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The Keynesian Model
Chapter 9

John Maynard Keynes and the General Theory
of Employment, Interest and Money

Derivation of the Keynesian AS
Crucial assumption:
If nd is less than ns, W does not fall
 Nominal wages are sticky downwards
(Fig. 9.1)
1.
2.
3.
4.
5.
6.
We start from an initial given point (P0,Y0) in
the (P,Y) space.
Increase P0 to P1. If nd > ns, W increases so that
W/P remains the same.
W1/P1 = W0/P0 and we have now (P1,Y0).
Now, let us decrease P0 to P2. In the very short
run, the real wage W0/P2 is associated with nd<ns,
and the wage does not fall (Keynesian assumption).
Employment falls to nlow and we have ‘involuntary
unemployment’.
Y falls to Ylow .
Using (P0,Y0) and (P2,Ylow), we derive the
Keynesian AS.
Survival guide fro ISLM with
Keynesian AS
1.
2.
3.
4.
Make all moves in the (i,Y) space and make all
shifts to IS and LM here.
Adjust Y (use the final value) in the (P,Y) space.
The AD shifts to keep Y in (I,Y) and (P,Y) spaces
consistent. Here, we get the final P and Y values.
Adjust the expenditure line. Determine if C and I
have changed. Also, determine what happens to
real wages. If nd < ns employment will fall. If nd > ns
nominal wages adjust to ensure that real wage
remains the same.
Interpret the results.
Policy Experiment I
 An increase in G (Fig. 9.2)
1.
2.
3.
4.
The IS curve shifts to the right. Interest rates (i)
increase, Y increases to Y1.
In the (P,Y) space, the AD curve shifts to the
right. Inflation increases (to P1).
The expenditures line shifts up. C increases; I
falls. ns > nd (both at W0/P0 and W0/P1 ), so W does
not change and real wages fall but employment
increases. Note the Keynesian multiplier effect.
Results: An increase in G increases employment,
C and Y. But I and real wages fall.
Policy Experiment II

An increase in M (Fig. 9.3)
LM shifts to the right and interest rates decrease.
2. In the (P,Y) space, the AD curve shifts to the right.
Inflation increases (to P1) and Y increases.
3. The expenditures line shifts up. C and I increase.
ns > nd (both at W0/P0 and W0/P1 ), so W does not
change and real wages fall but employment
increases.
4. Results: A monetary expansion as a tool of
demand-side stabilization is effective in increasing
Y and employment.
 Overheating (Fig. 9.4)
1.
Policy Experiment III

Engineering a soft-landing (Fig. 9.5)
Policymakers are trying to cool down the
overheated economy. The Fed contracts money.
1.
2.
3.
4.
LM2 shifts to the left (to LM1) and interest rates increase to
ihigher. Y falls to Ymoderate. Since monetary policy works with a
significant and variable lag, this process can take from 6
months to 2 years (Milton Friedman).
In the (P,Y) space, the AD curve shifts to the left (Ymoderate).
Inflation falls (to Pmoderate).
The expenditures line shifts down. C falls as Y declines, and
I falls as a result of higher interest rates. Since P falls, real
wages increase and employment falls to nlower.
Results: If the economy can be stabilized at Ymoderate,
Pmoderate, and nlower, then we can have a successful softlanding. Because contractionary fiscal policies involve
longer-term decision making and longer implementation
lags, monetary contraction remains the policy of choice to
engineer a soft-landing.
Policy Experiment IV

Engineering a soft-landing (Fig. 9.6):
When low interest rates no longer work!
Assume that consumer and investor confidence levels have
fallen dramatically (e.g. as a result of SAP bubble).
1.
IS0 shifts to the left (to IS1) and interest rates and Y fall.
2.
The Fed increases M and lowers interset rates further to
revive Y. Interest rates are at ifinal (very low rates) and Y
stabilizes at Yfinal , which is still lower than the initial level,Y0.
3.
In the (P,Y) space, AD0 shifts to ADfinal and P falls to Pfinal .
4.
The expenditures line shifts down. Cfinal is lower than C0 ,
and Ifinal is lower than I0 (assuming the effect from the fall in
investor confidence dominates the effect from the fall in
interest rates). As P increases, real wages increase so
unemployment increases.
5.
Results: We get a situation similar to the liquidity trap.
Expansionary monetary policy is impotent! Example: The
U.S. by late 2008.
The Phillips Curve

A negative relationship between the
rate of inflation and changes in
unemployment (published in a 1958
article by William Phillips).
 Consistent with the predictions of
the Keynesian model.
 Led to the (controversial) outputinflation tradeoff.
The Yield Curve and the Keynesian
Paradigm


Upward slopping yield curve: Often, indicative of an
economy in the early stages of a sustained recovery.
As the AD increases (as a result fiscal or monetary
expansion), the rate of inflation is expected to increase so
lenders will incorporate this in their decisions of long term
loans (the Fisher effect). Thus, long-term rates are higher
than short term rates.
Inverted yield curve: Often, indicative of an impending
recession.
(See experiment III) When the Fed engineers soft-landing,
lenders see that short-term interest rates (controlled by the
Fed) are going up and so they expect a recession or at least
a slowdown of the economy. This will eventually decrease
the rate of inflation so expectation of less future inflation
leads to lower nominal long-term interest rates.
The Great Depression:
Four Policy Mistakes
Wage Floors
2. Tax Increases and Decreases in
Government Spending
3. Liquidity Crisis
4. The Smoot-Hawley Act of 1930
1.


Could a Great Depression happen again?
Discussion: Article 9.3