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New-Keynesian Theory of
Aggregate Supply
Efficiency Wages
Learning Objectives
• Understand how efficiency wages affect the
slope of the aggregate supply curve.
• Learn to derive the short run aggregate supply
curve.
• Understand the relationship between the short
run and long run aggregate supply curves.
• Learn why money is not neutral in the newKeynesian model.
Aggregate Supply with Efficiency
Wages
• The new-Keynesian theory of aggregate
supply is based on the theory of efficiency
wages.
– Firms choose their wages to minimize the
wage bill and then choose employment to
maximize profit.
– Nominal wages, however, are sticky; ie., they
do not change as frequently as employment.
Y=F(L)
Y
Y
Y1
0
w/P
L 0
P
L1
Y1
Y
Y1*
Y
LS
U*
w1/P1*
P1
LD
0
L1*
LS
L 0
Deriving the Modern Aggregate
Supply Curve: Efficiency Wages
• We begin at the price level P1 where w1/P1*
is the efficiency wage.
• At w1/P1*, the level of unemployment is at
the natural rate of U*.
– L1 people are employed and LS minus L1* are
unemployed.
• Output equals Y1 at the price level P1.
Y=F(L)
Y
Y
Y2
Y1
0
w/P
L 0
P
L1 L2
w1/P1*
AS
LS
U*
Y
Y1 Y2
P2
U
w1/P2
P1
LD
0
L1* L2
L 0
Y1* Y2
Y
Deriving the Modern Aggregate
Supply Curve: Efficiency Wages
• Let the price level increase to P2 .
• Since nominal wages do not change, the
real wage falls to w1/P2.
• Firms try to hire more workers while
households send fewer workers to the labor
market.
• Unemployment falls below U*.
• Output rises to Y2 at the price level P2.
Y=F(L)
Y
Y
Y2
Y1
Y3
0 L 3 L1 L2
w/P
w1/P3
w1/P1*
L 0
P
U
Y3
AS
LS
U*
Y
Y1 Y2
P2
U
w1/P2
P1
P3
LD
0 L3 L1* L2
L 0
Y3
Y1* Y2
Y
Deriving the Modern Aggregate
Supply Curve: Efficiency Wages
• Let the price level decrease to P3 .
• Since nominal wages do not change, the
real wage rises to w1/P3.
• Firms reduce employment while households
send more workers to the labor market.
• Unemployment rises above U*.
• Output falls to Y3 at the price level P3.
The Modern Aggregate Supply
Curve: Efficiency Wages
• Summary:
– When nominal wages are sticky, a rise in the
price level results in higher levels of output,
and a fall in the price level results in lower
levels of output.
– When we plot the price level/output
combinations, we get an upward sloping
aggregate supply curve.
– Nominal wage is constant on any given
aggregate supply curve.
The Modern Aggregate Supply
Curve: Efficiency Wages
• Summary:
– When the real wage equals the efficiency wage,
unemployment is equal to its natural rate, and
the quantity of output produced is called the
“natural rate of output.”
– The natural rate of unemployment and output
depend only on the fundamentals of the
economy: preferences, endowments, and
technology.
The Classical Model and the NewKeynesian Model: Summary
P
LRAS
SRAS
In the classical model, the
aggregate supply curve is vertical.
As a result, any change in
aggregate demand causes a change
in only the price level.
P3
P2
P1
0
3
2
1
Y* Y1
In the new-Keynesian model, the
aggregate supply curve is upward
sloping in the short run.
AD2 As a result, any change in
aggregate demand causes a change
AD1
in both the price level and output.
Y
Economic Policy
• Unlike the classical model according to
new-Keynesian theory, the labor market
may not always be in equilibrium.
– When nominal wages are “sticky,” labor
demand can be less than labor supply.
– As a result, it is possible for macroeconomic
stabilization policies to change the level of
output in the short run.
Y
Y
Y=F(L)
0
w/P
L 0
P
Y
LRAS
SRAS
LS
w1/P1
U*
P1
AD1
LD
0
L1 L*
L 0
Y1 Y*
Y
The New-Keynesian Model
• We begin at the price level P1 where w1/P1*
is the efficiency wage.
• At w1/P1*, the level of unemployment is at
the natural rate of U*.
– L1 people are employed and Ls minus L1 are
unemployed.
• Output equals Y1 at the price level P1.
Y
Y
Y=F(L)
0
w/P
L 0
P
L3 L1
Y
LRAS
SRAS
LS
w1/P2
w1/P1
P1
P2
1
2
AD1
AD2
LD
0
L2 L1 L*
L
0
Y2 Y1 Y*
Y
The New-Keynesian Model: The
Non-Neutrality of Money
• Let the money supply contract, causing the
aggregate demand curve to shift to the left.
• The price level falls to P2, and the real wage
rises to w1/P2.
• Labor demand falls to L2while labor supply
rises.
• Unemployment rises above the natural rate.
• Output falls to Y2.
Y
Y
Y=F(L)
LRAS
0
w/P
L 0
P
Y
SRAS
LS
w1/P1*
w1/P2
P2
P1
2
1
AD2
AD1
LD
0
L1 L2 L*
L 0
Y1 Y2 Y*
Y
The New-Keynesian Model: An
Increase in the Money Supply
• Let the money supply increase, causing the
aggregate demand curve to shift to the right.
• The price level rises to P2, and the real wage
falls to w1/P2.
• Labor demand rises to L2 while labor supply
responds with a lag.
• Unemployment falls below the natural rate.
• Output rises to Y2.
The New-Keynesian Model: The
Non-Neutrality of Money
• A change in the money supply does not cause all
the variables to change in proportion because the
nominal wage is slow to adjust.
• Rather, the change in the money supply causes a
change in production and employment as well as a
change in prices.
• In this model, the economy adjusts through
changes in real variables as well as prices.
Unemployment and Okun’s Law
• The relationship between unemployment
and GDP is expressed by Okun’s Law.
• Okun’s Law says that the percentage change
in real GDP equals 3% - 2 times the change
in the unemployment rate. Why?
– GDP has grown over the long run by 3%, and
Okun found that for every 1% increase in
unemployment real GDP growth fell by 2%.
• % /\ GDPreal = 3% - 2(8% - 6%) = -1%
Theory and Facts
• During the Depression, the price level fell
by 30% and unemployment rose by 25%.
• During the 1930s, wages fell almost as
much as prices.
• Keynesian economists argue that the fall in
wages was slower than the fall in prices.
The Short-Run and the Long-Run
• The upward sloping aggregate supply curve
is a short-run supply curve.
• Why?
– As time passes, nominal wages will adjust to
the excess demand or excess supply.
• If the real wage has fallen because of a rise in the
price level, nominal wages will rise.
• If the real wage has risen because of a fall in the
price level, nominal wages will fall.
Getting from the Short Run to the
Long Run
When the price level is P2, the real wage
is too low and unemployment is below
the natural rate.
w/P
U3
U1*
W1/P3
W1/P1
W1/P2
LS
U2
Firms offer higher nominal wages,
causing unemployment to rise.
When the price level is P3, the real wage
is too high and unemployment is above
the natural rate.
LD
0
L3 L1* L2
L
Firms offer lower nominal wages,
causing unemployment to fall.
Moving to the Long Run
• If the economy continues to under-perform,
unemployment will remain above the natural rate,
and eventually nominal wages will fall.
• As nominal wages fall, production costs fall,
causing the short run aggregate supply curve to
shift to the right.
• Long run equilibrium is established at P0 and Y*.
Y
Y
Y=F(L)
0
w/P
L 0
P
L3 L1
Y
LRAS
SRAS1
SRAS2
SRAS3
LS
w1/P2
w1/P1
P1
P2
P0
2
3
LD
0
L2 L1 L*
L
0
Y2 Y1 Y*
AD1
AD2
Y
Moving to the Long Run
• If the economy continues to out-perform,
unemployment will remain below the natural
rate and eventually nominal wages will rise.
• As nominal wages rise, production costs rise,
causing the short run aggregate supply curve to
shift to the left.
• Equilibrium is established at P0 and Y1, where
w1/P1 equals w2/P0.
Y
Y
Y=F(L)
LRAS
0
w/P
L 0
P
Y
SRAS2
SRAS1
LS
P0
P2
P1
w1/P1
w1/P2
3
2
1
AD2
AD1
LD
0
L1 L2 L*
L 0
Y1 Y2 Y*
Y