ECON 330D2 Chapter Notes - Chapter 12: Real Interest Rate, Aggregate Supply, Aggregate Demand
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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
- 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
- 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
- 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 wmc, but the actual real wage
is w*, which is greater than wmc. This 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
- 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 P1, then the quantity of employment is
determined by the labour demand curve, Nd, with N=N1.
- the labour supply curve is irrelevant for determining employment in the sticky
- 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 N1, from the production function in figure 12.3b, we
determine real aggregate output, which is Y1. Thus, the point (Y1, P1) in figure
12.3c represents the level of output and a price level such that the rep firm is
willing to supply the quantity of output Y1 given the nominal wage, W, and the
price level P1.
- Suppose that the price level is higher, say P2>P1. This implies, 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, Nd, or employment equal to N2. Then, from the production
function in figure 12.3b, output is Y2>Y1, and in figure 12.3c we have another
point on the AS curve, namely (Y2, P2).
- 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
demand curve, Yd, 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
- 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(Y1, r), is downward-sloping because the quantity of money demanded falls as
the interest rate increases, given the level of real income, Y1, and the price level,
P. Thus, given real income, Y1, and the price level, P, the money market is in
equilibrium where money supply equals money demanded at r1. We therefore
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.