Chapter12_3rdEd - Wilt‘awm memes QMM Keynesian Business...

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Unformatted text preview: .. / Wilt‘awm memes ' QMM' Keynesian Business Cycle Theory: Sticky Wages and Prices IN THIS CHAI'ILR, EVE STUDY A BUSINLSS O‘le MODET “‘4 THE SPIRIT OF KEYHESS GENERAL Theory.l Keynesran business cycle models have been very influential with both academics and policymakers The basic formal modeling framework underlying these models was developed by Hicks in the late 193052 and popularized in Paul Samuel- son’s textbook in the 1950s In the 19605, large-scale versions of these Keynesian business cycle models were fit to data, and they are still used by some economists for forecasting and policy analysis. Although Keynesian models cenainly have some strong adherents,3 they have many detractors as well.‘ Pan of what we do in this chapter is to critically evaluate the Keynesian sticky wage model, just as we evaluated equilibrium business cycle models in Chapter 11. We see how well the Keynesian sticky wage model fits the key business cycle facts we discussed in Chapter 3, and we examine how useful it is for guiding the formulation of economic policy. In eonstntciing the Keynesian sticky wage model, we do not start from scratch but build on the monetary iniertemporal model studied in Chapter 10, The primary feature that makes a KeyneSian macroeconomic model different from the models that we have examined thus lar is that all prices and wages are not completely flexible—that is. some prices or wages are sticky. If some prices and wages cannot move so as to clear markets. then this will have important implications for how the economy behaves and for economic policy The Keynesian sticky wage model studied in this chapter is essentially identical to the monetary interteinporal model in Chapter l0, except that the nominal wage rate is not sufficiently flexible for the labor market to clear in the shon run. Given the failure of the labor market to clear. the Keynesian sticky wage model has far different properties from the monetary intertcmporal model, and we _; need to take a quue different graphical approach to analyzing how it works. ' ' in contrast to the monetary iniertemporal model in Chapter 10. the Keynesian sticky wage model has the property that money is not neutral. When the monetary :SeeJ M Keynes. 193?: The (‘mmal theory a] Employ "1071. Interest, and Mix-()3 Macmillan. lnndcn z] Hitks, [937 '\1r Keynes and the Classits A Suggested Interpretation.“ Famomrmm 5. H7459. ‘Sce L Ball and N G NlJnklw‘ I094 "A Sticky-Pnce Manifesto? Gimme-Romain Conjmnu Sam on Publit Policy 4|, 127-151 and Woodlartf. M. 1003 lntemt and Prices: Foundations of a Theory of Monetary Polity. Princeton University Press ‘Sec R. Lucas. 1980 “Methods and Probiems in Business Cycle Theory." Jamaal of Money. Credit, unJ [Linking 127 Mi -.‘17.=.'.":1"‘. ":T 442 Part V Money and Business Cycles authority increases the money supply. there is an increase in aggregate output and employment. in general. monetary policy can then be used to improve economic performance and welfare. Keynesians typically believe strongly that the government should play an active role in the economy. through both monetary and fiscal policy. and Keynesian business cycle models support this belief. Because the nominal wage does not move in the short run to clear the labor market in the Keynesian sticky wage model. there may be unemployment in that. given the market real wage. some people who wish to work cannot find employment. This is the first instance in this book of a genuine theory of unemployment; all of the macroeconomic models we have studied thus far explain only the quantity of employment and not the amount of utictiiployment in Chapter 16. we study other models of unemployment that take account of the search behavior of the unemployed and incentive problems in the workplace. In this chapter. we first construct the Keynesian sticky wage model. starting first with the labor market (where the critical difference in behavior from the monetary intertemporal model is). then proceeding to the construction of the is and LM curves. which capture behavior in the goods market and money market, respectively. Then, we show how the aggregate demand and aggregate supply curves are constructed. which jointly deterrnine equilibrium aggregate output and the price level. A key feature of the model is that it does not exhibit the classical dichotomy—the price level and real variables are simultaneously determined. Once we have put the Keynesian sticky wage model together, we put it to work. first in showing that money is not neutral. Then. we study the match between the model and the key business cycle facts from Chapter 3. Finally. we show how active monetary and fiscal policy can smooth out busmess cycles in the model by reacting to extraneous shocks to the economy. Much work in Keynestan macroeconomics focuses on sticky prices rather than. or in addition to. sticky wages. We show how our model can be altered to include sticky prices in a simple way. The sticky price model we construct has many of the same properties as the sticky wage model. but in how the labor market behaves it is quite different. These differences are potentially important in allowing us to distinguish empirically among different theories of the business cycle. The Labor Market in the Sticky Wage Model What makes the Keynesian sticky wage model different is the functioning of the labor market. so we start with a description of how this market works. 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 is costly to get workers and firms together frequently to negotiate wage agreements. so that wages are typically set at a given firm for a year or more. Further. it is also costly for Workers and firms to write complicated contracts, that is. contracts that provide for every contingency that might arise during the course of a labor contract. For example. workers might want to have a provision in a labor contract for nominal wages to rise faster in the event that inflation is higher than anticipated. and the firm might want nominal wages to rise at a slower rate if inflation is lower than anticipated. - .. . . _.... _._..... mum-n: “Human-.- 171'. .-...-..4.-.-_-.w.-:.'_...-=ba= .. Egg-4m - -1.2:I::.—~—-_ ..-~ Chapter l2 Keynesian Business Cycle Theory: Sticky wages and Prices 443 A labor contract in which future wage increases are geared to mflation is an indexed contract. lndexation to the inflation rate is relatively simple. because there are observed measures of inflation. such as the consumer price index. that could be used for this purpose. In spite of this. most labor contracts in the United States do not provide for complete indexation to inflation. although indexation was more common when inflation rates were higher. such as in the 19705. Given that indexation of wages to observed inflation rates iii labor contracts seems relatively low cost and yet is typically not done. we can understand why more complicated types of contingencies do not find their way into labor contracts. For example. consider a bakery that is negotiating a contract with its workers It might be cffictent for the workers to receive a higher wage over the course of the contractual period in the event that the firm sells an unexpectedly large quantity of bread or that an individual worker should receive a lower wage in the event that the worker's health is unexpectedly bad. However. it may be difficult for the workers to monitor the firm's output. or for the firm to monitor each worker‘s health. so that these particular features do not find their way into the labor contract. As well, the more factors that are included in a labor contract. the more difficult it is to negotiate the contract. Simple labor contracts arise in pan because contract negotiation is costly. lfworkers and firms negotiate wage contracts in nominal terms. we could represent this as a fixed nominal wage W for the economy as a whole. We must recognize that the nominal wage should be thought of as being fixed only in the short run Although the nominal wage W does not respond to factors affecting the labor market in the short run. we think of the nominal wage as being flexible over the long run Given that the nominal wage is fixed in the short run. we could have a Situation as in Figure 12 l where the market-clearing real wage rate is w__.;. but the market or actual real wage is w‘. which is greater than wm. 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 labor supply or labor demand curves. At the real wage w‘, emplomtcnt is determined by how much labor the representative firm wants to hire. which is N ’. However, the representative consumer wants to supply N” units of labor at the real wage w‘. and we can then think of the difference N" —- N' as Keynesian unemployment; that is. workers cannot work as much as they would like at the going wage. 1n the sticky wage model. the quantity of labor is always determined bv how much labor the representative firm wants to hire—that is, by the labor demand curve. The justification for this is that, in most employment relationships. the firm determines how many workers are employed with the firm and what their hours of work are Although the sticky wage model can capture an element of the phenomenon of unemployment. because in the model there potentially are would-be workers who would like to be employed but cannot find Jobs. the Keynesian depiction of unemployment is perhaps unsatisfactory. One problem is that unemployment. as measured in the US. unemployment survey, is job search activity. in the Keynesian sticky wage model. the representative consumer is not making chorccs about how hard to search for work or what job offers to accept. A second problem is that. in practice. some unemployment always exists, while in the labor market in the Keynesian sticky 444 Part V Money and Busmess Cycles Chapter I: Keynesian Business Cycle Theory: Sticky Wages and Prices 4-15 _——————-——————————-—-——_——-—— I Figure ‘2" The Labor Market in the Keynesian Sticky Wage Model. figure 12.2 The Labor Market in the Keynesian Sticky Wage Model in the Keynesian sticky wage model, the labor market need not clear. in the figure. the market real When There Is Excess Demand. wage w‘ is greater than the market-clearing real wage Wmt'. The quantity 0f employment is N'. , I“ "“5 circumstance the market "3‘ W3 C V’ is “:55 than the """k ' . . . . . ‘ _ ‘ . e - l . determtned bY the quantlty of labor that the representative firm wishes to hire. and N” — N' Is quantltv 0f employment. determined bY lgabm demand is N' Whith i: gc'::::9"":ar: nigihtmzaixw Keynesian unemployment. of labor that the representative consumer wishes to supply. I q Real Wage, w Wmc NI ‘ '0. _______________fl'°_vmza"_____— wage model. as we have sct ll up, there arc Circumstances in which there is no unemployment. ll employment is determined as the quantity ol labor desired by the representative firm at the market real wage-that is, by the quantity determined by the labor demand curve—then there is no unemployment if the market real wage is less than the market-clearing real wage. In this case, as in Figure l2.2, the market real wage is w‘. which is less than the market-clearing real wage Wm. At the market real wage, w‘ is the quantity of employment. determined by the representative firm. but N' ' is the quantity of labor that the representative consumer wants to supply. Thus, In this case the consumer is working more than he or she would like, which seems unpalatable. To make the model more palatable, we might suppose instead that. in the Situation depicted in Figure 12.2. the quantity of employment is determined by how much the representative consumer wants to work. In this case. employment would he N ’ ‘, and there would be an excess demand [or labor of N‘ -— N “, because the representative firm wants to hire a larger quantity of labor at the market wage than the representative consumer wants to supply. Although this fix is somewhat more appealing, there remains the undesirable feature that in this Circumstance there is no unemployment. whereas in practice there are always some people who are not employed but are searching for work. In Chapter lo, we analyze a model of search and unemployment in which the unemployment rate is determined by the choices of the unemployed i=5: Real Wage, w Employment, N concerning what job offers they take. In that model. the unemployment rate will always be positive. In the reminder of this chapter, we stick to circumStances in which the market real wage is no lower than the equilibrium real wage and employment is determined by the labor demand curve. This allows us to corLsidcr only cases where the model predicts positive unemployment. The Sticky Wage Aggregate Supply Curve Now that we have introduced the key element of the Keynaian sticky wage model. which is the labor market. we can fill in the other components of the model. An tmponant dillerence in the Keynesian model from the monetary intertcmporal model in Chapter I0 is that given the fixed nominal wage W, the real wage %' depends on the price level. Therefore, because employment is determined by labor demanded at the market real wage, employment and output depend on the price level. In this section. the component of the model we construct is the aggregate supply curve, which is a positive relationship between real output and the price level. The aggregate supply curve is derived in Figure 12.3. Because: the nominal wage W is fixed in the short run here. the real wage w = % changes when the price level changes. In Figure 12.3(3), if the price level is Pi, then the quantity ol employment is determined by the labor demand curve N“, with employment N = N1. Because the 446 Part V Money and Business Cycles Chapter [2 Keynesian Business Cycle Theory Sticky wages and Prices 447 _————-——-——-——————'——"_——— ‘ . labor supply curve is irrelevant for determining employment in the sticky wage model. ' . t et'on of theA re ate Supply Curve. _ .. . . .1 . . . . g - 23:13:: fizz-IL; wage W an iizregse in the price level reduces the market real wage. which we leave ll out of the diagram. This also implies that the supply of output does not | I increases employment as the representative firm hires more labor. This results in more output being depend on the real interest rate r. in contrast to the monetary intertemporal model. . - . Given em lo ment e ual to N from the roduction function in Ft ure 12.3(b) We ' ' ' ' d. which telds the p y q l‘ p g P'OdURd- ""15- a h'gh" 9"" level ""9"“ that more output '5 produce y detennine real aggregate output. which is Yl. Thus. the point (Yr. P.) in Figure l2.3(c) ygfid-slopigfigflw" pane‘waflrrfi ‘ *‘d‘ ' represents a level of output and a price level such that the representative firm is willing to supply the quantity of output Y1 given the nominal wage W and the price level P]. This point is then on the aggregate supply curve A5. Suppose that the price level is higher, say P; > P). This implies. because the nominal wage is fixed. that the real wage is lower—that is. PW; < 5' Seeing a lower real wage. the representative firm hires more labor. with the quantity of employment given by the labor demand curve Nd. or employment equal to N1. Then. from the production function in Figure 1230)). output is Y2 > Y}, and in Figure 12.3(c) we have another point on the aggregate supply curve AS. namely (Y1, P;). Similarly. we could ask how much output would be supplied by the representative firm for any value of the price level and trace out an upward-sloping aggregate supply curve AS. The aggregate supply curve implies that. given a fixed nominal wage W. an increase in the price level reduces the real wage. which increases labor demand and employment. and this implies that more output gets produced. Thus. the A5 cone is upward sloping. Factors Shifting the Sticky Wage Aggregate Supply Curve Now that we have constructed the aggregate supply curve. we must determine what factors shift the curve. so that we catt correctly use the curve as part of our model. in general. two factors can shift the AS curve. ' An increase in the nominal wage W shifts the aggregate supply curve to the left. If the nominal wage increases. then for any price level P. the real wage. w = % is higher This then implies that labor demand. 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 real wage causes a shift to the left in the aggregate supply curve. In Figure 12.4 the aggregate supply curve shifts from A5 to AS'. 0 A decrease in current total factor productivity 2 shifts the aggregate supply curve to the left. If there is a decrease in 2. total factor productivity, this causes a downward shift iii the production function and a shift to the left in the labor demand function. Given the nominal wage and the price level. which determine the real wage. less labor is demanded, and output supplied falls because employment is lower and because labor and capital are less productive. Again. the aggregate supply curve shifts to the left. as in Figure 12.4. (b) g; 2 Aggregate Demand: The IS and LM Curves " fic- Early Keynesian models often neglected aggregate supply and concentrated on aggre- .,_. _ . gate demand. These aggregate demand Keynesian models are often referred to as . - ,_..:_,..qs._.,=.fl=_-—. .73». -1—.-.- _ . “ML. 448 Part V Money and Business Cycles ___________________._____—————————— Figure I2.4 The Effect of an Increase in W or a Decrease in 2. An increase in W or a decrease in 2 implies that the representative firm hires less labor given the price level P. and output supplied therefore decreases. Thus. the aggregate supply curve shifts to the left. Prlce Level, P Real Output. Y _________________________._____ l5 — 1M models, because Hicks. in his formalization of Keynes's General Theory. used the terms l5 and W to refer to the curves in his model. The [5 curve in the Keynesian sticky wage model is identical to the output demand curve Y" in the monetary interiemporal model in Chapter 10. As in Chapters 9 and 10. the curve. as depicted in Figure 12.5. 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. Now, to derive the LM curve. we need to consider again the approach from the monetary intenemporal model that determines the demand for money. As when we considered short-run analysis in the monetary intertemporal model in Chapter 10. it is convenient to suppose for now that there is no long-run inflation. This implies. given the Fisher relation from Chapter 10. that the nominal and real interest rates are equal, or R = r. Then, from Chapter 10. 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 Chapter II Keynesian Bustness Cycle Theory Sticky Wages and Prices 449 Figur...
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