Chapter 12 Keynesian Business Cycle Analysis: Non-Market-Clearing Macroeconomics Economics 282...
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![Page 1: Chapter 12 Keynesian Business Cycle Analysis: Non-Market-Clearing Macroeconomics Economics 282 University of Alberta.](https://reader035.fdocuments.us/reader035/viewer/2022062314/56649d625503460f94a448d6/html5/thumbnails/1.jpg)
Chapter 12
Keynesian Business Cycle Analysis: Non-Market-Clearing
Macroeconomics
Economics 282
University of Alberta
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Keynesian Approach to Business Cycles
• One of the central ideas of Keynesism is that wages and prices are “rigid” or “sticky”.
• Wage and price rigidities imply the economy can be away from its general equilibrium for significant periods of time.
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Keynesian Approach to Business Cycles (continued)
• Keynesians: the stabilization policy is necessary to minimize recessions.
• New Keynesians: the stabilization policy is not necessary.
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Nominal-Wage Rigidity• In developing their approach Keynesians
heavily rely on wage and price rigidities.
• Nominal-wage rigidity is a situation when nominal wages are slow to adjust to changes in labour demand and supply.
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The SRAS Curve and Labour Contracts
• Labour contracts:– specify the nominal, as opposed to the real
wage;– specify employment conditions and nominal
wages for an extended period;– commit both sides to a nominal wage one to
three years into the future.
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The SRAS Curve and Labour Contracts (continued)
• Employers and workers form rational price expectations.
• The price and nominal wage are expected to be P0 and W0. The expected real wage is W0/P0.
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The SRAS Curve and Labour Contracts (continued)
• If P rises, W/P will be below expected, more N will be demanded, and more Y produced.
• Once the term of the contract expires, employees and firms renegotiate a new nominal wage.
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The SRAS Curve and Labour Contracts (continued)
• A new expected real wage will be set so as to clear the labour market.
• Y will differ from for the term of the labour contract.
)Pb(PYY e
Y
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Price Expectations and the Keynesian SRAS Curve
• The SRAS must intercept LRAS at the expected price level.
• The rational price expectation is determined by the intersection of the LRAS and the expected position of ADe.
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Anticipated Monetary Policy in the Keynesian Model
• Anticipated changes in money supply:– will have no effect on real variables;– they are taken into account during nominal
wage negotiations.
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Unanticipated Monetary Policy
• An unanticipated increase in the nominal money supply causes an unanticipated increase in aggregate demand.
• Firms respond to the lower real wage by hiring additional employees and by expending output.
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Unanticipated Monetary Policy (continued)
• In the new labour contract the price expectations are revised to the new price level.
• Money is not neutral in the short run but is neutral in the long run.
• Wage stickiness prevents the economy from reaching its general equilibrium in the short run.
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Anticipated Fiscal Policy in the Keynesian Model
• For Keynesians anticipated fiscal policy has no impact on real variables.
• In the classical model fiscal policy always affects employment and output due to effects on wealth.
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Unanticipated Fiscal Policy in the Keynesian Model
• A temporary, unanticipated increase in government purchases increases the demand for goods and reduces desired national saving.
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Unanticipated Fiscal Policy (continued)
• IS and AD curves shift up and to the right, P increases, W/P is lower than expected, employment and output increase.
• As P rises LM curve shifts up and to the left.
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Unanticipated Fiscal Policy (continued)
• The labour supply and FE line are unaffected.
• In the long run, contracts are renegotiated. After the adjustment the output is unaffected, the price level and the interest rate rise.
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Comparing Monetary and Fiscal Policy
• Both fiscal and monetary policies are aggregate demand policies.
• Both policies, if unanticipated, affect output and employment in the short run but are neutral in the long run.
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Comparing Monetary and Fiscal Policy (continued)
• Easy fiscal policy expands output through the multiplier effect and despite the effect of fiscal policy on the interest rate.
• Easy fiscal policy increases interest rate and crowds out both consumption and investment spending.
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Comparing Monetary and Fiscal Policy (continued)
• Monetary policy does not affect consumption and investment spending in the long run.
• Unanticipated fiscal expansion, by causing real interest rates to increase, crowds out consumption and investment spending.
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Criticisms of the Nominal Wage Rigidity Assumption
• Less than a third of the labour force in Canada is covered by contracts.
• Many labour contracts contain cost-of-living adjustments (COLAs).
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Criticisms (continued)• According to the model prediction real
wages should be countercyclical.
• Keynesians respond by incorporating productivity shocks and by assuming price stickiness.
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Price Stickiness• Models of nominal price rigidity:
– explain evidence of a procyclical movement of real wages;
– while also explaining how aggregate demand shocks can play an important role in explaining business cycles.
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Price Stickiness (continued)• Prices are sticky because firms, after
establishing a price for their output, find it is in their best interest not to adjust that price even though there has been a change in demand for their output.
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Price Stickiness (continued)• Flexible-price firms respond to increase in
aggregate demand by increasing price.
• Fixed-price firms respond to increase in aggregate demand by increasing output.
)Pb(PYY e
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Monopolistic Competition• A price taker considers the market price as
given.
• A price setter has some power to set price.
• Perfect competition is a situation in which all buyers and sellers are price takers.
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Monopolistic Competition• Monopolistic competition is a situation in
which individual producers can act as price setters:– there is some competition;– but a number of sellers is smaller;– and standardization of the product is
imperfect.
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Monopolistic Competition (continued)
• Keynesians point out that a relatively small part of the economy is perfectly competitive.
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Monopolistic Competition (continued)
• A price-setter:– sets a price in nominal terms for some period
of time;– meets the demand that is forthcoming at the
fixed nominal price– readjusts its price from time to time.
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Menu Cost and Price Setting• A menu cost is a cost of changing prices.
• If the loss in profits is less than the cost of changing prices – menu cost – the firm will not change its price.
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Empirical Evidence of Price Stickiness
• Major reasons of price stickiness are menu costs and a reluctance of managers to lead price changes.
• A pass-through from the exchange rate to domestic prices is slow or incomplete.
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Meeting the Demand at the Fixed Nominal Price
• A monopolistically competitive firm charges a price higher than its marginal cost (at a markup).
• When prices are sticky, firms react to changes in demand by changing the amount of production, rather than changing prices.
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Meeting the Demand (continued)
• The economy can produce an amount of output that is not on the full-employment line.
η)MC(1P
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Keynesian Business Cycle Theory
• Keynesians believe that a primary source of business cycle fluctuations is unanticipated shifts in the aggregate demand curve – aggregate demand shocks.
• Keynesians attribute recessions to “not enough demand” for goods.
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Keynesian Business Cycle Theory (continued)
• The Keynesian theory accounts for several business cycle facts:– recurrent fluctuations of Y in response to AD
shocks;– employment fluctuates in the same direction
as Y;– shocks to M are non-neutral, money is
procyclical and leading.
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Keynesian Business Cycle Theory (continued)
• Cyclical behaviour of durable and investment goods can be explained if shocks to them are themselves a main source of cycles.
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Keynesian Business Cycle Theory (continued)
• Inflation tends to slow during or just after recessions because demand pressure is low during recessions.
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Procyclical Labour Productivity
• This approach has a problem to explain the fact that labour productivity is procyclical.
• If the production function is stable, increases in employment during booms should reduce average labour productivity, so it should be countercyclical.
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Procyclical Labour Productivity (continued)
• Firms may hoard labour during recessions and use it less intensively. So, labour productivity falls during a recession.
• Labour hoarding is found to be reduced in the last two recessions in Canada.
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Macroeconomic Stabilization• According to Keynesians recessions are
undesirable, employment can be below the amount of labour that workers want to supply.
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Macroeconomic Stabilization (continued)
• Average economic well-being would be increased if governments tried to reduce cyclical fluctuations.
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Macroeconomic Stabilization (continued)
• Under no AD policy wages and prices will be eventually cut in the long run.
• While the adjustment process takes place economic well-being is reduced.
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Macroeconomic Stabilization (continued)
• If prices adjust slowly and the fiscal or monetary policies can be implemented quickly, the AD policy could move the economy back to full-employment output more quickly than doing nothing.
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Difficulties of the Policy of Macroeconomic Stabilization
• Actual macroeconomic stabilization is less successful than Keynesian theory suggests:– monetary and fiscal policies should be
coordinated;– depth of a recession is difficult to measure;– the size of effects of monetary and fiscal
policies is not known.
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Difficulties of the Policy (continued)
• Monetary and fiscal policies have lags.
• Policymakers should concentrate of fighting major recessions.
• Policymakers should be willing to take economic advice.
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Supply Shocks in the Keynesian Model
• In 1970s Keynesian theory failed to account for the stagflation.
• The theory predicts that inflation movements are procyclical.
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Supply Shocks (continued)• Keynesians admit that there can be
occasional episodes when supply shocks play a primary role in economic downturns.
• An adverse supply shock reduces MPN and demand for labor. The FE line and LRAS curve shift to the left.
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Supply Shocks (continued)• The adjustment takes place slowly.
• In the long run, full-employment output falls, the price level and the real interest rate increase.
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Supply Shocks (continued)• In the situation of adverse supply shock
fiscal and monetary policies can offer little help.
• An unanticipated contractionary AD policy can reduce the size of increase in the price level, but it can cause a fall in output below the new full-employment level.
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End of Chapter