1. X. Neoclassical synthesis

2. X.1 Keynes vs. real world

3. Keynes: theory Macroeconomics Equilibrium with unemployment
Incompatibility with standard microeconomics
It is NOT “General Theory”, but theory for economies in depression
The existence of equilibrium – in a strict sense - depends on assumption of rigid nominal wage

4. Keynes: AD and AS AD (for simplicity, still assume πe=0, i.e. i=r):
in LVII, slide 39, substitute (5) and (6) into (1),
Solve (4) for dr:
and substitute into (1) as well; we obtain:
AS: in the same slide, substitute (3) into (2) (and dK=0):
In AD schedule, increase of P implies decrease of Y, in AS schedule, increase of P implies increase of Y

5. Keynes: equilibrium and policies
In the more general Keynesian model, we can construct standard AD and AS schedules
Equilibrium: AD x AS intersection
However, equilibrium determined by position of AD and does not have to correspond to full employment one
Keynesian policies: shifting AD to the position where it determines equilibrium at full employment P AS
AD2
AD1 Y1 Yf Y

6. Keynes: true legacy for policies
General acceptance of policy recommendations:
Capitalism does not have internal forces to produce at full employment (potential product) continuously
The Governments can and should stimulate the aggregate demand to bring economies closer to full employment
The General Theory (and its ISLM simplification) provides the tools: fiscal and monetary policies

7. First applications During WWII, both in UK and in the USA
White Paper on Employment Policy
William Beveridge: Full Employment in a Free Society
Oxford Institute of Statistics: The Economics of Full Employment
Policy: British budget of 1941, US budgets since 1942

8. Keynes vs. real world (1)
AD and AS above – general version of Keynesian model, AS not very useful for practical for several reasons
Nominal wage given, inflationary expectation also constant
In the short-run: prices and wages rigid for many reasons
Informational problem, slow reaction of firms (do not change prices and wages instantaneously, etc. – see next chapters)
This is true for any point of business cycle, not only for depression
Consequently, in the (very) short-run, wages and prices constant: aggregate supply horizontal - SRAS

9. Keynes vs. real world (2)
In the real world the prices adjust and clear markets, even if in very short run sticky
When capital fixed, then product given by employment, and when after full adjustment of prices and wages labor market is in equilibrium as well, then this (equilibrium) employment determines full employment and potential product
Neoclassical synthesis: in the long-run: aggregate supply vertical (classical) - LRAS

10. X.2 The first attempt – downward nominal wage rigidity
Originally: F.Modigliani (1944) – downward wage rigidity
Reasons for rigid wages in general:
Long-term wage contracts, implicit wage agreements, power of trade unions
Some flexibility upward
Intuitively: if nominal wage rigid, then price increase lowers real wage  firms increase employment  product increases, i.e. demand increasing function of price

11. Franco Modigliani
, born in Rome, when young, immigrated to the USA
MIT
1944: elements of neoclassical synthesis (PhD)
1953: new theory of consumption function (life cycle hypothesis)
1958: contribution to the theory of money, Modigliani-Miller theorem
1985: Nobel price in economics

12. Model
Only for situation when product smaller or equal to potential (full employment) product
Labor market
Either in equilibrium – full employment and potential product
Or product lower than potential, involuntary unemployment  labor supply higher than demand and level of employment determined by demand (when , quantity realized on the market always equal to min (D,S))

13. W/P P AS E E N Y Y N

14. Wage rigidity – weakness of the model
Model explains the relation between the fall or increase of price and aggregate supply, when product lower or equal to potential one
Does not consider the situation, when product temporarily increases above potential level
Real wages move against business cycle

15. X.3 Phillips Curve

16. Dynamic adjustment
Nominal wages aren’t downward rigid forever, but there is a slow adjustment (“beyond the short-run”) → there is an adjustment of labor supply over particular moment of time
1958: A.W.Phillips: The Relation between Unemployment and the Role of Change of Money Wages. British data.
First investigation before Phillips: Irving Fisher already in 1926
Inverse relationship between unemployment and nominal wage change
Phillips: statistical fit for :
data fitted to this curve very well, too

17. Hypothesis
High unemployment: bargaining power of workers during wage negotiations is weak, firms are able to hire additional workers without offering much increase in nominal wage
Low unemployment: bargaining power of firms weak, as to hire more workers they must offer more substantial nominal wage increase
Wage main component of prices
Consequently: high unemployment implies low inflation and vice versa

18. Interpretation
Data seemed to suggest that there is a negative relation between change of nominal wages and unemployment
Two crucial questions:
Is this a stable, long-term relationship, valid for other countries as well (see US data on the next slide, for original Phillips data see Dornbush, Fischer,Startz in Literature to this Lecture)?
Many empirical studies followed
Theoretical explanation of this relationship
Policy consequences:
As in the short run, change in wages determine inflation, is there a trade-off between inflation and unemployment that can be effectively used by policy makers to simultaneously achieve both low inflation and low unemployment?

20. Phillips curve - concept
Note: here, in LX, we present original approach, as emerged after Philips‘ article in 1958
Define unemployment as u≡(NS-N)/NS
Remember: in K. model, we do not include labor supply function, but it exists, as NS(W/P)
However, in a particular moment of time, real wage W/P real wage is known, so value of labor supply NS is known as well (but in general,
N≠ NS)

21. Phillips curve – formalization (1)
From above:
To simplify, suppose discrete time:
and after rearrangement
Nominal wage in the next period is a function of current wage and a ratio current employment N and current labor supply NS

22. Phillips curve – formalization (2)
In words: wage in next period is equal wage in the current period, adjusted for the actual level of employment
At full employment (N=NS), next period wage equals current one
If employment is above full employment, (N>NS), wage in next period increases (and vice-versa)
Speed of adjustment – parameter ε
Formally: at present, W, NS constant  linear relation (WN line), with positive slope, between W+1 and N
ε large, WN steep. Ε small, WN approaches horizontal

23. Wage adjustment WN always passes through (NS,W)
If NNS, WN shifts in time

24. X.4 Dynamic aggregate supply

25. From wages to prices Short-term: labor costs - the only variable costs
Price determined by current labor costs plus a mark-up z > 0 (e.g. profit, embedded in price)
Simplification (for this chapter only) - production function with fixed coefficients:
a ... labor productivity
labor costs per unit of output: (1/a).W
Price (with incorporation of mark-up)

26. Dynamic AS (1) Building blocks Phillips curve:
Link from wages to prices:
Additional assumption: output and unemployment closely linked (in next Lectures Okun’s law):
, ω>0
Combining three equations above, see next slide

27. Dynamic AS (2) Remember then combining the three equation and
rearranging:
Simplifying as

28. Dynamic AS (2)
In words: price in the next period is equal price in the current period, adjusted for the difference between actual output and full employment one
Difference between actual output and Yf: concept of output gap – see future Lectures
AS is very steep for λ>>0, very flat for λ→0
Dynamics: AS shifts in time (always runs through point [Yf,P]) – see next slide

29. Dynamic aggregate supply
DAS2
DAS
DAS3 Y3 Yf Y2 Y
AS always passes through (Yf,P)
If YYf, AS shifts in time

30. X.5 Long term adjustment

31. Adjustment (1)
Assume starting point Yf at P+1 = P, different time periods and increase in nominal money.
Very short run: wages (and prices) don’t have any time to adjust → horizontal AS. An increase in nominal money leads to decrease in interest rate i and, because of the larger investment demand, leads to the increase of overall aggregate demand → excess demand

32. Adjustment (2)
Short to medium run: Excess demand → firms intend to increase the production, hiring more people → wages (and prices) slowly start to adjust (both nominal wage and price increase). An initial shift of AD (in the very short run) is partially offset, as in medium run, AS is positively sloped
New (static) equilibrium, as intersection of AD and AS. Not a dynamic one, adjustment not finished yet
W+1 ≠ W and P+1 ≠ P
Medium and long run: AS continues to shift to the left till the output doesn’t fall back to Yf, but with higher price P
Both static and dynamic equilibrium restored

33. Medium- to long-term adjustment
LRAS P C
P+…
SRAS+… B
P+1 A
SRAS
P (=P-1)
AD’ Y
Y+1 Y

34. Adjustment - summary
Aggregate demand: both in short- and long-run decreasing function of price
Aggregate supply
In the long-run: vertical at potential product, long-run aggregate supply (LRAS)
In very short-run (ISLM): horizontal at fixed price, short-run aggregate supply (SRAS)
In medium term: positively sloped AS
Shifts in AD
In the long-run, do not change product, but over-all price level – consistent with classical model
In very short-run, do change the level of product (and employment), but price is fixed – consistent with original version of Keynesian model

35. Short-run shift of AD (external shock that contracts AD)P
SRAS Y

36. Long-run shifts of AD external shock that contracts AD
LRAS P Y

37. From short- to long-run (1)
Short-run equilibrium:
AD equals AS, adjustment through quantities  AS adjusts to AD
Price fixed, equilibrium as state of rest, there can be excess supply on labor market (involuntary unemployment)
Actual product can be lower than potential one
Long-run equilibrium:
AD equals AS
Simultaneous adjustment of all prices generates equilibrium on all markets
Actual product equal to potential one

38. Long-run equilibrium P
LRAS E
SRAS AD Y

39. From short- to long-run (2)
Intuitive interpretation:
Fixed price corresponds either to the depression (Keynes) or to very short-run, when prices (and wages) are fixed in all economies and at (almost) all situations (exceptions – e.g. hyperinflations)
Long-run equilibrium – prices and wages had to react to changes in demand/supplies on all markets (including labor) and their adjustment cleared all markets simultaneously

40. Adjustment in the long-runP
LRAS
SRAS A Y

41. X.6 Conclusions

42. Neoclassical synthesis - summary
Neoclassical synthesis: in the short and medium run, a change of policy variables (e.g. G, M, T(.), etc.) can change (in the Keynesian tradition) the level of output. However, in the long run, there is always a built-in mechanism, which (in the classical tradition) brings the economy back to the full employment level of output, albeit with a different price level.

43. Phillips curve implication
There is a trade-off between inflation and unemployment
Higher unemployment → lower inflation and vice versa
Trade off, combined Keynesian demand management of either fiscal or monetary nature, was perceived as a basis for Keynesian economic policy after first period of post-war reconstruction
This initial belief to potential trade-off between unemployment and inflation, based on original Phillips curve, proved to be one of the biggest mistakes of modern macroeconomics
Later lectures: incorporation of inflationary expectations into Phillips curve

44. Literature to Ch. X
The Phillips curve, derivation of AS and dynamic adjustment explained here according Dornbusch, Fischer, Startz, Ch. 6
Including the simplification when production function has fixed coefficients and depends on labor only
Snowdon, B., Vane, H., Modern Macroeconomics, Edward Elgar Publishing, 2005., pp. 135 – 144
More detailed, but simple and comprehensive explanation
Downward wage rigidity: Modigliani, F., Liquidity- Preference and the Theory of Interest and Money, Econometrica XII (1944), pp , reprinted in many Macroeconomic Readings
It is always worth to read this original attempt to deal with Keynes
General discussion of AD and AS in Keynesian model: Sargent, Macroeconomics, Ch. 2