Macroeconomic AnalysisEcon 6022

Lecture 10

Fall, 2011

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Overview

• The essence of the Keynesian Theory

- Real-Wage Rigidity- Price Stickiness

• Justification of these two key assumptions• Monetary and Fiscal Policy in the Keynesian Model• Liquidity trap: theory and reality.

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Real-Wage Rigidity

• Keynesians: Wage rigidity is important in explainingunemployment

• If wage rate is flexible and quick to adjust, then thereshould be no unemployment.

• To get a model in which unemployment exists, Keynesiantheory posits that the real wage is slow to adjust toequilibrate the labor market

• Precisely, for unemployment to exist, the real wage mustexceed the market-clearing wage

• If the real wage is too high, why don’t firms reduce thewage?

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The Efficiency Wage Model

• There are several ways to justify sticky wage rate, here weintroduce ...

• The efficiency wage model: workers’ productivity maydepend on the wages they’re paid

• Lower real wage: higher Nd(w) and lower e(w)

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The Efficiency Wage Model

• At low levels of the real wage, workers make hardly anyeffort

• Effort rises as the real wage increases• As the real wage becomes very high, effort flattens out as

it reaches the maximum possible level

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Figure 11.1 Determination of the efficiency wage

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Real-Wage Rigidity

• Wage determination in the efficiency wage model- Given the effort curve, what determines the real wage firms

will pay?- To maximize profit, firms choose the real wage that gets the

most effort from workers for each dollar of real wages paid- The wage rate at point B is called the efficiency wage

(where Ew reaches maximum.)

- The real wage is rigid, as long as the effort curve doesn’tchange

• Quantities of Ns and Nd

• Efficiency of labor input, e

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Figure 11.2 Excess supply of labor in the efficiencywage model

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Real-Wage Rigidity

• Efficiency wages and the FE line- The FE line is vertical, as in the classical model, since

full-employment output is determined in the labor marketand doesn’t depend on the real interest rate

- But in the Keynesian model, changes in labor supply don’taffect the FE line, since they don’t affect equilibriumemployment

- A change in productivity does affect the FE line, since itaffects labor demand

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Price Stickiness

• Price stickiness is the tendency of prices to adjust slowly tochanges in the economy

- The data suggest that money is not neutral, so Keynesiansreject the classical model (without misperceptions)

- Keynesians developed the idea of price stickiness toexplain why money isn’t neutral

• Sources of price stickiness: Monopolistic competition andmenu costs

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Monopolistic competition

• If markets had perfect competition, the market would forceprices to adjust rapidly; sellers are price takers, becausethey must accept the market price

• In many markets, sellers have some degree of monopolypower; they are price setters under monopolisticcompetition

- They set prices in nominal terms and maintain those pricesfor some period

- They adjust output to meet the demand at their fixednominal price

- They readjust prices from time to time when costs ordemand change significantly

• Keynesians suggest that many markets are characterizedby monopolistic competition

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Menu costs and price stickiness

• The term menu costs comes from the costs faced by arestaurant when it changes prices—it must print newmenus

• Even small costs like these may prevent sellers fromchanging prices often

• Since competition isn’t perfect, having the wrong pricetemporarily won’t affect the seller’s profits much

• The firm will change prices when demand or costs ofproduction change enough to warrant the price change

• Summary: Monopolistic competition means firms don’tsuffer too much if they set a wrong price (or do not adjust itquickly); Menu cost rationalizes the infrequent adjustmentof prices.

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Monopolists and Demand Shock

• Since firms have some monopoly power, they price goodsat a markup over their marginal cost of production:

P = (1 + η)MC

• If demand turns out to be larger at that price than the firmplanned, the firm will still meet the demand at that price,since it earns additional profits due to the markup

• Since the firm is paying an efficiency wage, it can hiremore workers at that wage to produce more goods whennecessary

• This means that the economy can produce an amount ofoutput that is not on the FE line during the period in whichprices haven’t adjusted

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Firm’s pricing

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Meet the increase in demand

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Demand Shocks and Effective Labor Demand

• Demand shocks in final good market and effective labordemand in labor market

• The firm’s labor demand is thus determined by the demandfor its output

• The effective labor demand curve, NDe(Y ), shows howmuch labor is needed to produce the output demanded inthe economy (Fig. 11.3)

• It slopes upward from left to right because a firm needsmore labor to produce additional output

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Figure 11.3 The effective labor demand curve

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Monetary Policy in the Keynesian Model

• The Keynesian FE line differs from the classical model intwo respects

- The Keynesian level of full employment occurs where theefficiency wage line intersects the labor demand curve, notwhere labor supply equals labor demand, as in the classicalmodel

- Changes in labor supply don’t affect the FE line in theKeynesian model; they do in the classical model

• Since prices are sticky in the short run in the Keynesianmodel, the price level doesn’t adjust to restore generalequilibrium

- Keynesians assume that when not in general equilibrium,the economy lies at the intersection of the IS and LMcurves, and may be off the FE line

- This represents the assumption that firms meet the demandfor their products by adjusting employment model

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Figure 11.4 An increase in the money supply

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Easy Money in the Keynesian Model

• LM curve shifts down from LM1 to LM2

• Output rises and the real interest rate falls• Firms raise employment and production due to increased

demand• The increase in money supply is an expansionary

monetary policy (easy money); a decrease in moneysupply is contractionary monetary policy (tight money)

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Easy Money in the Keynesian Model-IS − LM

• Analysis of an increase in the nominal money supply (Fig.11.4)

- Easy money increases real money supply, causing the realinterest rate to fall to clear the money market

- The lower real interest rate increases consumption andinvestment

- With higher demand for output, firms increase productionand employment

- Eventually firms raise prices, the LM curve shifts back to itsoriginal level, and general equilibrium is restored

• Thus money is neutral in the long run, but not in the shortrun

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Easy Money in the Keynesian Model-AD − AS

• Monetary Policy in the Keynesian AD-AS framework- We can do the same analysis in the AD-AS framework- The main difference between the Keynesian and classical

approaches is the speed of price adjustment• The classical model has fast price adjustment, so the SRAS

curve is irrelevant• In the Keynesian model, the short-run aggregate supply

(SRAS) curve is horizontal, because monopolisticallycompetitive firms face menu costs

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Figure 9.14 Monetary Policy in AD-AS framework

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Monetary Policy in AD-AS framework

• Monetary Policy in the Keynesian AD-AS framework- The effect of a 10% increase in money supply is to shift the

AD curve up by 10%• Thus output rises in the short run to where the SRAS curve

intersects the AD curve• In the long run the price level rises, causing the SRAS curve

to shift up such that it intersects the AD and LRAS curves

- So in the Keynesian model, money is not neutral in theshort run, but it is neutral in the long run

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Fiscal Policy in the Keynesian Model

• The effect of increased government purchases (Fig. 11.5)- Keynesian analysis: A temporary increase in government

purchases shifts the IS curve up- Classical analysis: A temporary increase in government

purchases shifts the FE curve to the left- When prices adjust, the LM curve shifts up and equilibrium

is restored at the full-employment level of output with ahigher real interest rate than before

• What has changed in the long run? And why?

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Figure 11.5 An increase in government purchases

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Figure 11.6 An increase in government purchases inthe Keynesian AD-AS framework

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The Keynesian Theory of Business Cycles andMacroeconomic Stabilization

• Keynesian business cycle theory- Keynesians think aggregate demand shocks are the

primary source of business cycle fluctuations- Aggregate demand shocks are shocks to the IS or LM

curves,• Examples:

- fiscal policy,- changes in desired investment arising from changes in the

expected future marginal product of capital,- changes in consumer confidence that affect desired saving,

and changes in money demand or supply (Fig. 11.7)

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Figure 11.7 A recession arising from an aggregatedemand shock

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Macroeconomic stabilization

• Keynesians favor government actions to stabilize theeconomy

• Recessions are undesirable because the unemployed arehurt

• If the government does nothing, eventually the price levelwill decline, restoring general equilibrium. But output andemployment may remain below their full-employment levelsfor some time

- The government could increase the money supply, shiftingthe LM curve down to move the economy to generalequilibrium

- The government could increase government purchases toshift the IS curve back up to restore general equilibrium

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Figure 11.8 Stabilization policy in the Keynesianmodel

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Liquidity Trap

• The liquidity trap, in Keynesian economics, is a situationwhere monetary policy is unable to stimulate an economy,either through lowering interest rates or increasing themoney supply.

• Given a very low interest rate, the bond and money arealmost perfect substitutes.

• People are willing to hold as much money as supplied.

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Liquidity trap in the Keynesian model

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Liquidity Trap in reality• Liquidity trap (LT) is much more than a theoretical

possibility.• Three important episodes of liquidity trap in modern

advanced economies.• Japan during 1990’s, the U.S. during Great Depression

and between 2008-2010.• On September 17 of 2008, the interest rate for 3-month

treasury bills (the most popular) fell to 0.06%, the loweston record, and today are standing at 0.08%.

• U.S. interest rates were well below 1% throughout theGreat Depression, and the same was true for Japan in the1990s, where they stood at one-tenth of 1%.

• Further analysis and implications: A summaryHow Much Of The World Is In a Liquidity Trap? (Krugman,March 17, 2010)The humbling of the Fed (Krugman, September 22, 2008)

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Advance Topics

• A preview of modern macroeconomics: inter-temporalapproach

• Methodology: micro-founded, dynamic, two-period models• Math: First Order Condition• Topics: Consumption and Savings, optimal government

policies, OLG model (and strategic monetary policy)• Applications: 1) “HKD 6000 cash handout”; 2) Saving

puzzle in China; 3) Low saving rate in the U.S.; 4)Ricardian equivalency; and 5) Social Security System inChina.

• Goals: understand how modern macroeconomics analyzethe real world issues and the first taste of cutting-edgemacroeconomics.

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