I.               New Keynesian Theory

 

         As you will recall from your Econ-112, Keynesian economists have relied on rigid wages and prices to provide an explanation of non-market clearing.  In particular they have used wage rigidity to explain unemployment.  They do not buy the argument that all unemployment is voluntary and that it is due to mismatches between a heterogeneous population of workers searching amongst heterogeneous jobs.  Keynesians have argued that recessions are characterized by involuntary unemployment due to low demand for output and workers.  They deny that real wages adjust quickly.  As we can see below if the real wage is above the market clearing level quantity supplied exceeds quantity demanded.

 

Now, in this lecture we will develop a model of the labor market which will allow us to tell a story about involuntary unemployment which we couldn’t tell before.  If the market is clearing as shown below then there is no involuntary unemployment.

 

Everyone who wants a job can get one.  Recall the way in which equilibrium is obtained in this supply and demand model.  If the going wage exceeds the equilibrium wage, we argue that the wage will fall.  Why?  Because the quantity of workers supplied exceeds the quantity demanded.  This will bid the price of labor, the wage, down.  The wage falls till the market clears.  If the wage is less than the equilibrium wage, we argue that the wage will be bid up.  To induce more labor to be forth coming, firms will offer to pay a wage higher than the going wage and this will result in a higher and higher wage.  This process concludes when the wage reaches the equilibrium level. 

 

         Classical economists have argued that real wage rigidity and any type of rigidity is “ad hoc”.  In the classical model there is no involuntary unemployment.  People who are not working are voluntarily not in the labor force.  In reality measured unemployment is never zero and it is the problem of unemployment in recessions that concerns policymakers the most.  Classical economists have a more sophisticated version of their model to account for unemployment. 

 

1)    Workers and jobs have different requirements, so there is a matching problem.

2)    It takes time to match workers to jobs, so there is always some unemployment.

3)    Unemployment rises in recessions because productivity shocks cause increased mismatches between workers and jobs.

4)    A shock that increases mismatching raises frictional unemployment and may also cause structural unemployment if the types of skills needed by employers change.

5)    The shock causes the natural rate of unemployment to rise so there’s still no cyclical unemployment in the classical model.

 

         Nobel Laureate Robert E. Lucas has criticized the use of models, some times called fix-price models on the following grounds

 

1)    Why should the “involuntarily unemployed” in the above model be identified with unemployment data?  There are no unemployed people only unemployed hours of labor services.

2)    No one finds or seeks a job or gets laid off from a job.

3)    The model is useless for designing policy like unemployment benefit programs.  “Benefits might as well be assigned to a seller of 40 hours per week, on the ground that he wished to sell 60, as to a seller of 10 hours.  The fix-price model cannot help us get past the limits of the Walrasian scenario on which the equilibrium models rest because it too accepts the Walrasian abstraction from any kind of continuing relationship between buyers and sellers, or between firms and employees.”

 

         Lucas makes an important point about theorizing.  Some theorists such as Real Business Cycle theorists explain the business cycle by attempting to explain the volatility in employment and real output.  They use competitive models that exhibit volatility and quantities and prices are market clearing.  Thus in these models the notion of unemployment has no role.  There is no such thing as involuntary unemployment.  Lucas thinks that this approach is a credible way to approach thinking about the economy.  But, Keynesians do not.  When Keynesians explain the business cycle they mean accounting for unemployment that reoccurs throughout the business cycle.  Therefore models with clearing markets are of no use to this approach.  “As a matter of social science, the issue of whether to focus theoretically on unemployment or to focus on other features of business cycles and hope to learn something about unemployment as a by-product is one of research strategy, neither point of view being usefully enough developed at this point to have proved the other inferior.”

 

Economists have shown that there is a tremendous amount of churning of jobs both within and across industries.  But this worker match theory can’t explain all unemployment.

 

1)    Many workers are laid off temporarily; there’s no mismatch, just a change in the timing of work.

2)    If recessions were times of increased mismatch, there should be a rise in help-wanted ads in recessions, but in fact they fall.

 

Can government fiscal policy reduce unemployment?

 

1)    Cannot improve mismatch problem.

2)    Some economists argue that barriers to labor-match adjustment should be eliminated by reducing burdensome regulations on businesses or by getting rid of the minimum wage.

 

Why are real wages rigid? 

 

II.              Real Wage Rigidity

A.    Wage rigidity is important in explaining unemployment

1.    In the classical model, unemployment is due to mismatches between workers and firms

2.    Keynesians are skeptical, believing that recessions lead to substantial cyclical employment

3.    To get a model in which unemployment persists, Keynesian theory posits that the real wage is slow to adjust to equilibrate the labor market.

B.    Some reasons for real-wage rigidity

1.    For unemployment to exist, the real wage must exceed the market-clearing wage.

2.    If the real wage is too high, why don’t firms reduce the wage?

a)   One possibility is that the minimum wage and labor unions prevent wages from being reduced

(1)  But most U.S. workers aren’t minimum wage workers, nor are they in unions
(2)  The minimum wage would explain why the nominal wage is rigid, but not why the real wage is rigid.
(3)  This might be a better explanation in Europe, where unions are far more powerful

b)   Another possibility is that a firm may want to pay high wages to get a stable labor force and avoid turnover costs-costs of hiring and training new worker

c)   A third reason is that workers’ productivity may depend on the wages they are paid what is called an efficiency wage and the model explaining this situation is called the efficiency wage model.

 

Note that b) and c) break out of the typical perfectly competitive assumptions.  The classical analysis of the labor market does not recognize difficult to monitor work situations.  It assumes that the amount of effort that each worker gives is given exogenously and is known by the employer.  We shall see below that if we weaken this assumption we not only get a model with different properties but we have a possible explanation for involuntary unemployment.

C.    The Efficiency Wage Model

1.    Workers who feel well treated will work harder and more efficiently (the carrot); this is Akerlof’s gift exchange motive (warm fuzzies).

2.    Workers who are well paid won’t risk losing their jobs by shirking (the stick).

3.    Both the gift exchange motive and the shirking model imply that a worker’s effort depends on the real wage.

4.    The effort curve, plotting effort against the real wage, is S-Shaped

D.   Wage determination in the efficiency wage model

1.    At low levels of the real wage, workers make hardly any effort

2.    Effort rises as the real wage increases

3.    As the real wage becomes very high, effort flattens out as it reaches the maximum possible level

4.    Two regions

a)    region one is increasing at an increasing rate

b)   region two is increasing at a decreasing rate

E.     Wage determination in the efficiency wage model

1.    Given the effort curve, what determines the real wage firms will pay?

2.    To maximize profit, firms choose the real wage that gets the most effort from workers for each dollar of real wages paid.  Thus, the firm maximizes the effort per dollar of wage.

3.    A is the point at which effort per dollar is maximized.  Note that the line emanating from the origin has a slope which is E/w.  This is effort per dollar.  Therefore, when the slope of the ray from the origin is maximized, given the effort curve, we know the equilibrium pair of effort and real wage.

4.    The wage rate at point A is called the efficiency wage.

5.     The real wage is rigid as long as the effort curve doesn’t change.

F.    Employment and Unemployment in the Efficiency Wage Model

1.    The labor market now determines employment and unemployment, depending on how far the efficiency wage is above the market-clearing wage.  If the efficiency wage is not higher than the market-clearing wage then firms would have to pay the market clearing wage and there would be no unemployment. 

2.    The wage is not determined by the intersection of supply and demand in the labor market.  We find the wage by maximizing effort per dollar using the effort curve. 

3.    Take that equilibrium wage, w*, and find out the quantity of laborers demanded and the quantity of laborers supplied. 

4.     We do this by locating w* in the vertical axis and drawing a line over to the labor demand and the labor supply schedules.

5.    The labor supply curve is upward sloping:  as the real wage rises workers wish to substitute work for leisure.  The labor demand curve is the marginal product of labor when the effort level is determined by the efficiency wage.

6.    The difference between the quantity of labor supplied and the quantity of labor demanded is the amount of unemployment.

 

7.    The fact that there’s unemployment puts no downward pressure on the real wage, since firms know if they reduce the real wage, effort will decline. 

8.    Why don’t the unemployed bid the wage down as would occur in the classical model?  The firm would not find any offers to provide the same level of effort at a lower wage as credible.  They know that the worker will provide lower levels of effort at a lower wage.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

G.   How does the efficiency wage theory compare with the data?

1.    Henry Ford example in the book

2.    Plants that pay higher wages appear to experience less shirking

3.     But the theory implies that the real wage is completely rigid, whereas the data suggests that the real wage moves over time and over the business cycle.

4.    Of course it is possible to give a more elaborate version of the efficiency wage model and to allow for the efficiency wage to change over time.

a)    Workers would be less likely to shirk and would work harder during recessions since the probability of job loss increases.

b)   The effort curve would rotate, yielding a lower efficiency wage and a higher level of effort.

c)    A lower real wage would accord with what we “see” in recessions.

H.   Efficiency wages and the FE line

1.    The FE line is vertical, as in the classical model, since full-employment output is determined in the labor market and doesn’t depend on the real interest rate.

2.    But in the Keynesian model, changes in labor supply don’t affect the FE line, since they don’t affect equilibrium employment

3.    A change in productivity does affect the FE line, since it affects labor demand.

 

III.           Price Stickiness

A.    Price stickiness is the tendency of prices to adjust slowly to changes in the economy

1.    The data suggests that money is not neutral, so Keynesians reject the classical model (without misperceptions)

2.    Keynesians utilize the assumption of price stickiness to explain why money isn’t neutral.

3.    An alternative version of the Keynesian model assumes that nominal wages are sticky, rather than prices; that model also suggests that money isn’t neutral

 

B.    Sources of price stickiness:  Monopolistic competition and menu costs

1.    Monopolistic competition

a)   If markets had perfect competition, the market would force prices to adjust rapidly; sellers are price takers, because they must accept the market price

b)   In many markets, sellers have some degree of monopoly power; they are price setters under monopolistic competition

c)   Keynesians suggest that many markets are characterized by monopolistic competition

d)   In monopolistically competitive markets, sellers do three things

(1)  They set prices in nominal terms and maintain those prices for some period
(2)  They adjust output to meet the demand at their fixed nominal price
(3)  They readjust prices from time to time when costs or demand change significantly

e)   Menu costs and price stickiness

(1)  The term menu costs comes from the costs faced by a restaurant when it changes price-it must print new menus
(2)  Even small costs like these may prevent sellers from changing prices often
(3)  Since competition isn’t perfect, having the wrong price temporarily won’t affect the seller’s profits much
(4)  The firm will change prices when demand or costs of production change enough to warrant the price change.

f)     Empirical evidence on price stickiness

(1)  Industrial prices seem to be changed more often in competitive industries, less often in more monopolistic industries
(2)  Consumer prices also seem sticky
(3)  But catalog prices also don’t seem to change much from one issue to the next and often change by only small amounts, suggesting that while prices are sticky, menu costs may not be the reason

g)   Meeting the demand at the fixed nominal price

(1)  Since firms have some monopoly power, they price goods at a markup over their marginal cost of production:  P = (1 + h)MC 
(2)  If demand turns out to be larger at that price than the firm planned, the firm will still meet the demand at that price, since it earns additional profits due to the markup
(3)  Since the firm is paying an efficiency wage, it can hire more workers at that wage to produce more goods when necessary
(4)  This means that the economy can produce an amount of output that is not on the FE line during the period in which prices have not adjusted.

h)   Effective labor demand

(1)  The firm’s labor demand is thus determined by the demand for its output
(2)  The effective labor demand curve, NDe(Y), shows how much labor is needed to produce the output demanded in the economy (Figure below)
(3)  It slopes upward from left to right because a firm needs more labor to produce additional output

 

 

 

 

IV.          Monetary and Fiscal Policy in the Keynesian Model

A.    Monetary Policy

1.    Monetary policy in the Keynesian IS-LM model

a)   The Keynesian FE line differs from the classical model in two respects

(1)  The Keynesian level of full employment occurs where the efficiency wage line intersects the labor demand curve, not where labor supply equals labor demand, as in the classical model
(2)  Changes in labor supply don’t affect the FE line in the Keynesian model; they do in the classical model

b)   Since prices are sticky in the short run in the Keynesian model, the price does not adjust to restore equilibrium.

(1)  Keynesian assume that when not in general equilibrium, the economy lies at the intersection of the IS and LM curves, and may be off the FE line
(2)  This represents the assumption that firms meet the demand for their products by adjusting employment

c)    Analysis of a decrease in the money supply.

(1)  LM curve shifts up from LM1 to LM2.
(2)  Output declines and the real interest rate rises
(3)  Firms cut employment and production due to decreased demand
(4)  The decrease in money supply is contractionary monetary policy (tight money); an increase in money supply is expansionary monetary policy (easy money)
(5)  Tight money reduces real money supply, causing the real interest rate to rise to clear the money market
(6)  The higher real inters rate reduces consumption and investment
(7)  With lower demand for output, firms cut production and employment
(8)  Eventually firms cut prices, the LM curve shifts back to its original level and general equilibrium is restored.
(9)  Thus money is neutral in the long run, but not in the short run.

 

B.    The Keynesian AD-AS framework

1.    The aggregate demand curve is the same as in the classical model; it represents the intersection of the IS and LM curves

2.    The short-run aggregate supply (SRAS) curve is horizontal, due to price stickiness, but the long-run aggregate supply (LRAS) curve is vertical.

3.    The main difference between the Keynesian and Classical approaches is the speed of price adjustment

a)   The classical model has fast price adjustment so the SRAS curve is irrelevant.

b)   In the Keynesian model, the SRAS curve is horizontal, because of monopolistically competitive firms that face menu costs. 

4.     The effect of a 10% reduction in the money supply is to shift the AD curve back by 10%

a)   The US output falls in the short run where the SRAS curve intersects the AD curve.

b)   In the long run the price level falls, causing the SRAS curve to shift down such that it intersects the AD and LRAS curves.

 

5.    So in the Keynesian model, money is not neutral in the short run, but it is neutral in the long run.

 

C.    Fiscal Policy

1.    The effect of increased government purchases

a)    A temporary increase in government purchases shifts the IS curve up (see the graph top of next page)

b)   In the short run, output and the real interest rate increase

c)    The multiplier, DY/DG, tells how much increase in output comes from the increase in government spending

d)   The multiplier associated with any particular type of spending is the short-run change in total output resulting from a one-unit change in that type of spending.  So for the case we wish to consider, if government purchases increase by DG, the short-run increase in output between the two point A and B on the graph is DY. 

(1)  Keynesians think the multiplier is bigger than 1, so that not only does total output rise due to the increase in government purchases, but output going to the private sector increases as well
(2)  Classical analysis also gets an increase in output, but only because higher current or future taxes caused an increase in labor supply, a shift of the FE line.  Potential output rises.
(3)  In the Keynesian model, the FE line doesn’t shift (b/c of efficiency wages), only the IS curve does.

e)    When prices adjust, the LM curve shifts up and equilibrium is restored at the full-employment level of output with a higher real interest rate than before. How long can the economy stay at point B?  Only as long as it takes for the price level to adjust.  Keynesians believe that price level adjustment takes quite a long time even several years.  In the long firms will adjust their prices and the price level will rise.  The LM curve shifts up and to the left till it arrives at point C where the economy is once again in general equilibrium.  Note that this use of fiscal policy didn’t increase the potential level of output for in the long run the full-employment level of output is once again achieved. 

f)     Similar analysis comes from looking at the AD-AS framework.  The increase in government purchases affects output by raising aggregate demand.  Recall that the IS-LM intersection shifts to the right.  Output increases above potential output in the short run since firms will satisfy extra demand at the initial price level.  The upward shift in the IS curve raises aggregate demand for output at any given price level

g)    Expansionary fiscal policy leads to an increase in aggregate demand.  Output rises above the full-employment level of output at point B.  At B aggregate demand for output is greater than full-employment output. Eventually firms raise their prices. 

h)   In the long run the economy reaches potential output at point C.  The economy is once again in general equilibrium

2.    The effect of lower taxes

a)   Keynesians believe that a reduction of (lump-sum) taxes is expansionary, just like an increase in government purchases

b)    Keynesians reject Ricardian equivalence, believing that the reduction in taxes increases consumption spending, reducing desired national saving and shifting the IS curve up.  Recall that Ricardian equivalence states that a lump-sum tax cut does not affect consumption or national saving.

c)   The only difference between lower taxes and increased government purchases is that when taxes are lower, consumption increases as a percentage of full-employment output (because a tax cut will lower desired national savings via increased desired consumption.) whereas when government purchases increase, government purchases become a larger percentage of full-employment output.

3.   

D.   Application:  Macroeconomic policy and the real interest rate in the early 1980s and the early 1990s

1.    In the early 1980s US fiscal policy and monetary policy changed significantly

a)    Monetary policy began changing in late 1979, as the Fed under Paul Volcker tightened policy to reduce inflation

b)    At the same time, fiscal policy became easier due to substantial tax cuts

2.     The combination of tight monetary policy and easy fiscal policy led to a recession, as the LM curve shifted more than the IS curve

a)   Output declined and the real interest rate rose

b)   The real interest rate hit its highest level since the 1930s

c)  

3.    The policies were reversed in the early 1990s

a)   Concern about the size of the government budget deficit led to fiscal policy tightening

b)   The Fed began easing policy in 1989 and maintained an easy policy through the 1990-1991 recession

4.    As a result, real interest rates fall sharply

a)    The nominal interest rate on three month Treasury bills fell from 9% in 1989 to 3% in 1993; long-term interest rates also declined substantially

b)   Since inflation didn’t change much, the decline in nominal interest rates also meant that real interest rates declined

5.    Though there were other things going on at the time (oil price shocks in both 1979 and 1990), the Keynesian model seems to give a reasonable explanation for the movements in real interest rates

VIII.    The Keynesian Theory of Business Cycles and Macroeconomic Stabilization

A.   Keynesian business cycle theory

1.    Keynesians think aggregate demand shocks are the primary source of business cycle fluctuations

2.    Aggregate demand shocks are shocks to the IS or LM curves, such as fiscal policy, changes in desired investment arising from changes in the expected future marginal product of capital changes in consumer confidence that affect desired saving, and changes in money demand or supply

3.    A recession is caused by a shift of the aggregate demand curve to the left, either from the IS curve shifting down, or the LM curve shifting up

4.    The Keynesian theory fits certain business cycle facts

a)   There are recurrent fluctuations in output

b)   Employment fluctuates in the same direction as output

c)   Money is procyclical and leading

d)   Investment and durable goods spending is procyclical and volatile

(1)  This is explained by the Keynesian model if shocks to investment and durable goods spending are a main source of business cycles
(2)  Keynes believed in “animal spirits,” waves of pessimism and optimism, as a key source of business cycles

e)   Inflation is procyclical and lagging

(1)  The Keynesian model fits the data on inflation, because the price level declines after a recession has begun, as the economy moves toward general equilibrium.

5.    Procyclical labor productivity and labor hoarding

a)   The Keynesian model suggests countercyclical labor productivity, since when employment rises, diminishing returns to labor set in

b)   But labor productivity is procyclical in the data

c)   Keynesians suggest that all workers aren’t fired in recessions because of the costs of hiring  and training new workers

d)   Instead, firms keep redundant employees on the payroll and reduce hours they work or put them on make-work tasks that don’t contribute to measured output

e)   Thus in recessions, measured productivity is low; in expansions, when the workers are back to full-time production, there is a jump in productivity

f)     The labor-hoarding notion is supported by several empirical studies

(1)  A survey of manufacturing firms finds that plant managers could have reduced employment further than they did in a downturn without any loss of output and that workers were assigned to make-work tasks
(2)  Industrial injury rates are procyclical, suggesting that workers work harder in expansions.

B.    Macroeconomic stabilization

1.    Keynesians favor government actions to stabilize the economy

2.    Recessions are undesirable because the unemployed are hurt

3.    Suppose there’s a shock that shifts the IS curve down, causing a recession

a)   If the government does nothing, eventually the price level will decline, restoring general equilibrium.  But output and employment may remain below their full-employment levels for some time

b)   The government could increase the money supply, shifting the LM curve down to move the economy to general equilibrium.

c)   The government could increase government purchases to shift the IS curve back up to restore general equilibrium

d)  

4.    Using monetary or fiscal policy to restore general equilibrium has the advantage of acting quickly, rather than waiting some time for the price level to decline

5.    But the price level is higher in the long run when using policy than it would be if the government took no action

6.    The choice of monetary or fiscal policy affects the composition of spending

a)   An increase in government purchases crowds out consumption and investment spending because of a higher real interest rate

b)   Tax burdens are also higher when government purchases increase, further reducing consumption

7.    Difficulties of macro stabilization

a)   Macro stabilization:  the use of monetary and fiscal policies to moderate the business cycle; also called aggregate demand management

b)   In practice macro stabilization hasn’t been very successful

c)   Problem:  How do we know how far the economy is from full employment?  Recall the difficulties of stabilization which we listed in a earlier hand out.

d)   Problem:  Don’t know the quantitative impact on output of a change in policy.  As we have noted before in class, when an exogenous variable changes at best we can give the direction of changes in endogenous variables which ensue. ( Recall that in some cases we couldn’t even do that!).

e)   Also, because policies take time to implement and take effect, using them requires good forecasts of the position of the economy 6 months to a year in the future.  But forecasts are notoriously imprecise.

f)     Of course all of these criticisms amount to a condemnation of what Friedman dubbed “fine tuning”.  Note though that this is not an argument against the sue of stabilization policy during depressions and significant recessions.

8.    The political environment:  The role of the Council of Economic Advisers in formulating economic policy

a)   Members of the council come from the academy, bringing fresh ideas and perspectives to policy discussions.  As we have noted it is the younger scholars who are always the revolutionaries.  Take as an example Lucas, Barro, Feldstein, and Sargent.  Consider the rise of the Keynesian model after Keynes’s General Theory the army of converts to Keynes’s aggregate model of the economy were primarily made up of the young.  This is almost entirely true but not quite for the pioneer in the research of business cycles, Alvin Hansen was already an established economist who became a Keynesian and went on to play a major role in shaping what came to be known as Keynesian aggregate demand management in his famous seminar series given at Harvard.

b)   Walter Heller, chair of the council under President Kennedy, was able to work with the administration, convincing them to use expansionary fiscal policy to stimulate the economy.  Note that we have mentioned this before when we discussed the occasions on which aggregate demand policy appeared to be successful.

c)   Martin Feldstein, who chaired the council under President Reagan, disagreed with the administration about the effects of its proposed tax cuts

(1)  Feldstein argued publicly that the tax cuts would lead to high government deficits higher real interest rates, and lo investment
(2)  As a result, the administration stopped relying on the council for advice
(3)  By taking the dispute public, Feldstein lost the president’s trust, though he maintained his academic reputation.  This is an interesting dilemma.  What should an official do when he/she is placed in a situation in which he/she does not agree with a particular policy promoted by the president who hired them in the first place?  Does this dilemma sound familiar?  Well, it should.  Heard of Robert McNamara anyone?

C.   Supply shocks in the Keynesian model

1.    Until the mid-1970s, Keynesians focused on demand shocks as the main source of business cycles

2.    But the oil price shock that hit the economy beginning in 1973 forced Keynesians to reformulate their theory

3.    Now Keynesians concede that supply shocks can cause recessions, but they don’t think supply shocks are the main source of recessions

4.    An adverse oil price shock shifts the FE line to the left

a)   The average price level rises, shifting the LM curve left (from LM1 to LM2), because the large increase in the price of oil outweighs the menu costs that would otherwise hold prices fixed

b)   The LM curve could shift farther left than the FE line, as in the figure, though that isn’t necessary

c)  

d)   So in the short run, inflation rises and output falls

e)   There’s not much that stabilization policy can do about the decline in output that occurs, because of the lower level of full-employment output

f)     Inflation is already increased due to the shock; expansionary policy to increase output would increase inflation further.

IX.         Labor Contracts and Nominal-Wage Rigidity

A.    Some Keynesians think the nonneutrality of money is because of nominal-wage rigidity, not nominal-price rigidity

1.    Nominal wages could be rigid because of long-term contracts between firms and unions.  The text notes that most labor contracts specify employment conditions and nominal wages for a period of three years.  The contract specifies the nominal wage rate, but not the amount of employment.  Employers decide how many hours workers provide and whether workers are laid off or not.

2.    With nominal-wage rigidity, the short-run aggregate supply curve is no longer horizontal but now slopes upward.  Why is this so?

3.    Consider a rise in the price level:  W is determined by the contract and does not change, but w = W/P falls.  That is, the real wage falls when the price level rises.

4.    As the real wage falls, firms will demand more labor.  Since firms unilaterally decide the level of employment, the rise in the demand for labor will lead to an increase in employment and therefore to an increase in output.

5.    So, a rising price level will lead to an increase in the amount of output supplied.  Hence the SRAS curve is upward sloping.

B.   Even with an upward sloping SRAS curve the main results of the Keynesian model still hold

C.   Nonneutrality of money

1.    Money isn’t neutral in this model.  As the money supply increases, AD shifts along a stable upward sloping SRAS curve.

2.    As a result, output and the price level increase

3.    Over time, workers will negotiate higher nominal wages and the SRAS curve will shift left to restore general equilibrium

4.    Thus money is nonneutral in the short run but neutral in the long run.

5.     

6.    Objections to the theory

a)   Only about 1/6 of the US labor force is unionized and covered by long-term wage contracts; however, some nonunion workers get wages similar to those in union contracts, and other workers may have implicit contracts that act like long-term contracts

b)   Some labor contracts are indexed to inflation, so the real wage is fixed, not the nominal wage; however, most contracts aren’t completely indexed

c)   The theory predicts that real wages will be countercyclical; however, if they are both aggregate supply shocks and aggregate demand shocks, real wages may turn out on average to be procyclical, but could still be countercyclical for demand shocks.

 

 

 

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Discuss Analytical problems 1 and 2 here because they use the Keynesian IS-LM model.