Chapter 12 Keynesian Business Cycle Analysis NonMarketClearing Macroeconomics

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 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 P 0 and W 0. The expected real wage is W 0/P 0.

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 labour contract. for the term of the

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-ofliving 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.

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.

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 1970 s 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.

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