New Keynesian Theory
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
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 couldnít 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.
economists have argued that real wage rigidity and any type of rigidity is ďad
hocĒ. 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
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 thereís still no cyclical unemployment
in the classical model.
Robert E. Lucas has criticized the use of models, some times called fix-price
models on the following grounds
1) Why should the ďinvoluntarily
unemployedĒ 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. ďBenefits 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
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. ďAs 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
Economists have shown
that there is a tremendous amount of churning of jobs both within and across
industries. But this worker match
theory canít explain all unemployment.
1) Many workers are laid
off temporarily; thereís 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
1) Cannot improve mismatch
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?
rigidity is important in explaining unemployment
In the classical model, unemployment is due to mismatches
between workers and firms
Keynesians are skeptical, believing that recessions lead to
substantial cyclical employment
To get a model in which unemployment persists, Keynesian
theory posits that the real wage is slow to adjust to equilibrate the labor
reasons for real-wage rigidity
For unemployment to exist, the real wage must exceed the
If the real wage is too high, why donít firms reduce the wage?
One possibility is that the minimum wage and labor unions
prevent wages from being reduced
(1) But most
U.S. workers arenít 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
(3) This might
be a better explanation in Europe, where unions are far more powerful
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
A third reason is that workersí 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.
Efficiency Wage Model
Workers who feel well treated will work harder and more
efficiently (the carrot); this is Akerlofís gift exchange motive (warm
Workers who are well paid wonít risk losing their jobs by
shirking (the stick).
Both the gift exchange motive and the shirking model imply
that a workerís effort depends on the real wage.
The effort curve, plotting effort against the real wage, is
D. Wage determination in the efficiency wage model
At low levels of the real wage, workers make hardly any effort
Effort rises as the real wage increases
As the real wage becomes very high, effort flattens out as it
reaches the maximum possible level
one is increasing at an increasing rate
b) region two is increasing
at a decreasing rate
E. Wage determination in the efficiency
Given the effort curve, what determines the real wage firms
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.
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.
The wage rate at point A is called the efficiency wage.
The real wage is rigid as long as the effort curve
Employment and Unemployment in the Efficiency Wage Model
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.
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.
Take that equilibrium wage, w*, and find out the quantity of
laborers demanded and the quantity of laborers supplied.
We do this by locating w* in the vertical axis and
drawing a line over to the labor demand and the labor supply schedules.
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.
The difference between the quantity of labor supplied and the
quantity of labor demanded is the amount of unemployment.
The fact that thereís unemployment puts no downward pressure
on the real wage, since firms know if they reduce the real wage, effort will
Why donít 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?
Henry Ford example in the book
Plants that pay higher wages appear to experience less
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.
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
would be less likely to shirk and would work harder during recessions since the
probability of job loss increases.
The effort curve would rotate, yielding a lower efficiency
wage and a higher level of effort.
lower real wage would accord with what we ďseeĒ in recessions.
wages and the FE line
The FE line is vertical, as in the classical model, since
full-employment output is determined in the labor market and doesnít depend on
the real interest rate.
But in the Keynesian model, changes in labor supply donít
affect the FE line, since they donít affect equilibrium employment
A change in productivity does affect the FE line, since it
affects labor demand.
stickiness is the tendency of prices to adjust slowly to changes in the economy
The data suggests that money is not neutral, so Keynesians
reject the classical model (without misperceptions)
Keynesians utilize the assumption of price stickiness to
explain why money isnít neutral.
An alternative version of the Keynesian model assumes that
nominal wages are sticky, rather than prices; that model also suggests that
money isnít neutral
of price stickiness: Monopolistic
competition and menu costs
If markets had perfect competition, the market would force
prices to adjust rapidly; sellers are price takers, because they must accept
the market price
In many markets, sellers have some degree of monopoly power;
they are price setters under monopolistic competition
Keynesians suggest that many markets are characterized by
In monopolistically competitive markets, sellers do three
(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
readjust prices from time to time when costs or demand change significantly
Menu costs and price stickiness
The term menu costs comes from the costs faced by a restaurant
when it changes price-it must print new menus
Even small costs like these may prevent sellers from changing
Since competition isnít perfect, having the wrong price
temporarily wonít affect the sellerís profits much
The firm will change prices when demand or costs of production
change enough to warrant the price change.
Empirical evidence on price stickiness
Industrial prices seem to be changed more often in competitive
industries, less often in more monopolistic industries
Consumer prices also seem sticky
But catalog prices also donít 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
Meeting the demand at the fixed nominal price
Since firms have some monopoly power, they price goods at a
markup over their marginal cost of production: P = (1 + h)MC
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
Since the firm is paying an efficiency wage, it can hire
more workers at that wage to produce more goods when necessary
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
Effective labor demand
The firmís labor demand is thus determined by the demand for
The effective labor demand curve, NDe(Y), shows how
much labor is needed to produce the output demanded in the economy (Figure
It slopes upward from left to right because a firm needs more
labor to produce additional output
Monetary and Fiscal Policy in the Keynesian Model
Monetary policy in the Keynesian IS-LM model
The Keynesian FE line differs from the classical model in two
(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
(2) Changes in
labor supply donít affect the FE line in the Keynesian model; they do in the
Since prices are sticky in the short run in the Keynesian
model, the price does not adjust to restore equilibrium.
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
This represents the assumption that firms meet the
demand for their products by adjusting employment
of a decrease in the money supply.
(1) LM curve
shifts up from LM1 to LM2.
declines and the real interest rate rises
(3) Firms cut
employment and production due to decreased demand
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
(6) The higher
real inters rate reduces consumption and investment
(7) With lower
demand for output, firms cut production and employment
Eventually firms cut prices, the LM curve shifts back
to its original level and general equilibrium is restored.
Thus money is neutral in the long run, but not in the short
Keynesian AD-AS framework
The aggregate demand curve is the same as in the classical
model; it represents the intersection of the IS and LM curves
The short-run aggregate supply (SRAS) curve is horizontal, due
to price stickiness, but the long-run aggregate supply (LRAS) curve is
The main difference between the Keynesian and Classical
approaches is the speed of price adjustment
The classical model has fast price adjustment so the SRAS
curve is irrelevant.
the Keynesian model, the SRAS curve is horizontal, because of monopolistically
competitive firms that face menu costs.
The effect of a 10% reduction in the money supply is to
shift the AD curve back by 10%
The US output falls in the short run where the SRAS curve
intersects the AD curve.
In the long run the price level falls, causing the SRAS curve
to shift down such that it intersects the AD and LRAS curves.
So in the Keynesian model, money is not neutral in the short
run, but it is neutral in the long run.
The effect of increased government purchases
temporary increase in government purchases shifts the IS curve up (see the
graph top of next page)
In the short run, output and the real interest rate increase
multiplier, DY/DG, tells how much increase in output comes from the increase in
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
the short-run increase in output between the two point A and B on the graph is DY.
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
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.
In the Keynesian model, the FE line doesnít shift (b/c of
efficiency wages), only the IS curve does.
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
didnít increase the potential level of output for in the long run the
full-employment level of output is once again achieved.
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
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.
In the long run the economy reaches potential output at point
C. The economy is once again in
The effect of lower taxes
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.
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
Macroeconomic policy and the real interest rate in the early 1980s and
the early 1990s
In the early 1980s US fiscal policy and monetary policy
policy began changing in late 1979, as the Fed under Paul Volcker tightened
policy to reduce inflation
At the same time,
fiscal policy became easier due to substantial tax cuts
The combination of tight monetary policy and easy
fiscal policy led to a recession, as the LM curve shifted more than the IS
Output declined and the real interest rate rose
The real interest rate hit its highest level since the 1930s
The policies were reversed in the early 1990s
Concern about the size of the government budget deficit led to
fiscal policy tightening
Fed began easing policy in 1989 and maintained an easy policy through the
As a result, real interest rates fall sharply
nominal interest rate on three month Treasury bills fell from 9% in 1989 to 3%
in 1993; long-term interest rates also declined substantially
Since inflation didnít change much, the decline in nominal
interest rates also meant that real interest rates declined
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
Keynesian Theory of Business Cycles and Macroeconomic Stabilization
Keynesian business cycle theory
Keynesians think aggregate demand shocks are the primary
source of business cycle fluctuations
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
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
The Keynesian theory fits certain business cycle facts
There are recurrent fluctuations in output
Employment fluctuates in the same direction as output
Money is procyclical and leading
Investment and durable goods spending is procyclical and
(1) This is
explained by the Keynesian model if shocks to investment and durable goods
spending are a main source of business cycles
believed in ďanimal spirits,Ē waves of pessimism and optimism, as a key source
of business cycles
Inflation is procyclical and lagging
The Keynesian model fits the data on inflation, because the
price level declines after a recession has begun, as the economy moves toward
Procyclical labor productivity and labor hoarding
The Keynesian model suggests countercyclical labor
productivity, since when employment rises, diminishing returns to labor set in
labor productivity is procyclical in the data
Keynesians suggest that all workers arenít fired in recessions
because of the costs of hiring and
training new workers
Instead, firms keep redundant employees on the payroll and
reduce hours they work or put them on make-work tasks that donít contribute to
Thus in recessions, measured productivity is low; in
expansions, when the workers are back to full-time production, there is a jump
The labor-hoarding notion is supported by several empirical
(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
injury rates are procyclical, suggesting that workers work harder in
Keynesians favor government actions to stabilize the economy
Recessions are undesirable because the unemployed are hurt
Suppose thereís a shock that shifts the IS curve down, causing
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
The government could increase the money supply, shifting the
LM curve down to move the economy to general equilibrium.
The government could increase government purchases to shift
the IS curve back up to restore general equilibrium
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
But the price level is higher in the long run when using
policy than it would be if the government took no action
The choice of monetary or fiscal policy affects the
composition of spending
An increase in government purchases crowds out consumption and
investment spending because of a higher real interest rate
Tax burdens are also higher when government purchases
increase, further reducing consumption
Difficulties of macro stabilization
the use of monetary and fiscal policies to moderate the business cycle;
also called aggregate demand management
In practice macro stabilization hasnít been very successful
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.
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 couldnít even
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.
Of course all of these criticisms amount to a condemnation of
what Friedman dubbed ďfine tuningĒ.
Note though that this is not an argument against the sue of
stabilization policy during depressions and significant recessions.
The political environment: The role of the Council of Economic Advisers in formulating
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 Keynesís General
Theory the army of converts to Keynesís 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.
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.
Martin Feldstein, who chaired the council under President
Reagan, disagreed with the administration about the effects of its proposed tax
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 presidentís 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
Supply shocks in the Keynesian model
Until the mid-1970s, Keynesians focused on demand shocks as
the main source of business cycles
But the oil price shock that hit the economy beginning in 1973
forced Keynesians to reformulate their theory
Now Keynesians concede that supply shocks can cause
recessions, but they donít think supply shocks are the main source of
An adverse oil price shock shifts the FE line to the left
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
The LM curve could shift farther left than the FE line, as in
the figure, though that isnít necessary
So in the short run, inflation rises and output falls
Thereís not much that stabilization policy can do about the
decline in output that occurs, because of the lower level of full-employment
Inflation is already increased due to the shock; expansionary
policy to increase output would increase inflation further.
Labor Contracts and Nominal-Wage Rigidity
Keynesians think the nonneutrality of money is because of nominal-wage
rigidity, not nominal-price rigidity
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.
With nominal-wage rigidity, the short-run aggregate supply
curve is no longer horizontal but now slopes upward. Why is this so?
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.
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.
So, a rising price level will lead to an increase in the
amount of output supplied. Hence
the SRAS curve is upward sloping.
Even with an upward sloping SRAS curve the main results of the
Keynesian model still hold
Nonneutrality of money
Money isnít neutral in this model. As the money supply increases, AD shifts along a stable
upward sloping SRAS curve.
As a result, output and the price level increase
Over time, workers will negotiate higher nominal wages and the
SRAS curve will shift left to restore general equilibrium
Thus money is nonneutral in the short run but neutral in the
Objections to the theory
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
Some labor contracts are indexed to inflation, so the real
wage is fixed, not the nominal wage; however, most contracts arenít completely
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.
---------- Sidebars ----------
Discuss Analytical problems 1 and 2 here
because they use the Keynesian IS-LM model.