is higher, possible crowding
out of investment and consumption
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12-26
Sticky Price Model
• Instead of sticky wages, assume sticky prices
• Firms do not change their nominal prices in the
short run, as this is too costly.
• If demand rises, then firms satisfy this demand
by increasing output.
• This implies a horizontal output supply curve:
firms supply any quantity demanded
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12-27
Figure 12.22 The Keynesian
Sticky Price Model
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12-28
Equation 12.1
The quantity of employment N must be
consistent with the quantity of output Y and the
production function:
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12-29
Equation 12.2
Employment is then an increasing function of
Y/z and K.
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12-30
Figure 12.23 Determination of
Employment in the Sticky Price Model
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12-31
Figure 12.24 The Effect of an Increase in
Total Factor Productivity on Employment
in the Sticky Wage Model
• Problematic prediction of
sticky price model:
employment goes down with a
positive tfp shock
• Discussion in literature on
whether this is consistent with
empirical findings or not
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