Lecture Notes on Macroeconomics ECo306 Spring 2014 Ghassan DIBEH

Chapter 5: IS-LM with Variable Prices In the Keynesian model, that we developed up till now (chapters 3 and 4), we did not consider the determination of the price level. Actually, Keynes assumed that money wages in the capitalist economy were rigid and hence the price level was constant. New post-Keynes developments in the field attempted to include price dynamics into the economic models that would bring full employment in the long-run came. The Neoclassical synthesis introduced price flexibility into the Keynesian system to derive stabilizing forces that operated in the long-run in the capitalist economy.

The Aggregate Demand Function According to Keynes, workers care about their relative position in the wage structure and bargain with employers over the money wage. In this view of the labor market as contractual with nominal wages fixed for a period, the price level is assumed constant. In this respect, the classical assumption that labor markets determine the real wage was considered unrealistic by Keynes as workers have no power over the determination of the real wage. Given such view of the labor market, we add the following closure equation to the IS-LM model: 𝑷= 𝑷

The Aggregate Demand Function Now we allow in the IS-LM model, the possibility of a change in P. The first step in the construction of the new IS-LM model is including explicitly P to deflate the nominal variables in the model. The only nominal variable in the model is money. The money demand function then becomes the demand for real money balances ( 𝑴 𝑷 ). Equilibrium in money markets becomes: ( 𝑴 𝑷 ) 𝒅 = 𝑴 𝑷 OR 𝑴 𝑷 =𝑳(𝒚,𝒓)

The Aggregate Demand Function This makes the LM curve a function of: 𝑴 𝑷 𝑐 1 𝑦− 𝑐 2 𝑟= 𝑀 𝑃 𝒓= 𝒄 𝟏 𝒄 𝟐 𝒚− 𝟏 𝒄 𝟐 𝑴 𝑷 (LM Curve) Graphically, the LM curve can be represented as LM(P) with different LM curves for different price levels:

The Aggregate Demand Function For 𝑃 0 > 𝑃 1 > 𝑃 2 > 𝑃 3 , the LM curves shift to the right as P decreases. The reason is that as the price level goes down, the real money balances increase shifting the LM to the right (the equivalent of increasing M in the fixed price model).

The Aggregate Demand Function The change in the LM function, given an IS function, produces a set of points (𝑦, 𝑃) that correspond to equilibrium in money and goods markets. These form the aggregate demand function (AD)

Algebraic derivation of the aggregate demand function The IS curve is given by: The equilibrium ( ) gives: The effect of is to shift the AD curve.

Algebraic derivation of the aggregate demand function Algebraically, these can be written for respectively In the AD framework the Keynesian model can be represented by the following AD and AS functions respectively

Algebraic derivation of the aggregate demand function Graphically, The Keynesian Underemployment Equilibrium. The condition 𝑃= 𝑃 is equivalent to a horizontal aggregate supply function.

The Neoclassical Synthesis In the aftermath of Keynes’s theory of macroeconomics, the field was divided sharply between the Keynesians and the few outposts of remaining classical economists (especially after WWII) in academia and government. On one side, the Keynesians believed that the capitalist economy generated underemployment equilibrium in the normal state of affairs and that government has a role to play in curing recessions through monetary and fiscal policies. On the other side, the classicals believed the economy is inherently stable and markets generate full employment and hence governments’ fiscal and monetary policies are not needed but furthermore are actually harmful.

The Neoclassical Synthesis In the 1950’s and 1960’s a synthesis between the two traditions arose called the Neo-classical synthesis. The synthesis allocated the temporal domains of the applicability of both theories. In the short-run, Keynesian economics were valid and in the long-run the classical model. The synthesis can be summarized as follows: In the Short run 𝑷= 𝑷 In the Long run, P is flexible.

The Neoclassical Synthesis In the SR, Keynesian economics applied but as prices adjusted in the long- run, the classical world dominated. The macroeconomic equilibrium can then be represented as follows: There are two aggregates supply functions: a short-run aggregate supply (SRAS) and a long-run aggregate supply (LRAS). The economy in the long run will adjust to 𝑌 𝐸 = 𝑌 𝑓 .

The Keynes and Pigou Effects In the above model, there is in the short-run the possibility that the economy due to certain level of aggregate demand (given by mpc, MEC and r) is in underemployment equilibrium at point A where 𝑌 𝐸 < 𝑌 𝑓 The question is then: How does the economy move from point A to point C?

The Keynes and Pigou Effects The traditional Keynesian approach is through fiscal and monetary policies. The increase in G or M will shift AD to the right until 𝑌 𝐸 = 𝑌 𝑓

The Keynes and Pigou Effects Or, and here comes the Neoclassical synthesis, the price level will adjust downward until the economy is again at equilibrium point C where 𝑌 𝐸 = 𝑌 𝑓 The Neoclassical synthesis advanced that there are two mechanisms by which the economy, through flexible P, will move to full employment equilibrium:

The Keynes and Pigou Effects 1- The Keynes effect: Keynes in the GT, discussed the possibility that a reduction in the price level leading to an increase in real money ( 𝑀 𝑃 ) would lead to a reduction in the interest rate and the movement of the economy to full employment. Graphically, the Keynes effect can be seen in the IS-LM model: Algebraically: The reduction in 𝑃 will increase the real money supply shifting the LM curve to the right until 𝑌 𝐸 = 𝑌 𝑓

The Keynes and Pigou Effects 2- The Pigou effect: . In 1943, Arthur Pigou published a paper that argued that the effect of a reduction of the general price level was to increase the real wealth of consumers and hence would increase aggregate consumption. The increase in C would cure recession and bring the economy back to full employment equilibrium. This is called the Pigou effect or the real balance effect. Given the community’s wealth as then the real wealth is and the consumption function can be written as: and the IS curve then becomes:

The Keynes and Pigou Effects Graphically, the IS curve shifts to the right when the 𝑃 goes down. Hence the falling price level will lead to an increase in AD that will push the economy to full employment. Algebraically the AD demand function becomes with the Pigou effect:

The Keynes and Pigou Effects The combined effects would make the adjustment of the economy along the AD function faster