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Exam zone Chapter 12 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.TRANSCRIPT
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