1 Chapter 12: Keynesian Business Cycle Analysis Focus: Why are prices and wages sticky in the short run? Efficiency Wage, Menu Cost, Monopolistic Competition What causes business cycle? Should government intervene?

2 Reasons for sticky wages: 1) Minimum Wage, Unions etc. 2) Turnover Cost 3) Efficiency Wage Basic idea behind efficiency wage is that workers’ productivity depends on wage. Higher the wage, more effort a worker puts in and thus higher his productivity.

3 Reasons for positive association between wage and effort: 1) Gift Exchange Motive, Higher Morale 2) Shirking (or getting fired) is costly Effort curve relates the amount of effort to the real wage, and it is upward sloping. Efficiency wage is the real wage which maximizes the workers’ effort per unit of real wage.

4 Reasons for price stickiness: 1) Monopolistic Competition 2) Menu Cost With monopolistic competition, a profit maximizing firm charges price (P) higher than its marginal cost (MC): P = (1+ ή )MC, where ή is called markup.

5 According to Keynesian economists, business cycle is mainly caused by fluctuations in aggregate demand – factors which shift IS or LM curves. These factors include changes in confidence of consumers or businessmen, changes in government expenditure, money demand and supply etc.

6 Predictions of Keynesian model are consistent with many business cycle facts. The main short-coming of the Keynesian model is that it predicts labor productivity to be anticyclical, while empirically it has been found to be procyclical. Labor hoarding – tendency of firms to keep more workers than necessary during recession – can generate procyclical labor productivity in Keynesian model.