econ 313: macroeconomics i w/c 19 october 2015 · pdf filesimultaneous equilibrium in goods...
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ECON 313: MACROECONOMICS I
W/C 19th October 2015
THE KEYNESIAN SYSTEM IV
Aggregate Demand and Supply
Dr. Ebo Turkson
The Keynesian Aggregate Demand Schedule Relaxing the Assumption of Fixed General Price level
Using the IS-LM Schedules to derive the AD Schedule
The Keynesian AD Schedule combined with Classical Theory of AS
A Contractual View of the Labour Market Sources of Wage Rigidities
A Flexible Price-Fixed Money Wage Model
Labour Supply and Variability in the Money Wage
The Effects of Shifts in the AS Schedule
Conclusion: Keynes Versus the Classics
Recall the essential notion embodied in the simple Keynesian model; For output to be at the equilibrium level AD=Y
Underlying this notion has always been the assumption that whatever the level of output that is demanded will be supplied at the given price. i.e. Supply is demand determined
This implied a horizontal AS schedule As we begin to vary price the AS will longer be
horizontal
0
P0
Real GDP
Fixed Price Keynesian AS Schedule
AS
The Keynesian Aggregate Demand Schedule
Focus: What is the relationship between the
price level and the level of output?
Approach: Study how changes in P affects
the level of output implied by the
simultaneous equilibrium in goods and
money markets (IS-LM)
The AD captures the effects of the price level on output. It is derived from the simultaneous equilibrium in the goods and money markets
Deriving the AD
Recall the equations for the IS and LM;
𝑟𝐼𝑆= 𝐶0−𝑐1𝑇+𝐼0+𝐺
𝑖1−
1−𝑐1
𝑖1Y
𝑟𝐿𝑀= −1
𝑏2
𝑀
𝑃+
𝑏1
𝑏2Y
Solving these two simultaneously yields the AD equation
Deriving the AD
𝐴𝐷: 𝑌= 1
1−𝑐1+𝑖1𝑏1𝑏2
[𝐶0 − 𝑐1𝑇 + 𝐼0 + 𝐺 +𝑖1
𝑏2(𝑀
𝑃)]
Generally the AD can be summarized as;
𝑌=f (𝑀
𝑃, G , T)
(+,+,-)
All the variables with the exception of P will either shifts the IS or LM and therefore the AD curve
The derivation of the aggregate demand
curve
An increase in the price level leads to a
decrease in output
P ( 𝑴 𝑷) EDM
ESB PB r (LM
shifts upwards to left)
Inv. AE Y
• Starting from the equilibrium conditions for the goods and financial markets, we have derived the aggregate demand relation.
• This relation implies that the level of output is a decreasing function of the price level. It is represented by a downward-sloping curve, called the aggregate demand curve.
• Changes in monetary or fiscal policy – or, more generally, in any variable other than the price level that shifts the IS or the LM curves – shift the aggregate demand curve.
Y YM
PG T
, ,
( , , )
Shifts of the aggregate demand curve
At a given price level, an increase in government spending increases output, shifting the aggregate
demand curve to the right. At a given price level, a decrease in nominal money decreases output,
shifting the aggregate demand curve to the left
The impact of policy actions on demand is not enough to know its effect on Output/GDP
It depends on the assumptions we make about the AS
The AS can be one of the following;
Vertical (Classical)
Horizontal (Keynesian Fixed-Price Model)
Upward sloping (Keynesian variable Price Model)
Given these possibilities the impact of policy on AD will have a different effect on Y and/or P.
The impact of policy actions on demand is not enough to know its effect on Output/GDP
It depends on the assumptions we make about the AS
The AS can be one of the following;
Vertical (Classical)
Horizontal (Keynesian Fixed-Price Model)
Upward sloping (Keynesian variable Price Model)
Given these possibilities the impact of policy on AD will have a different effect on Y and/or P.
Where do you think the truth lies?
Probably somewhere in between, meaning the AS is probably upward sloping.
Let us first look at the case where we have the Classical assumptions of AS.
In the Classical model, the full employment level (N0) is determined at the point where Ns and Nd are in equilibrium. (part a)
Notice that both Ns and Nd areexpressed as functions of the real wage (W/P).
What does this mean?
It means that if P changes, then W changes in the same proportion so that W/P is unchanged. (perfectly flexible W and P, and perfect information)
Equilibrium output (Y0) is then determined using the production function shown in part b.Figure 8.5 Classical Supply Assumptions
Figure 8.6 Effect of an Increase in Government
Expenditures with Classical Labor Market
Assumptions
In part a, an increase in
government expenditures shifts
the IS schedule to the right,
from, IS0 to IS1.
In part b the aggregate
demand schedule shifts to the
right from Yd0 to Yd
1.
The increase in aggregate demand causes the price level to rise from P0 to P1,
The increase in the price level “shifts” the LM schedule in part a from LM(M0/P0) to LM(M0/P1).
The level of output is unchanged at Y0.
Unlike the Classical Keynes believe that money wage does to fully adjust to keep the economy at full employment.
The classicals believed that money wage is perfectly flexible and that given labour demand and supply the money wage will adjust to any price changes such that the real wage is constant
Keynes believed that there are a variety of reasons why money wage will not quickly adjust to price changes
He believed that money wages could be flexible upwards but very rigid downwards.
Sources of Wage Rigidity
1. Workers will resist money cuts even if demand for labour falls ( i.e. increase in unemployment).
2. Wages are set by labour contracts (collective bargaining) often for 2 or 3 years and as such within that period if there is a fall in labour demand or general price level , money wages will not fall.
3. Even if there is no labour contracts, there is an implicit agreement between employers and employees to fix the money wages over some time period.
Even if the market conditions require for a cut employers will rather lay off some workers rather than reduce the money wages
According to Keynes the contractual view of the labour market makes it highly unlikely for money wages to be perfectly flexible as the classicals assumed.
Keynes assumed that although prices are free to vary, the money wage is fixed or at worse money wage will not fully adjust to prices
Keynes accepted the classical theory of labour demand;
W=MPN.P
Firms maximize profits by demanding labour up to the point where the cost of employing the last worker (W) equals the value of MP by that unit of labour (MPN.P)
Given labour SS it is the demand that is the constraining factor to output supply
Given labour SS it is labour DD that is the constraining factor to output supply and employment.
Thus the number of workers firms will hire and as such the amount of output they will supply depends on the price level.
Thus ;
When P (MPN. P) (MPN. P)>W Firms will Employment (N) because they add more to revenue than cost Given the Production function and constant productivity Y
Clearly indicating a positive relation between P and Y
Figure 8.8 The Keynesian Aggregate Supply
Curve When the Money Wage Is Fixed
Part a shows the levels of
employment N0, N1, N2 for
three successively higher
price levels P0, P1, P2.
Part b shows the levels of
output Y0, Y1, Y2 that will be
produced at these three
levels of employment.
In part c, we put together the
information in a and b to
show output supplied at each
of the three price levels.
Role of AS in Determining GDP response to AD Policy Shock
Real GDP
P0
AS2
P1
Y0
E
AS1
Y1
AD0
AS0
E0
Y2
E2
E1
P2
Classical theory of AS is fundamentally incompatible with the Keynesian
system
Expansionary Monetary Policy
Real GDP
r0
Y0
E
Y1
IS0
LM0(𝑴𝟎
𝑷𝟎)
E0
YC
E1
LM1(𝑴𝟏
𝑷𝟎)
LM2(𝑴𝟏
𝑷𝟏)
r1
rC
Expansionary Monetary Policy
Real GDP
P0
AS
P1
Y0
E
Y1
AD0
AD1
E0
YC
E1
Expansionary Monetary Policy
Contractionary Monetary Policy
Opposite is also true
M ( 𝑴 𝑷) ESM EDB PB r (LM
shifts downwards to left to LM1 and AD shifts
rightward) Y and P shifts LM upwards
towards original to LM2 r from rc to r1 Inv.
AE Y from Yc to Y1
Expansionary Fiscal Policy
Real GDP
r0
Y0
E
Y1
IS0
LM0(𝑴𝟎
𝑷𝟎)
E0
YC
E1
LM1(𝑴𝟎
𝑷𝟏)
r1
rC
IS1
Expansionary Fiscal Policy
Real GDP
P0
AS
P1
Y0
E
Y1
AD0
AD1
E0
YC
E1
Expansionary Monetary Policy
Contractionary Fiscal Policy
Opposite is also true
G Y Shifts in IS rightward r (because
YMD EDM ESB PB r)
Because IS shifts rightward AD also shifts rightward
P shifts LM upwards to LM1 r from rc to r1
Inv. AE Y from Yc to Y1
With the upward-sloping aggregate supply curve (Ys), at higher prices, output increases.
This appears to be the same as the fixed-wage case. We will see in the next diagram that there is a difference.
The upward-sloping (Ys) in the flexible wage case is based on the assumptions that knowledge is imperfect.
Workers base their wage expectations on past results: expectations are backward looking.
Thus the labor supply curve, Ns(Pe) does not change as price goes up because expectations are frozen.
Workers see the higher W and think they are better off, thus they are willing to work more
Because their perception is imperfect, the are actually worse off because as P, W/P.
Figure 8.11 The Keynesian Aggregate Supply
Curve When the Money Wage Is Variable
Part c combines the
information in parts a and b
to show the relationship
between the price level and
output.
If W is flexible, that implies
that the labor market is at
full employment, and any
further increase in demand
means W must if firms are
to hire more workers.
Part a shows the equilibrium
levels of employment N0, N1, N2,
corresponding to successively
higher values of the price level,
P0, P1, P2
Part b gives the level of output,
Y0, Y1, Y2 that will be produced at
each of these employment levels.
Figure 8.12 Keynesian Aggregate Supply Curves
for the Fixed- and Variable-Money-Wage Cases
In the variable wage case,
the Ns is low, thus there is
full employment at W0.
As P in the variable
wage case, firms must pay
higher W to attract
workers.
The rise in the money
wage in the variable-wage
case dampens the effect
on employment and
output from an increase
in price.
Thus the aggregate supply
schedule in part c is
steeper when the money
wage is variable than
when the it is fixed.
If wages are variable, a given increase in aggregate demand has a greater effect on price and a lesser effect on income.
Do you understand why?
If wages are rigid, a given increase in aggregate demand has a lesser effect on price and a greater effect on income
Do you understand why?
Figure 8.13 Price and Output Variations with
Shifts in Aggregate Demand and Supply
For changes in output that
result from shifts in the
aggregate demand schedule
along a fixed supply schedule, as
in part a, price and output move
in the same direction.
For output changes that result
from shifts in aggregate supply
along a fixed demand schedule,
as in part b, price and output
move in the opposite direction.
What are the policy implications
of a “stimulus package” that
stimulates AD, versus one that
stimulates AS?
Figure 8.14 Shift in the Aggregate Supply Schedule
with an Increase in the Expected Price Level
An increase in the
expected price level shifts
the labor supply schedule
to the left from Ns(Pe0) to
Ns(Pe1) in part a.
At a given price level, P0,
employment declines from
N0 to Nl, wage goes up
from W0 to W1, and
output falls from Y0 to Y1
(part b).
This decline in output for
a given price level is
reflected in a shift to the
left in the aggregate
supply schedule from
Ys(Pe0) to Ys(Pe
1) in part c.
An autonomous increase in the price of energy inputs shifts the aggregate supply schedule to the left from Ys
0(Pe0) to Ys
1(Pe0)
Output falls from Y0 to Y1 and the price level rises from P0 to P1.
As labor suppliers perceive the rise in the price level, the expected price level rises from Pe
0 to Pe1.
The aggregate supply schedule shifts farther to the left to Ys
1 (Pe1).
Output falls to Y2, and the price level rises to P2.
Figure 8.16 Effects of an Autonomous Increase in
the World Price of Energy Inputs
Figure 8.17 Classical and Keynesian
Aggregate Supply and Demand Curves
The Classical aggregate supply
schedule is vertical, whereas the
Keynesian aggregate supply schedule
slopes upward to the right.
The Classical aggregate demand
schedule depends only on the level of
the money supply (M0).
In the Keynesian system, aggregate
demand depends also on the levels of
fiscal variables (G0, T0), the level of
autonomous investment (I0), and
other variables.
Where to from here?
The Monetarist Counterrevolution