Download long run

XVII. New Keynesian Economics
XVII.1 AD – AS model once again
• Agregate demand : both in long and short term
decreasing function of price
• Agregate supply
– In the long run – vertical at potential product
– In the short term – horizontal at the level of fixed
price
• Shifts of AD (because of monetary or fiscal
policy)
– In the long run does not change product, but a price
level
– In the short run changes product (and employment),
but price remains constant
AD shifts – short run
P
P1
E2
E1
SRAS
AD1
AD 2
Y2
Y1
Y
AD shifts - long run
LRAS
P
P1
E1
P2
E2
Yf
AD1
AD 2
Y
Long term equilibrium
P
LRAS
E
SRAS
AD
Yf
Y
From short to long run (1)
• Short run equilibrium:
– AD equals AS, quantity adjustment, AS adjusts to
AD
– Price fixed, equilibrium as state of rest, on the labor
market an excess supply might exist
(unemployment)
– Product might be lower than potential (natural)
• Long run equilibrium:
– AD equals AS
– Prices adjusted, so that on all markets supply equals
demand
– Product on potential (natural) level
From short to long run (2)
Intuitive interpretation:
• Fixed price: either depression (Keynes) or a
very short run, when prices (wages) are
sluggish in any economy and (almost) in any
situation (except e.g. hyperinflation)
• Long term equilibrium – prices and wages had
to react to changes in demand and supply on
various markets (including labor market) and
cleared the markets through its adjustment
Aggregate supply in short to medium
run
• Adjustment process (from short to long run)
takes some time  question
– How is the aggregate supply specified in this
transition period?  increasing function of price
• No unified theory till today
– Neoclassical synthesis: downward wage and price
rigidities (no market clearing)
– Phillips curve: adaptive expectations hypothesis
– New Classical Economics: market clearing, rational
expectations, Lucas’ AS
– End of 1980s – revival of Keynes: “The New
Keynesian Economics” (NKE)
Another view on the same problem …
• In the very long run: economy always at natural levels, AS
vertical
• If AS positively sloped → money is not neutral, i.e. increase
of money supply increases output (and price) and vice-versa
• Beginning of 1990s: NKE, 2 questions:
– Is money non-neutral? Do we build the theory that denies classical
dichotomy?
– Do real market imperfections determine economic fluctuations
• The second question defines NKE: theoretical explanation of
market imperfections and the link to deviations from
natural values
– Prices are not fixed (adjust slowly, etc.) because of short run, but
because of market imperfections
– Not unified theory, rather many different models and in next parts,
Mankiw’s textbook is followed (see Literature)
XVII.2 Nominal wage rigidity
• Originally: F.Modigliani (1944) – downward
wage rigidity
• In general: wages rigid in both directions,
reasons:
– Long term wage contracts, eventually
implicit contracts, power of the unions
• Intuitively: if wages rigid, then price increase
lowers real wage  firms increase employment
 product increases and supply increasing
function of the price
Wage: targeted and actual
Wage negotiations:
• Always negotiated nominal wage at the expected price
Pe , so both firms and workers have in mind targeted
real wage, so wT a W = wT . Pe
• Employment given by demand  firms then decide
according price P
- (W/P) = wT . (Pe /P)
– if P = Pe , then (W/P) = wT
– if P > Pe , then (W/P) < wT
– if P < Pe , then (W/P) > wT
– Unexpected growth of price means fall of real wage
 higher employment  higher product;
conversely, fall of price  lower product
Higher price  higher AS (and vice versa)
W/P
W1
P2
W1
P1
P
B
A
N2
N1
Y
AS
ND
N
 
Y=F K,N
Y1
Y2
N2
N1
N
P1
P2
A
B
Y2 Y1
Y
From wage to AS
• Difference between actual and expected
price reflects price movements
– One possible interpretation – if in moment t,
expectation equals price, than actual price,
determining real wage, is price in moment
t+1
• Generalization:

Y=Yf + P-P
e
,
 >0
• Counter cyclical movement of real wage
XVII.3 Wrong perception of price
level by workers
Starting assumption – firms always know
prices, workers only expect them and will
know real price only with a time lag
• Demand for labor N D =N D W P 
e
S
S
N
=N
W
P
• Supply of labor


W W P
• Always P = P . P and ratio P P e reflects
a degree of wrong perception of price
level by workers
e
e
Model (1)
• Demand for labor: decreasing function of
real wage
• Supply of labor: increasing function of
expected real wage, can be written as




e

N =N W P =N W P . P P 
S
S
e
S
– Labor supply curve shifts according the
e
P
P
ratio
• Model assumes simultaneous clearing of
all markets
Wrong price perception: price
increase
N1S
W/P
N S2
W P 1
W P 2
N D =N D W P 
N1
N2
N
• Demand – decreasing
function od real wage
• Supply – increasing
function ofW P .P P e 
S
• N1 initial supply
• Unexpected price
increase  labor
supply shifts to the
right  real wage fall
 new equilibrium
with higher
employment
Model (2)
• Price increase  employment increase
• AD – increasing function of price
• In general again Y=Yf + P-P e  ,  > 0
AS
P
Yf
Y
XVII.4 Incomplete price
information
Assumptions:
• No difference between firms and workers
• On the markets, agents know
– Very well the price of goods they produce
– Not so well the price of most other goods
• Agents produce one good and consume
many goods
Basic idea
• Unexpected increase of overall price level, then
each agent
– As producer perceives the increase of the price of
“its” product and feel incentives to increase
production
– As a consumer doesn’t perceive the price increase as
an overall one, as he doesn’t know all other prices
• In general – at change of absolute price level
agent wrongly assumes the change of only
relative prices (of “his” product)  increases
supply because of increase of price
• Formally again
 ,
Y=Yf + P-P
e
 >0
XVII.5 Sticky-Price Model
• Starting point: no perfect competition, different
reasons for prices being sticky → firms are able to
set their prices (at least to some extent)
– i.e., firms have some degree of monopoly
• Two prices: overall level P, individual price of the
firm p
• p determined by P and by deviation of output form
natural level
– higher output → higher marginal costs → higher p
p = P + a(Y – Yf) , a>0
Sticky and flexible prices
• Firms are price setters and some of them
face sticky prices, some of them face
flexible prices, i.e. they must react to
change in demand, but can set their price
(do not take it from the market)
• Flexible prices: p = P + a(Y – Yf)
• Sticky prices: p = Pe , i.e. firms, when
setting a price that will remain sticky, set
the price to the expected overall level
Price level determination
• Suppose that s – fraction of firms with sticky
prices (0<s<1)
• Overall price level – weighted average of
prices, set by the different groups of firms:
P = sPe + (1-s)[P + s(Y-Yf)]
• Subtracting (1-s)P from both sides and
dividing by s:
P = Pe + [(1-s)a/s](Y-Yf)
Interpretation
• Pe high → P high: when firms with sticky prices
expect high prices, they set their price high and
contribute to the high overall price level
• Output high → demand high → firms with
flexible prices set them high, again high overall
level P

Y  Yf   P  P
e

s
, 
1-s a
• Pro-cyclical movements of real wage
XVII.6 Summary
• Particular models of short term
aggregate supply differ, but do not
exclude each other exclusively
• All models generate AS that – in the short
run – is increasing function of price


Y=Yf + P-P e ,  >0
Interpretation

Y=Yf + P-P
e
,
 >0
• Variations from potential (natural) product are
proportional to variations of actual price from
expected one
• Actual price higher than expected  product
higher than potential; and vice versa
• In graphical terms: short term AS is increasing,
slope 1 
• Expected price becomes a model parameter
– When actual and expected price equal, product on
potential level
– Change of expected price shifts AS curve
• Dynamics
AS in long and short term
P
LRAS
AS
Pe
Yf
Y
Literature to Ch. XVIII
• Mankiw, Macroeconomics, Ch.13
• Snowdon, Vane, Modern Macroeconomics,
Ch.7 Read parts 7.1 – 7.4. In subsequent parts the NKE
is discussed in much more detail and from a slightly
different angle
• See references in Snowdon and Vane