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ECON 330D2
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Chapter 12

# ECON 330 Chapter 12.docx

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McGill University

Economics (Arts)

ECON 330D2

Markus Poshce

Winter

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Chapter 12- Edition 2
- The primary feature that makes a Keynesian macroeconomic model different is
that some prices and wages aren’t completely flexible- sticky.
- The New Keynesian model is essentially identical to the monetary intertemporal
model except that price level is not sufficiently flexible for the goods market to
clear in the short run
- In contrast to the monetary intertemporal model (MIM), the New Keynesian
model (NK) will have the property that money isn’t neutral. When the monetary
authority increases money supply, there will be an increase in aggregate output
and employment.
- Given the failure of the labour market to clear, the NK sticky wage model will
have different properties than MIM
- Keynesian strongly believe that the government should play an active role in the
economy, through the monetary and fiscal policy. When the monetary authority
increases the money supply, there will be an increase in aggregate output and
employment
- Since the nominal wage doesn’t move in the short run to clear the labour market
in this model, there may be unemployment in that, given the market real wage,
some people who want to work can’t find employment
- A key feature of the model is that it doesn’t exhibit the classical dichotomy- the
price level and real variables are simultaneously determined
The Labour Market in the Keynesian Sticky Wage Model
- Keynesians argue that, in the short run, the nominal market wage, W, is
imperfectly flexible. The rationale for this is that there are institutional rigidities in
how nominal wages are set. For example, it’s costly for workers and firms to get
together frequently to negotiate wage agreements, so that wages are typically set
at a given firm for a year or more.
- Workers might want a have a provision in a labour contract for nominal wages to
rise faster in the event that inflation is higher than anticipated, and the firms might
want nominal wages to rise at a slower rate if inflation is lower than anticipated. A
labour contract in which future wage increases are geared to inflation is an
indexed contract
- Nominal wage should be thought of as being fixed only in the short run. Though
the nominal wage, W, won’t respond to factors affecting the labour market in the
short run, we will think of the nominal wage as being flexible over the long run.
- Given that nominal wage is fixed in the short run, we could have a situation as in
figure 12.1, where the market-clearing real wage is w , butmche actual real wage
is w , which is greater than w .mchis situation could arise because the nominal
wage was negotiated in the past, with the expectation by workers and firms that it would be a market-clearing wage, but then unforeseen circumstances caused
unanticipated shifts in the labour supply and labour demand curves. At the real
*
wage w , employment is determined by how much labour the rep firm wasn’t to
hire, which is N . However, the rep consumer wants to supply N units of labour
* ** *
at the real wage, w , and we can think of the difference N -N as Keynesian
unemployment; that is, workers cannot work as much as they would like at the
going wage.
- In the sticky wage model, the quantity of labour will always be determined by how
much labour the rep firm wants to hire- the labour demand curve
The Sticky Wage Aggregate Supply Curve
- An important difference in the NK model from the MI model is that given the fixed
nominal wage, W, the real wage, W/P, will depend on the price level. Therefore,
since employment is determined by labour demanded at the market real wage,
employment and output will depend on the price level
- The aggregate supply curve (AS) is a positive relationship between real output
and price level
- The AS curve is derived in figure 12.3. Since the nominal wage W is fixed in the
short run here, the real wage, w=W/P, will change when the price level changes.
In Figure 12.3a, if the price level is P ,1then the quantity of employment is
determined by the labour demand curve, N , with N=N . 1
- the labour supply curve is irrelevant for determining employment in the sticky
wage model
- Note that this will also imply that the supply of output won’t depend on the
real interest rate, r, in contrast to the MI model.
- Given employment equal to N , from 1he production function in figure 12.3b, we
determine real aggregate output, which is Y . Thus,1the point (Y P ) in fi1,r1
12.3c represents the level of output and a price level such that the rep firm is
willing to supply the quantity of output Y giv1n the nominal wage, W, and the
price level P .
1
- Suppose that the price level is higher, say P >P . 2his1implies, since the nominal
wage is fixed, that the real wage will be lower. Seeing a lower real wage, the rep
firm will hire more labour, with the quantity of employment given by the labour
demand curve, N , or employment equal to N . Then, f2om the production
function in figure 12.3b, output is Y >Y2, an1 in figure 12.3c we have another
point on the AS curve, namely (Y , P )2 2
- The AS curve implies that, given a fixed nominal wage, W, an increase in the
price level reduces the real wage, which increases labour demand and
employment, and this implies that more output gets produced. Thus, the AS
curve is upward sloping. Factors Shifting the Sticky Wage AS Curve
- In general, 2 factors will shift the AS curve:
1) An increase in the nominal wage, W, shifts the AS curve to the left. If the
nominal wage increases, then for any price level, P, the real wage, w=W/P, is
higher. This them implies that the quantity of labour demanded, which equals
employment in the sticky wage model, must fall, and therefore output falls.
Thus, for any price level, the quantity of output is lower, and so an increase in
the nominal wage causes a shift left in the AS curve
2) A decrease in the current total factor productivity, z, shifts the AS curve to the
left. A decrease in z, total factor productivity, causes a downward shift in the
production function and a shift left in the labour demand function. Given the
nominal wage and price level, which determine the real wage, less labour is
demanded, and output supplied falls because employment is lower and
because labour and capital are less productive
Aggregate Demand: The IS and LM Curves
- The IS curve in the Keynesian sticky wage model is identical to the output
d
demand curve, Y , in the MI model.
- The curve is downward-sloping because an increase in the real interest rate, r,
causes consumers to substitute future consumption for current consumption, and
causes firms to reduce investment, so that the demands for consumption and
investment goods fall when r rises.
- It will be convenient to suppose there is no long-run inflation. This implies, given
the Fisher relation, that the nominal and real interest rates are equal, or R=r.
Then, the demand for real money balances is given by L(Y,r); that is, the real
demand for money is increasing in aggregate real income, Y, and decreasing in
the real interest rate, r.
- Recall from chapter 10 that an increase in Y increases lifetime wealth, increasing
the demand for goods purchased with money, and an increase in r increases the
opportunity cost of holding money, so that the demand for real cash balances
decreases
- Given that the nominal money supply, M, is determined exogenously by the
government, equilibrium in the money market is determined by M=PL(Y,r), or
nominal money supply equals nominal money demand.
- In figure 12.6a, with the real interest rate on the y-axis, the money supply curve is
given by the vertical lime, and the current nominal money demand curve,
PL(Y , r), is downward-sloping because the quantity of money demanded falls as
1
the interest rate increases, given the level of real income, Y , 1nd the price level,
P. Thus, given real income, Y , a1d the price level, P, the money market is in
equilibrium where money supply equals money demanded at r . We therefore
1 have an output-interest pair (Y ,1 1 for which the money market is in equilibrium
(given P) in figure 12.6b.
- Now, suppose that the level of real income is higher, say Y , while the price level
2
remains the same at P. This implies that money demand increases for each real
interest rate, or the current nominal money demand curve shifts rightward to
PL(Y 2 r) from PL (Y ,1). This then implies that the money market will be in
equilibrium at a higher real interest rate, r2>r 1 Now, we have another output-
interest rate pair, (Y2, 2 ) for which the money market is in equilibrium, given P, in
figure 12.6b.
- Similarly, is we consider all possible levels of income and the associated levels of
the real interest rate for which the money market is in equilibrium, we will derive
an upward-sloping curve, which is the LM curve in figure 12.6b. This curve is
upward sloping because, given the real money supply, M/P, real money demand
increases when income increases, and so for the money demand market to be in
equilibrium the real interest rate must rise to reduce real money demand
Shifts in the IS Curve
- Factors we considered that lead to shifts in the output demand curve, Y , also d
shift the IS curve, since the IS curve is the same thing as the output demand
curve. For our short-run analysis, the IS curve will shift to the right as a result of:
1) An increase in government spending, G. This increases demand for goods
consumed by the government
2) A decrease in the present value of taxes. This increases the demand for
current consumption goods by the rep consumer
3) An anticipated increase in future income. This increases lifetime wealth for
the consumer, thus increasing the demand for consumption goods.
4) A decrease in the current capital stock, K. Recall that, if the capital stock
decreases, then the future MPK will rise, and there is an increase in the
demand for investment goods
5) An increase in future total factor productivity, z’. If z is expected to rise in the
future, the future MPK will rise, and there is an increase in the demand for
investment goods
Shifts in the LM Curve
- Will shift if:
1) If the money supply, M, increases, the LM curve shifts right. In figure 12.8a,
suppose that the monetary authority increases the money supply from M to 1
M 2ith the price level held constant at P and aggregate income held constant
at Y 1 Initially, the nominal demand for money is given by PL(Y , r) a1d the
money market is in equilibrium at the real interest rate, r . 1hen the money supply increases, the money demand curve doesn’t shift, but the money
s1 s2
supply curve shifts to the rights from M to M . Now, the money market is in
equilibrium for a real interest rate of r . Therefore, in figure 12.8b, the point
2
(Y1, 1 is on the initial LM curve, LM , 1s this is the real income/real interest
rate combo such that the money market is in equilibrium. After the money
supply increases, the point (Y , r1) 2s on the new LM curve, LM . That i2, for
any level of real income, the real interest rate must now be lower so that
money demand will rise to meet the higher money supply. Therefore, the LM
curve shifts down, or to the right, when the money supply increases.
2) If P increases, the LM curve shifts to the left. In figure 12.9a, with the money
supply and aggregate income held constant at M and Y , respectiv1ly, the
price level increases from P to 1 . Th2s causes the money demand curve to
shift rightward from P L1Y ,r1 to P L(2 , r1. Then, in equilibrium, the real
interest rate must increase from r to 1 . W2 then know that, in figure 12.9b, a
point on the initial LM curve, LM , is (Y , r ), while a point on the new LM
1 1 1
curve, LM ,2is (Y ,1r 2. For any level of real income, an increase in the price
level increases the demand for money, so that the real interest rate must rise
to decrease the demand for money so that this demand will equal the
constant supply of money. Therefore, the LM curve will shift up or to the left
3) If there is a positive shift in the money demand function L(Y,r), the LM curve
shifts to the left. In figure 12.10a the money market is initially in equilibrium,
given the price level, P, and the level of current real income, Y , for1the real
interest rate r1. The initial real demand for money is L (Y ,1r).1Then, suppose
that the demand for money rises, which would occur, for example, if there
were an increase in the risk associated with holding alternative assets to
money. Then, the nominal demand for money shifts to the right in figure
12.10a, from PL (Y , r) to PL (Y , r). As a result, given the level of real income
1 1 2 1
Y1, the equilibrium real interest rate will now be r >r 2 T1us, in figure 12.10b,
(Y1, r1) is a point on the initial LM curve, LM , 1hile (Y , 1 ) 2s a point on the
new LM curve, LM . Si2ce money demand is higher for any level of income,
given the price level P, the real interest rate must be higher in order to reduce
money demand to equal the fixed money supply. Thus, the LM curve will shift
up or to the left with a positive shift in the money demand function.
The Aggregate Demand Curve
- The aggregate demand curve is derived from the IS-LM diagram. Recall that IS-
LM diagram is constructed for a given price level, P. In figure 12.11a, the initial
LM curve, LM , i1 drawn for price level P . Th1s, (Y ,P ) d1no1es a real output
and price level pair such that the money market and goods market are in
equilibrium in figure 12.11b. Now, suppose that the price level is higher, say P2>P 1 Then, the increase in the price level causes the LM curve to shift left to
LM . As a result, the money market and

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