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Chapter 12 Keynesian Business Cycle Theory: Sticky Wages and Prices Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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* Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-5 Figure 12.4 The Effect of an Increase in W or a Decrease in z Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 12-8 Figure 12.7 Determination of r and Y Given P Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 raises Pearson Addison-Wesley. All rights reserved. bonds Ms, increases price of bonds and decreases interest rate 12-10 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-11 Figure 12.10 A Positive Shift in Money Demand Shifts the LM Curve to the Left Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-13 Figure 12.12 A Shift to the Right in the IS Curve Shifts the AD Curve to the Right Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-14 Figure 12.13 A Shift to the Right in the LM Curve Shifts the AD Curve to the Right Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-19 Figure 12.16 Percentage Deviations from Trend in the Money Supply and Real GDP for the Period 1959–2006 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-20 Figure 12.18 An Increase in the Demand for Investment Goods in the Sticky Wage Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-21 Table 12.2 Data vs. Predictions of the Keynesian Sticky Wage Model with Investment Shocks Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-27 Figure 12.22 The Keynesian Sticky Price Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-28 Equation 12.1 The quantity of employment N must be consistent with the quantity of output Y and the production function: Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-29 Equation 12.2 Employment is then an increasing function of Y/z and K. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-30 Figure 12.23 Determination of Employment in the Sticky Price Model Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-32