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Chapter 12
Keynesian Business Cycle
Analysis: Non-Market-Clearing
Macroeconomics
Economics 282
University of Alberta
Keynesian Approach to
Business Cycles
• One of the central ideas of Keynesism is
that wages and prices are “rigid” or
“sticky”.
• Wage and price rigidities imply the
economy can be away from its general
equilibrium for significant periods of time.
Keynesian Approach to
Business Cycles (continued)
• Keynesians: the stabilization policy is
necessary to minimize recessions.
• New Keynesians: the stabilization policy is
not necessary.
Nominal-Wage Rigidity
• In developing their approach Keynesians
heavily rely on wage and price rigidities.
• Nominal-wage rigidity is a situation when
nominal wages are slow to adjust to
changes in labour demand and supply.
The SRAS Curve and Labour
Contracts
• Labour contracts:
– specify the nominal, as opposed to the real
wage;
– specify employment conditions and nominal
wages for an extended period;
– commit both sides to a nominal wage one to
three years into the future.
The SRAS Curve and Labour
Contracts (continued)
• Employers and workers form rational price
expectations.
• The price and nominal wage are expected
to be P0 and W0. The expected real wage
is W0/P0.
The SRAS Curve and Labour
Contracts (continued)
• If P rises, W/P will be below expected,
more N will be demanded, and more Y
produced.
• Once the term of the contract expires,
employees and firms renegotiate a new
nominal wage.
The SRAS Curve and Labour
Contracts (continued)
• A new expected real wage will be set so
as to clear the labour market.
Y  Y  b(P  P )
e
• Y will differ from Y for the term of the
labour contract.
Price Expectations and the
Keynesian SRAS Curve
• The SRAS must intercept LRAS at the
expected price level.
• The rational price expectation is
determined by the intersection of the
LRAS and the expected position of ADe.
Anticipated Monetary Policy in
the Keynesian Model
• Anticipated changes in money supply:
– will have no effect on real variables;
– they are taken into account during nominal
wage negotiations.
Unanticipated Monetary Policy
• An unanticipated increase in the nominal
money supply causes an unanticipated
increase in aggregate demand.
• Firms respond to the lower real wage by
hiring additional employees and by
expending output.
Unanticipated Monetary Policy
(continued)
• In the new labour contract the price
expectations are revised to the new price
level.
• Money is not neutral in the short run but is
neutral in the long run.
• Wage stickiness prevents the economy
from reaching its general equilibrium in the
short run.
Anticipated Fiscal Policy in the
Keynesian Model
• For Keynesians anticipated fiscal policy
has no impact on real variables.
• In the classical model fiscal policy always
affects employment and output due to
effects on wealth.
Unanticipated Fiscal Policy in
the Keynesian Model
• A temporary, unanticipated increase in
government purchases increases the
demand for goods and reduces desired
national saving.
Unanticipated Fiscal Policy
(continued)
• IS and AD curves shift up and to the right,
P increases, W/P is lower than expected,
employment and output increase.
• As P rises LM curve shifts up and to the
left.
Unanticipated Fiscal Policy
(continued)
• The labour supply and FE line are
unaffected.
• In the long run, contracts are renegotiated.
After the adjustment the output is
unaffected, the price level and the interest
rate rise.
Comparing Monetary and Fiscal
Policy
• Both fiscal and monetary policies are
aggregate demand policies.
• Both policies, if unanticipated, affect
output and employment in the short run
but are neutral in the long run.
Comparing Monetary and Fiscal
Policy (continued)
• Easy fiscal policy expands output through
the multiplier effect and despite the effect
of fiscal policy on the interest rate.
• Easy fiscal policy increases interest rate
and crowds out both consumption and
investment spending.
Comparing Monetary and Fiscal
Policy (continued)
• Monetary policy does not affect
consumption and investment spending in
the long run.
• Unanticipated fiscal expansion, by causing
real interest rates to increase, crowds out
consumption and investment spending.
Criticisms of the Nominal Wage
Rigidity Assumption
• Less than a third of the labour force in
Canada is covered by contracts.
• Many labour contracts contain cost-ofliving adjustments (COLAs).
Criticisms (continued)
• According to the model prediction real
wages should be countercyclical.
• Keynesians respond by incorporating
productivity shocks and by assuming price
stickiness.
Price Stickiness
• Models of nominal price rigidity:
– explain evidence of a procyclical movement of
real wages;
– while also explaining how aggregate demand
shocks can play an important role in
explaining business cycles.
Price Stickiness (continued)
• Prices are sticky because firms, after
establishing a price for their output, find it
is in their best interest not to adjust that
price even though there has been a
change in demand for their output.
Price Stickiness (continued)
• Flexible-price firms respond to increase in
aggregate demand by increasing price.
• Fixed-price firms respond to increase in
aggregate demand by increasing output.
Y  Y  b(P  P )
e
Monopolistic Competition
• A price taker considers the market price as
given.
• A price setter has some power to set price.
• Perfect competition is a situation in which
all buyers and sellers are price takers.
Monopolistic Competition
• Monopolistic competition is a situation in
which individual producers can act as
price setters:
– there is some competition;
– but a number of sellers is smaller;
– and standardization of the product is
imperfect.
Monopolistic Competition
(continued)
• Keynesians point out that a relatively small
part of the economy is perfectly
competitive.
Monopolistic Competition
(continued)
• A price-setter:
– sets a price in nominal terms for some period
of time;
– meets the demand that is forthcoming at the
fixed nominal price
– readjusts its price from time to time.
Menu Cost and Price Setting
• A menu cost is a cost of changing prices.
• If the loss in profits is less than the cost of
changing prices – menu cost – the firm will
not change its price.
Empirical Evidence of Price
Stickiness
• Major reasons of price stickiness are
menu costs and a reluctance of managers
to lead price changes.
• A pass-through from the exchange rate to
domestic prices is slow or incomplete.
Meeting the Demand at the
Fixed Nominal Price
• A monopolistically competitive firm
charges a price higher than its marginal
cost (at a markup).
• When prices are sticky, firms react to
changes in demand by changing the
amount of production, rather than
changing prices.
Meeting the Demand
(continued)
P  (1  η)MC
• The economy can produce an amount of
output that is not on the full-employment
line.
Keynesian Business Cycle
Theory
• Keynesians believe that a primary source
of business cycle fluctuations is
unanticipated shifts in the aggregate
demand curve – aggregate demand
shocks.
• Keynesians attribute recessions to “not
enough demand” for goods.
Keynesian Business Cycle
Theory (continued)
• The Keynesian theory accounts for several
business cycle facts:
– recurrent fluctuations of Y in response to AD
shocks;
– employment fluctuates in the same direction
as Y;
– shocks to M are non-neutral, money is
procyclical and leading.
Keynesian Business Cycle
Theory (continued)
• Cyclical behaviour of durable and
investment goods can be explained if
shocks to them are themselves a main
source of cycles.
Keynesian Business Cycle
Theory (continued)
• Inflation tends to slow during or just after
recessions because demand pressure is
low during recessions.
Procyclical Labour Productivity
• This approach has a problem to explain
the fact that labour productivity is
procyclical.
• If the production function is stable,
increases in employment during booms
should reduce average labour productivity,
so it should be countercyclical.
Procyclical Labour Productivity
(continued)
• Firms may hoard labour during recessions
and use it less intensively. So, labour
productivity falls during a recession.
• Labour hoarding is found to be reduced in
the last two recessions in Canada.
Macroeconomic Stabilization
• According to Keynesians recessions are
undesirable, employment can be below
the amount of labour that workers want to
supply.
Macroeconomic Stabilization
(continued)
• Average economic well-being would be
increased if governments tried to reduce
cyclical fluctuations.
Macroeconomic Stabilization
(continued)
• Under no AD policy wages and prices will
be eventually cut in the long run.
• While the adjustment process takes place
economic well-being is reduced.
Macroeconomic Stabilization
(continued)
• If prices adjust slowly and the fiscal or
monetary policies can be implemented
quickly, the AD policy could move the
economy back to full-employment output
more quickly than doing nothing.
Difficulties of the Policy of
Macroeconomic Stabilization
• Actual macroeconomic stabilization is less
successful than Keynesian theory
suggests:
– monetary and fiscal policies should be
coordinated;
– depth of a recession is difficult to measure;
– the size of effects of monetary and fiscal
policies is not known.
Difficulties of the Policy
(continued)
• Monetary and fiscal policies have lags.
• Policymakers should concentrate of
fighting major recessions.
• Policymakers should be willing to take
economic advice.
Supply Shocks in the Keynesian
Model
• In 1970s Keynesian theory failed to
account for the stagflation.
• The theory predicts that inflation
movements are procyclical.
Supply Shocks (continued)
• Keynesians admit that there can be
occasional episodes when supply shocks
play a primary role in economic
downturns.
• An adverse supply shock reduces MPN
and demand for labor. The FE line and
LRAS curve shift to the left.
Supply Shocks (continued)
• The adjustment takes place slowly.
• In the long run, full-employment output
falls, the price level and the real interest
rate increase.
Supply Shocks (continued)
• In the situation of adverse supply shock
fiscal and monetary policies can offer little
help.
• An unanticipated contractionary AD policy
can reduce the size of increase in the
price level, but it can cause a fall in output
below the new full-employment level.
End of Chapter