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.

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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.

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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.

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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