Exam

zone

Chapter 12

Keynesian Business Cycle

Analysis: Non-Market-Clearing

Macroeconomics

Economics 282

University of Alberta

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.

Keynesian Approach to

Business Cycles (continued) • Keynesians: the stabilization policy is

necessary to minimize recessions.

• New Keynesians: the stabilization policy is

not necessary.

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.

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.

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.

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.

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(PYYe

Y

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.

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.

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.

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.

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.

Unanticipated Fiscal Policy in

the Keynesian Model • A temporary, unanticipated increase in

government purchases increases the

demand for goods and reduces desired

national saving.

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.

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.

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.

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.

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.

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).

Criticisms (continued)

• According to the model prediction real

wages should be countercyclical.

• Keynesians respond by incorporating

productivity shocks and by assuming price

stickiness.

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.

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.

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(PYYe

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.

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.

Monopolistic Competition

(continued) • Keynesians point out that a relatively small

part of the economy is perfectly

competitive.

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.

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.

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.

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.

Meeting the Demand

(continued)

• The economy can produce an amount of

output that is not on the full-employment

line.

η)MC(1P

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.

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.

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.

Keynesian Business Cycle

Theory (continued) • Inflation tends to slow during or just after

recessions because demand pressure is

low during recessions.

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.

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.

Macroeconomic Stabilization

• According to Keynesians recessions are

undesirable, employment can be below

the amount of labour that workers want to

supply.

Macroeconomic Stabilization

(continued) • Average economic well-being would be

increased if governments tried to reduce

cyclical fluctuations.

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.

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.

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.

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.

Supply Shocks in the Keynesian

Model • In 1970s Keynesian theory failed to

account for the stagflation.

• The theory predicts that inflation

movements are procyclical.

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.

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.

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.

End of Chapter