The Keynesian ModelThe Keynesian Model

Chapter 9Chapter 9

John Maynard Keynes and the John Maynard Keynes and the General Theory General Theory of Employment, Interest and Moneyof Employment, Interest and Money

Derivation of the Keynesian ASDerivation of the Keynesian AS

Crucial assumptionCrucial assumption: :

If nIf ndd is less than n is less than nss, W does not fall , W does not fall

Nominal wages are sticky downwardsNominal wages are sticky downwards

(Fig. 9.1)(Fig. 9.1)1.1. We start from an initial given point (We start from an initial given point (P0,Y0) in the ) in the

(P,Y) space. (P,Y) space.

2.2. Increase Increase P0 to P1. If nIf ndd > n > nss, W increases so that , W increases so that W/P remains the same.W/P remains the same.

3. W1/P1 = W0/P0 and we have now ((P1,Y0))..

4.4. Now, let us decreaseNow, let us decrease P0 to P2. In the very short run, the real wage W0/P2 is associated with nndd<n<nss, and the wage does not fall (Keynesian assumption). Employment falls to nlow and we have ‘involuntary unemployment’.

5. Y falls to Ylow .

6. Using ((P0,Y0) and () and (P2,Ylow), we derive the Keynesian ), we derive the Keynesian AS.AS.

1.1. Make all moves in the (i,Y) space and make all Make all moves in the (i,Y) space and make all shifts to IS and LM here.shifts to IS and LM here.

2.2. Adjust Y (use the final value) in the (P,Y) space. Adjust Y (use the final value) in the (P,Y) space. The AD shifts to keep Y in (I,Y) and (P,Y) spaces The AD shifts to keep Y in (I,Y) and (P,Y) spaces consistent. Here, we get the final P and Y values.consistent. Here, we get the final P and Y values.

3.3. Adjust the expenditure line. Determine if Adjust the expenditure line. Determine if C C and and II have changed. Also, determine what happens to have changed. Also, determine what happens to real wages. If real wages. If nndd < n < ns s employment will fall. If nemployment will fall. If ndd > n > ns s nominal wages adjust to ensure that real wage nominal wages adjust to ensure that real wage remains the same.remains the same.

4.4. Interpret the results.Interpret the results.

Survival guide fro ISLM with Survival guide fro ISLM with Keynesian ASKeynesian AS

Policy Experiment IPolicy Experiment I An increase in G An increase in G (Fig. 9.2)(Fig. 9.2)

1.1. The The ISIS curve shifts to the right. Interest rates (i) curve shifts to the right. Interest rates (i) increase, Y increases to Yincrease, Y increases to Y11..

2.2. In the (P,Y) space, the AD curve shifts to the In the (P,Y) space, the AD curve shifts to the right. Inflation increases (to Pright. Inflation increases (to P11).).

3.3. The expenditures line shifts up. The expenditures line shifts up. CC increases; increases; I I falls. nfalls. nss > n > nd d (both at (both at W0/P0 and W0/P1 ), so W does not change and real wages fall but employment increases. Note the Keynesian multiplier effect.

4.4. ResultsResults: An increase in G increases employment, : An increase in G increases employment, CC and and YY. But . But II and real wages fall. and real wages fall.

Policy Experiment IIPolicy Experiment II An increase in MAn increase in M (Fig. 9.3) (Fig. 9.3)

1.1. LM shifts to the right and interest rates decrease.LM shifts to the right and interest rates decrease.2.2. In the (P,Y) space, the AD curve shifts to the right. In the (P,Y) space, the AD curve shifts to the right.

Inflation increases (to PInflation increases (to P11) and Y increases.) and Y increases.3.3. The expenditures line shifts up. The expenditures line shifts up. C and IC and I increase. increase.

nnss > n > nd d (both at (both at W0/P0 and W0/P1 ), so W does not change and real wages fall but employment increases.

4.4. ResultsResults: A monetary expansion as a tool of : A monetary expansion as a tool of demand-side stabilization is effective in increasing demand-side stabilization is effective in increasing Y and employment.Y and employment.

OverheatingOverheating (Fig. 9.4) (Fig. 9.4)

Policy Experiment IIIPolicy Experiment III Engineering a soft-landingEngineering a soft-landing (Fig. 9.5)(Fig. 9.5)

Policymakers are trying to cool down the Policymakers are trying to cool down the overheated economy. The Fed contracts money.overheated economy. The Fed contracts money.

1.1. LMLM22 shifts to the left (to LM shifts to the left (to LM11) and interest rates increase to ) and interest rates increase to iihigherhigher. Y falls to Y. Y falls to Ymoderatemoderate. Since monetary policy works with a . Since monetary policy works with a significant and variable lag, this process can take from 6 significant and variable lag, this process can take from 6 months to 2 years (Milton Friedman).months to 2 years (Milton Friedman).

2.2. In the (P,Y) space, the AD curve shifts to the left (YIn the (P,Y) space, the AD curve shifts to the left (Ymoderatemoderate). ). Inflation falls (to PInflation falls (to Pmoderatemoderate).).

3.3. The expenditures line shifts down. The expenditures line shifts down. C C falls asfalls as Y Y declines, declines, and and II falls as a result of higher interest rates. Since P falls, real falls as a result of higher interest rates. Since P falls, real wages increase and employment falls to nwages increase and employment falls to nlowerlower. .

4.4. ResultsResults: If the economy can be stabilized at Y: If the economy can be stabilized at Ymoderatemoderate, P, Pmoderatemoderate, , and nand nlower, lower, then we can have a successful soft-landingthen we can have a successful soft-landing. . Because contractionary fiscal policies involve longer-term Because contractionary fiscal policies involve longer-term decision making and longer implementation lags, monetary decision making and longer implementation lags, monetary contraction remains the policy of choice to engineer a soft-contraction remains the policy of choice to engineer a soft-landing. landing.

Policy Experiment IVPolicy Experiment IV Engineering a soft-landingEngineering a soft-landing (Fig. 9.6):(Fig. 9.6): When low interest rates no longer work!When low interest rates no longer work!Assume that consumer and investor confidence levels have Assume that consumer and investor confidence levels have fallen dramatically (e.g. as a result of SAP bubble).fallen dramatically (e.g. as a result of SAP bubble).1.1. ISIS00 shifts to the left (to IS shifts to the left (to IS11) and interest rates and Y fall. ) and interest rates and Y fall. 2.2. The Fed increases M and lowers interset rates further to The Fed increases M and lowers interset rates further to

revive Y. Interest rates are at irevive Y. Interest rates are at ifinal final (very low rates) and Y (very low rates) and Y stabilizes at Ystabilizes at Yfinalfinal , which is still lower than the initial level,Y , which is still lower than the initial level,Y00..

3.3. In the (P,Y) space, ADIn the (P,Y) space, AD00 shifts to AD shifts to ADfinalfinal and P falls to P and P falls to Pfinalfinal . .4.4. The expenditures line shifts down. The expenditures line shifts down. CCfinalfinal is lower than is lower than C C0 0 , ,

and Iand Ifinalfinal is lower than is lower than II00 (assuming the effect from the fall in (assuming the effect from the fall in investor confidence dominates the effect from the fall in investor confidence dominates the effect from the fall in interest rates). As P increases, real wages increase so interest rates). As P increases, real wages increase so unemployment increases. unemployment increases.

5.5. ResultsResults: We get a situation similar to the : We get a situation similar to the liquidity trapliquidity trap. . Expansionary monetary policy is impotent! Expansionary monetary policy is impotent! Example:Example: The The U.S. by late 2008.U.S. by late 2008.

The Phillips CurveThe Phillips Curve

A negative relationship between the A negative relationship between the rate of inflation and changes in rate of inflation and changes in unemployment (published in a 1958 unemployment (published in a 1958 article by William Phillips).article by William Phillips).

Consistent with the predictions of Consistent with the predictions of the Keynesian model. the Keynesian model.

Led to the (controversial) output-Led to the (controversial) output-inflation tradeoff.inflation tradeoff.

The Yield Curve and the Keynesian The Yield Curve and the Keynesian ParadigmParadigm

Upward slopping yield curve: Upward slopping yield curve: Often,Often, indicative of an indicative of an economy in the early stages of a sustained recovery. economy in the early stages of a sustained recovery.

As the AD increases (as a result fiscal or monetary As the AD increases (as a result fiscal or monetary expansion), the rate of inflation is expected to increase so expansion), the rate of inflation is expected to increase so lenders will incorporate this in their decisions of long term lenders will incorporate this in their decisions of long term loans (the Fisher effect). Thus, long-term rates are higher loans (the Fisher effect). Thus, long-term rates are higher than short term rates. than short term rates.

Inverted yield curve: Inverted yield curve: OftenOften, indicative of an impending , indicative of an impending recession.recession.

(See experiment III) When the Fed engineers soft-landing, (See experiment III) When the Fed engineers soft-landing, lenders see that short-term interest rates (controlled by the lenders see that short-term interest rates (controlled by the Fed) are going up and so they expect a recession or at least Fed) are going up and so they expect a recession or at least a slowdown of the economy. This will eventually decrease a slowdown of the economy. This will eventually decrease the rate of inflation so expectation of less future inflation the rate of inflation so expectation of less future inflation leads to lower nominal long-term interest rates.leads to lower nominal long-term interest rates.

The Great Depression: The Great Depression: Four Policy MistakesFour Policy Mistakes

1.1. Wage FloorsWage Floors2.2. Tax Increases and Decreases in Tax Increases and Decreases in

Government SpendingGovernment Spending3.3. Liquidity CrisisLiquidity Crisis4.4. The Smoot-Hawley Act of 1930The Smoot-Hawley Act of 1930

Could a Great Depression happen again?Could a Great Depression happen again? Discussion: Article 9.3Discussion: Article 9.3