004: Macroeconomic Theory
Lecture 3
Mausumi Das
Lecture Notes, DSE
July 31, 2014
Keynesian System: A Comparative Statics
What happens whenW¯ goes up?
Keynesian System: E¤ect of a Rise in Nominal Wage Rate
The AS schedule shifts to the left - reducing the equilibrium level of output and increasing the equilibrium price level.
Question: What about thereal wage rate? Would the real wage rate be higher/lower or remain the same in the new equilibrium?
Keynesian System: E¤ect of a Rise in Nominal Wage Rate (Contd.)
The real wage rate in this model behaves in a contra-cyclicalfashion - it is low in periods of boom (high output/high employment) and high in periods of bust (low output/low employment).
This feature of the model is not supported by the empirical facts.
It has been observed that real wage rate typically moves in
pro-cyclical manner. In periods of boom, employment, output and real wage rate - all move in the upward direction; opposite happens during recessions.
Extension of the Keynesian System: The Neo-Keynesians
& Sticky Prices
An extension of the general Keynesian structure was later proposed, which was able to address this issue, while retaining the other basic Keynesian features. This is the Neo-Keynesian extension, proposed by Barro-Grossman and Malinvaud in the 1970s.
This extension assumes that not only that nominal wage is rigid, but so is the nominal price level. (This school is also known as the
‘Disequilibrium Macroeconomics’or the Macroeconomics of ‘Quantity Rationing’)
Sticky prices mean that the aggregate supply curve is horizontal at someP =P¯.
Notice that a horizontal supply AS schedule means that this system is completely demand-determined. AtP¯ whatever output demanded is always supplied. (Thus this set up is diametrically opposite to the supply-determined Classical System discussed earlier).
The Neo-Keynesians & Sticky Prices (Contd.)
Notice that if output is demand-determined then the producers may not have the choice of picking the level of employment that
maximises their pro…t:
Suppose atP=P,¯ the level of aggregate demand (from the AD curve) isYˆ(P¯).
On the other, suppose atP=P¯ andW =W¯ , the pro…t maximizing
…rms would like to employN amount of labour such that output supplied isY (P,¯ W¯) =F(N ,K¯), where PF¯ N(N ,K¯) =W¯. If thedemand constarint is binding thenYˆ(P¯)<Y (P,¯ W¯ ). In other words, at the pro…t maximising level of employment, there is excess supply in the Goods Market.
Since prices are sticky, adjustments have to be made in terms of quantities. This implies that the quantity produced cannot be Y (P,¯ W¯ ); it can at max. beYˆ.
This quantity adjustment will have implications for the labour demand function as well.
Labour Market under Sticky Prices:
When prices are sticky and the economy is demand-constrained, the labour demand function is given by:
ND =Nˆ :F(N,ˆ K¯) =Yˆ.
Question: Do the …rms still make positive pro…t employingNˆ instead of N ?
Labour Market under Sticky Prices (Contd.):
Now let’s see what happens when the nominal wage rate whenW¯ goes up:
Nothing changes in the Goods Market, except that now there is a re-distribution of income from pro…t-eraners to wage-earners.
Labour Market under Sticky Prices (Contd.):
If workers have di¤erent propensity to consume than pro…t-earners, this might have implications for the consumption function and therefore for aggregate demand. In fact if workers’propoensity to consume is higher, the aggreagte demand may get augmented due to a rise in the nominal wage rate.
This will relax the demand constraint and aggreagte output will increase in that case.
Thus real wage and output (as well as employment) would move in the same direction. In other words, the real wage rate now moves pro-cyclically- consistent with the empirical evidence.
Other Extensions of Keynes & the Classics:
Quantity Theory of Money(A Special Case of the Classical System):
Money Demand Equation now becomes:
M =PkY; k a positive constant (velocity of circulation money) The aggregate demand schedule in theY-Pplane is still downward sloping.
Nothing much changes either in the Classical or in the Keynesian System.
Liquidity Trap (A Special Case of the Keynesian System) Equation of the LM curve now becomes:
r =r¯
(Implicit assumption: money supply is endogenous.)
The aggregate demand schedule in theY-Pplane is now vertical.
In the Keynesian System output is completely demand-determined.
Question: What happens if we import this assumption to the Classical System?
Other Extensions of Keynes & the Classics (Contd.):
Autonomous Investment(A Special Case of the Keynesian System):
Equation of the IS curve now becomes:
Y =C(Y) +¯I+G¯
The aggregate demand schedule in theY-Pplane is once again vertical.
In the Keynesian System output is completely demand-determined.
Question: What happens if we import this assumption to the Classical System?
