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Chapter 12
Keynesian
Business Cycle
Theory: Sticky
Wages and Prices
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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.
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Rigidity of Wages in SR
• The nominal market wage is imperfectly flexible.
– Institutional rigidity in how nominal wages are set. Costly to
bring firms and workers together to renegotiate contract terms.
So nominal wages are normally set at a yearly basis.
– Costly to write complicated contracts.
Ex1: most nominal wages are not completely inflation-indexed
in U.S. even though the cost of doing so is low.
EX2: imperfect information
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Figure 12.1 The Labor Market in
the Keynesian Sticky Wage Model
w*: market actual real wage
set in the past, with expectation
that it would be market-clearing
real wage.
N**: employment that firms are willing
To hire at w = w*.
N*: employment that workers are
Willing to supply at w = w*.
N** - N* = Keynesian Unemployment
if employment is determined by Nd curve.
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Figure 12.2 The Labor Market in the
Keynesian Sticky Wage Model When
There Is Excess Demand
N* - N** = Keynesian Unemployment
if employment is determined by Ns curve.
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Aggregate Supply Curve
• Since nominal wage W is fixed in the SR, the
real wage W/P depends on price level.
• Employment N is determined by Nd curve, so Ns
curve is ignored in determination of N (Output
in this model does not depend on real interest
rate r.
• For a given N, output Y is determined by
production function.
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Figure 12.3 Construction of the
Aggregate Supply Curve
AS curve implies that given a fixed nominal
wage, an increase in P reduces real wage,
which increases labor demand, and therefore
employment. Hence, output rises.
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Figure 12.4 The Effect of an
Increase in W or a Decrease in z
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IS Curve
• With higher real interest rate, future
consumption becomes relatively cheaper to
current consumption. Substitute current
consumption for future consumption.
• Higher real interest rate reduces the investment
made by firms.
• Negative relationship between r and Yd.
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Figure 12.5 The IS Curve
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LM Curve
• Assume no LR inflation, so R = r by Fisher Equ.
• Real money demand = L( Y, r), increases with Y,
and decreases with r (recall Ch 10).
• In money market, at equilibrium, Ms = Md = M.
So M = P L( Y, r).
• Given Y and P, quantity of money M decreases
with r.
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Figure 12.6 Money Demand,
Money Supply, and the LM Curve
Y2 > Y1
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Figure 12.7 Determination of r
and Y Given P
For a given P, the goods market
and money market are both in
equilibrium at the point where IS
and LM curves intersect at Y=Y*,
r=r*.
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Shifts in IS Curve
•
•
•
•
•
An increase in current G.
A decrease in current T.
An anticipated increase in future income.
A decrease in the current K.
An increase in future z
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Shifts in LM Curve
• An increase in money supply.
• A decrease in price.
• A decrease in money demand.
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Figure 12.8 The Effect of an Increase
in the Money Supply on the LM Curve
For a given Y1
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Figure 12.9 The Effect of an Increase
in the Price Level on the LM Curve
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Figure 12.10 A Positive Shift in Money
Demand Shifts the LM Curve to the
Left
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Figure 12.11 The Aggregate
Demand Curve
IS-LM diagram is constructed
for a given P.
P affects the position of LM
curve, not IS curve.
Initially, two markets are in equilibrium
with (Y1, P1).
With P2>P1, LM curve shifts to left, and
two markets reach new equ. at (Y2, P2).
AD curve implies that an increase in P reduces
real money supply and causes a drop in output
at which two markets are in equ.
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Shift of AD Curve - Figure 12.12 A Shift
to the Right in the IS Curve Shifts the AD
Curve to the Right
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Shift of AD Curve - Figure 12.13 A Shift
to the Right in the LM Curve Shifts the AD
Curve to the Right
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Shift in AD Curve
• Given what we know about the factors that shift the IS
and LM curves and the relation between IS and LM
curves and the AD curves, we know how AD curve
shifts.
• AD shifts to right if
–
–
–
–
–
–
G increases.
Current T decreases.
Current K decreases.
Future z increases.
Ms increases.
Negative shift in money demand function.
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Complete Model Equilibrium
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Nonneutrality of Money
• Money is not neutral in the short run when nominal
wages are sticky.
Example: an increase in 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.
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Figure 12.15 An Increase in the
Money Supply in the Sticky Wage
Model
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Table 12.1 Data vs. Predictions of the
Keynesian Sticky Wage Model with
Monetary Shocks
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Real-Life Case – 1981-1982 US
Recessions
• Under the guidance of the Keynesian theory, in
order to fight against high inflation, Federal
Reserve Banks conducted contractionary
monetary policy, which led to severe recessions
in 1981-1982.
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Figure 12.16 Percentage Deviations
from Trend in the Money Supply and Real
GDP for the Period 1959–2006
A drop in M precedes
the drop in GDP in
1981-1982 recession.
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Figure 12.17 Real and Nominal
Interest Rates, 1934–2006
Both R and r increases
prior to the 1981-1982
recession.
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Applications
• Business cycles are caused by AD shocks.
• Ex: an increase in investment.
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Figure 12.18 An Increase in the Demand
for Investment Goods in the Sticky Wage
Model
With I increases, IS and AD curve shift to
right, leading to higher output Y and price
P.
Higher P leads LM curve to shift to left.
Since Y rises, real money increases. So
the overall effect is IS shifts to right, and
LM shifts to left.
In the labor market, rise in P lowers the
real wage, leading to higher employment.
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Table 12.2 Data vs. Predictions of the
Keynesian Sticky Wage Model with
Investment Shocks
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Government Intervention
• In face of an oil price shock, which leads to a drop in z,
and real wage to be larger than market rate (inefficiency
arises due to presence of unemployment), there are two
types of responses by government.
• Option 1: doing nothing, and let market take its course.
• Option 2: conduct appropriate monetary or fiscal policy
to restore efficiency.
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Figure 12.19 Long-Run
Adjustment of the Nominal Wage
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Option 1 – Long Run Adjustment
• 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.
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Option 2 – Government
Intervention
• 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.
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Figure 12.20 Stabilization Policy in the
Sticky Wage Model – Monetary Policy
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Figure 12.21 Stabilization Policy in the
Sticky Wage Model – Fiscal Policy
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Conclusions
• Since some prices and wages are not perfectly flexible,
supply is not equal to demand in all markets. As a result,
economic efficiency is not always achieved in a world
without government intervention.
• Fiscal and monetary policy can be made quickly
enough, and information on the behavior of the
economy is good enough. Then fiscal and monetary
policy can improve efficiency by countering shocks that
causes deviations from full equ. employment.
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Sticky Price Model
• Firms do not change their nominal prices in the
short run, as this is too costly (menu cost).
• If demand rises, then firms satisfy this demand
by increasing output. As a result, AS curve is
horizontal and outputs are determined by
aggregate demand (AD curve).
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Figure 12.22 The Keynesian
Sticky Price Model
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Equation 12.1
The quantity of employment N must be
consistent with the quantity of output Y and the
production function:
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Equation 12.2
Employment is then an increasing function of
Y/z and K.
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Figure 12.23 Determination of
Employment in the Sticky Price Model
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Figure 12.24 The Effect of an Increase in
Total Factor Productivity on Employment
in the Sticky Wage Model
So as z increases, N drops, which is
not consistent with business cycle data.
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