3rd Lecture: macroeconomic fluctuations, traditional Keynesian theory National and Kapodistrian University of Athens Department of Economics Master Program in Applied Economics UADPhilEcon Keynesian theories 3rd Lecture: macroeconomic fluctuations, traditional Keynesian theory Nikolina Kosteletou

Basic assumptions and characteristics Prices and wages are not perfectly flexible. Nominal stickiness Nominal rigidities Slow-moving nominal adjustments →real effects on output and employment.

Keynesian models: basic relationships among aggregates Static models Demand side is important (goods market, money market – effective demand) Supply side (labor market, employment, output)

Keynesian models From the Keynesian cross to the IS-LM model From the IS-LM to the AD-AS model.

Aggregate Demand and Supply AS AD Y

From the Keynesian cross to the IS-LM Keynesian cross: demand side (no money) Real values matter Prices are constant Planned and actual expenditure Expenditure - output Equilibrium E: planned real expenditure

equilibrium E: planned real expenditure. In equilibrium planned expenditure is equal to actual expenditure. Actual expenditure is equal to output, Y. In equilibrium planned expenditure is equal to the economy’s output. E=Y If actual expenditure is greater than planned → inventories. Firms cut their production. → Keynesian cross

Keynesian cross E E=Y E A 45o Y

Planned expenditure E Components: C, I, G (closed economy) C=C(Y-T) I=I(i-πe) G, T exogenous Standard specification of E: E=C(Y-T) + I(i-πe) + G

General specification of planned expenditure E = E(Y, (i-πe), G, T) Assumptions about the effect of changes of determinants of components, on expenditure: 0<EY<1, Ei-πe <0, EG>0, ET<0.

IS Relates Y and i for which planned expenditure is equal to actual expenditure. The slope of the IS is negative: Y=E(Y, (i-πe), G, T) dY/di=(∂E/ ∂ Y)∙(dY/di) +(∂ E/ ∂(i-πe)) ∙(d(i-πe) /di) ⇒ dY/di=(∂ E/ ∂ Y)∙(dY/di) + Ei-πe dY/di= Ei-πe /1-EY <0

dY/di= Ei-πe /1-EY Slope of IS: di/dY= (1-EY)/ Ei-πe <0 the is flatter The larger is EY and the larger is Ei

i E E=Y E A 45o Y Y

LM Combinations of Y and i that lead to equilibrium the money market for a given price level. Money: high powered money (currency and reserves issued by authorities) (money base, reserve money)

Demand for real money balances (M/P)d=L(i,Y) Li<0, Ly>0 (M/P) d=(M/P) s=M/P Slope of the LM di/dy

d (M/P)/di = (∂L/ ∂i)(di/di) + (∂L/ ∂Y)(dY/di) ⇒ (M/P)=L(i,Y) Slope of the LM: d (M/P)/di = (∂L/ ∂i)(di/di) + (∂L/ ∂Y)(dY/di) ⇒ 0= (∂L/ ∂i) +(∂L/ ∂Y)(dY/di) 0 = Li + Ly(dY/di) )(dY/di) ⇒ dY/di = -Li/Ly >0

i LM Y

dY/di = -Li/Ly >0 LM steeper: the larger is Ly (classical case) the smaller is Li LM flatter: the smaller is Ly the larger is Li (Keynesian case)

Elasticity of the demand for money With respect to income: (d(M/P)/M/P)/(dY/Y) %(M/P)/%Y dln(M/P)/dlnY =0 (flat LM) i dY/di = -Li/Ly >0 LM Y

Elasticity of the demand for money With respect to the interest rate: (d(M/P)/M/P)/(di/i) %(M/P)/%i dln(M/P)/dlni =0 (vertical LM) i LM dY/di = -Li/Ly >0 Y