Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 12 Keynesian Business Cycle Theory: Sticky Wages and Prices

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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 N d curve.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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 N s curve.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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 N d curve, so N s 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.4 The Effect of an Increase in W or a Decrease in z

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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 Y d.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.5 The IS Curve

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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, M s = M d = M. So M = P L( Y, r). Given Y and P, quantity of money M decreases with r.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.6 Money Demand, Money Supply, and the LM Curve Y 2 > Y 1

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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*.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Shifts in LM Curve An increase in money supply. A decrease in price. A decrease in money demand.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.8 The Effect of an Increase in the Money Supply on the LM Curve For a given Y 1

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.9 The Effect of an Increase in the Price Level on the LM Curve

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure A Positive Shift in Money Demand Shifts the LM Curve to the Left

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 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 (Y 1, P 1 ). With P 2 >P 1, LM curve shifts to left, and two markets reach new equ. at (Y 2, P 2 ). 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Shift of AD Curve - Figure A Shift to the Right in the IS Curve Shifts the AD Curve to the Right

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Shift of AD Curve - Figure A Shift to the Right in the LM Curve Shifts the AD Curve to the Right

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Complete Model - Equilibrium

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure An Increase in the Money Supply in the Sticky Wage Model

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 12.1 Data vs. Predictions of the Keynesian Sticky Wage Model with Monetary Shocks

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Real-Life Case – 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 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 recession.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure Real and Nominal Interest Rates, 1934–2006 Both R and r increases prior to the recession.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Applications Business cycles are caused by AD shocks. Ex: an increase in investment.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 12.2 Data vs. Predictions of the Keynesian Sticky Wage Model with Investment Shocks

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure Long-Run Adjustment of the Nominal Wage

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure Stabilization Policy in the Sticky Wage Model – Monetary Policy

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure Stabilization Policy in the Sticky Wage Model – Fiscal Policy

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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).

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure The Keynesian Sticky Price Model

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 12.1 The quantity of employment N must be consistent with the quantity of output Y and the production function:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 12.2 Employment is then an increasing function of Y/z and K.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure Determination of Employment in the Sticky Price Model

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 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.