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X. Neoclassical synthesis

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X.1 Keynes vs. real world

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Keynes: theory Macroeconomics Equilibrium with unemployment Incompatibility with standard microeconomics It is NOT “General Theory”, but theory for economies in depression –The existence of equilibrium – in a strict sense - depends on assumption of rigid nominal wage

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Keynes: AD and AS AD (for simplicity, still assume π e =0, i.e. i=r): –in LVII, slide 39, substitute (5) and (6) into (1), –Solve (4) for dr: and substitute into (1) as well; we obtain: AS: in the same slide, substitute (3) into (2) (and dK=0): In AD schedule, increase of P implies decrease of Y, in AS schedule, increase of P implies increase of Y

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Keynes: equilibrium and policies In the more general Keynesian model, we can construct standard AD and AS schedules Equilibrium: AD x AS intersection –However, equilibrium determined by position of AD and does not have to correspond to full employment one Keynesian policies: shifting AD to the position where it determines equilibrium at full employment AS AD 1 AD 2 Y P Y1Y1 YfYf

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Keynes: true legacy for policies General acceptance of policy recommendations: Capitalism does not have internal forces to produce at full employment (potential product) continuously The Governments can and should stimulate the aggregate demand to bring economies closer to full employment The General Theory (and its ISLM simplification) provides the tools: fiscal and monetary policies

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First applications During WWII, both in UK and in the USA –White Paper on Employment Policy –William Beveridge: Full Employment in a Free Society –Oxford Institute of Statistics: The Economics of Full Employment –Policy: British budget of 1941, US budgets since 1942

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Keynes vs. real world (1) AD and AS above – general version of Keynesian model, AS not very useful for practical for several reasons –Nominal wage given, inflationary expectation also constant In the short-run: prices and wages rigid for many reasons –Informational problem, slow reaction of firms (do not change prices and wages instantaneously, etc. – see next chapters) –This is true for any point of business cycle, not only for depression Consequently, in the (very) short-run, wages and prices constant: aggregate supply horizontal - SRAS

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Keynes vs. real world (2) In the real world the prices adjust and clear markets, even if in very short run sticky When capital fixed, then product given by employment, and when after full adjustment of prices and wages labor market is in equilibrium as well, then this (equilibrium) employment determines full employment and potential product Neoclassical synthesis: in the long-run: aggregate supply vertical (classical) - LRAS

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X.2 The first attempt – downward nominal wage rigidity Originally: F.Modigliani (1944) – downward wage rigidity Reasons for rigid wages in general: –Long-term wage contracts, implicit wage agreements, power of trade unions –Some flexibility upward Intuitively: if nominal wage rigid, then price increase lowers real wage firms increase employment product increases, i.e. demand increasing function of price

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Franco Modigliani 1918-2003, born in Rome, when young, immigrated to the USA MIT 1944: elements of neoclassical synthesis (PhD) 1953: new theory of consumption function (life cycle hypothesis) 1958: contribution to the theory of money, Modigliani- Miller theorem 1985: Nobel price in economics

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Model Only for situation when product smaller or equal to potential (full employment) product Labor market –Either in equilibrium – full employment and potential product –Or product lower than potential, involuntary unemployment labor supply higher than demand and level of employment determined by demand (when, quantity realized on the market always equal to min (D,S))

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N W/P E N Y Y P AS E

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Wage rigidity – weakness of the model Model explains the relation between the fall or increase of price and aggregate supply, when product lower or equal to potential one Does not consider the situation, when product temporarily increases above potential level Real wages move against business cycle

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X.3 Phillips Curve

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Dynamic adjustment Nominal wages aren’t downward rigid forever, but there is a slow adjustment (“beyond the short-run”) → there is an adjustment of labor supply over particular moment of time 1958: A.W.Phillips: The Relation between Unemployment and the Role of Change of Money Wages. British data. –First investigation before Phillips: Irving Fisher already in 1926 –Inverse relationship between unemployment and nominal wage change –Phillips: statistical fit for 1861-1913: –1948-1957 data fitted to this curve very well, too

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Hypothesis High unemployment: bargaining power of workers during wage negotiations is weak, firms are able to hire additional workers without offering much increase in nominal wage Low unemployment: bargaining power of firms weak, as to hire more workers they must offer more substantial nominal wage increase Wage main component of prices Consequently: high unemployment implies low inflation and vice versa

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Interpretation Data seemed to suggest that there is a negative relation between change of nominal wages and unemployment Two crucial questions: –Is this a stable, long-term relationship, valid for other countries as well (see US data on the next slide, for original Phillips data see Dornbush, Fischer,Startz in Literature to this Lecture)? Many empirical studies followed –Theoretical explanation of this relationship Policy consequences: –As in the short run, change in wages determine inflation, is there a trade-off between inflation and unemployment that can be effectively used by policy makers to simultaneously achieve both low inflation and low unemployment?

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Phillips curve - concept Note: here, in LX, we present original approach, as emerged after Philips‘ article in 1958 Define unemployment as u≡(N S -N)/N S –Remember: in K. model, we do not include labor supply function, but it exists, as N S (W/P) –However, in a particular moment of time, real wage W/P real wage is known, so value of labor supply N S is known as well (but in general, N≠ N S )

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Phillips curve – formalization (1) From above: To simplify, suppose discrete time: and after rearrangement Nominal wage in the next period is a function of current wage and a ratio current employment N and current labor supply N S

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Phillips curve – formalization (2) In words: wage in next period is equal wage in the current period, adjusted for the actual level of employment –At full employment (N=N S ), next period wage equals current one –If employment is above full employment, (N>N S ), wage in next period increases (and vice-versa) Speed of adjustment – parameter ε Formally: at present, W, N S constant linear relation (WN line), with positive slope, between W +1 and N – ε large, WN steep. Ε small, WN approaches horizontal

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Wage adjustment W +1 N WN1WN1 NSNS WN always passes through (N S,W) If NN S, WN shifts in time N2N2 N3N3 WN2WN2 WN3WN3

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X.4 Dynamic aggregate supply

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From wages to prices Short-term: labor costs - the only variable costs Price determined by current labor costs plus a mark-up z > 0 (e.g. profit, embedded in price) Simplification (for this chapter only) - production function with fixed coefficients: a... labor productivity –labor costs per unit of output: (1/a).W Price (with incorporation of mark-up)

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Dynamic AS (1) Building blocks Phillips curve: Link from wages to prices: Additional assumption: output and unemployment closely linked (in next Lectures Okun’s law):, ω>0 Combining three equations above, see next slide

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Dynamic AS (2) Remember then combining the three equation and rearranging: Simplifying as

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Dynamic AS (2) In words: price in the next period is equal price in the current period, adjusted for the difference between actual output and full employment one –Difference between actual output and Y f : concept of output gap – see future Lectures AS is very steep for λ>>0, very flat for λ→0 Dynamics: AS shifts in time (always runs through point [Y f,P]) – see next slide

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Dynamic aggregate supply P +1 Y DAS YfYf AS always passes through (Y f,P) If YY f, AS shifts in time Y2Y2 Y3Y3 DAS 2 DAS 3

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X.5 Long term adjustment

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Adjustment (1) Assume starting point Y f at P +1 = P, different time periods and increase in nominal money. Very short run: wages (and prices) don’t have any time to adjust → horizontal AS. An increase in nominal money leads to decrease in interest rate i and, because of the larger investment demand, leads to the increase of overall aggregate demand → excess demand

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Adjustment (2) Short to medium run: Excess demand → firms intend to increase the production, hiring more people → wages (and prices) slowly start to adjust (both nominal wage and price increase). An initial shift of AD (in the very short run) is partially offset, as in medium run, AS is positively sloped New (static) equilibrium, as intersection of AD and AS. Not a dynamic one, adjustment not finished yet –W +1 ≠ W and P +1 ≠ P Medium and long run: AS continues to shift to the left till the output doesn’t fall back to Y f, but with higher price P –Both static and dynamic equilibrium restored

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Medium- to long-term adjustment P Y LRAS A B C SRAS Y +1 Y P (=P -1 ) P +1 P +… AD’ SRAS +…

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Adjustment - summary Aggregate demand: both in short- and long-run decreasing function of price Aggregate supply –In the long-run: vertical at potential product, long- run aggregate supply (LRAS) –In very short-run (ISLM): horizontal at fixed price, short-run aggregate supply (SRAS) –In medium term: positively sloped AS Shifts in AD –In the long-run, do not change product, but over-all price level – consistent with classical model –In very short-run, do change the level of product (and employment), but price is fixed – consistent with original version of Keynesian model

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Short-run shift of AD (external shock that contracts AD) P Y SRAS

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Long-run shifts of AD external shock that contracts AD P Y LRAS

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From short- to long-run (1) Short-run equilibrium: –AD equals AS, adjustment through quantities AS adjusts to AD –Price fixed, equilibrium as state of rest, there can be excess supply on labor market (involuntary unemployment) –Actual product can be lower than potential one Long-run equilibrium: –AD equals AS –Simultaneous adjustment of all prices generates equilibrium on all markets –Actual product equal to potential one

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P Y LRAS SRAS AD Long-run equilibrium E

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From short- to long-run (2) Intuitive interpretation: Fixed price corresponds either to the depression (Keynes) or to very short-run, when prices (and wages) are fixed in all economies and at (almost) all situations (exceptions – e.g. hyperinflations) Long-run equilibrium – prices and wages had to react to changes in demand/supplies on all markets (including labor) and their adjustment cleared all markets simultaneously

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P Y LRAS SRAS Adjustment in the long-run A

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X.6 Conclusions

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Neoclassical synthesis - summary Neoclassical synthesis: in the short and medium run, a change of policy variables (e.g. G, M, T(.), etc.) can change (in the Keynesian tradition) the level of output. However, in the long run, there is always a built-in mechanism, which (in the classical tradition) brings the economy back to the full employment level of output, albeit with a different price level.

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Phillips curve implication There is a trade-off between inflation and unemployment –Higher unemployment → lower inflation and vice versa Trade off, combined Keynesian demand management of either fiscal or monetary nature, was perceived as a basis for Keynesian economic policy after first period of post-war reconstruction This initial belief to potential trade-off between unemployment and inflation, based on original Phillips curve, proved to be one of the biggest mistakes of modern macroeconomics Later lectures: incorporation of inflationary expectations into Phillips curve

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Literature to Ch. X The Phillips curve, derivation of AS and dynamic adjustment explained here according Dornbusch, Fischer, Startz, Ch. 6 –Including the simplification when production function has fixed coefficients and depends on labor only Snowdon, B., Vane, H., Modern Macroeconomics, Edward Elgar Publishing, 2005., pp. 135 – 144 –More detailed, but simple and comprehensive explanation Downward wage rigidity: Modigliani, F., Liquidity- Preference and the Theory of Interest and Money, Econometrica XII (1944), pp. 45-88, reprinted in many Macroeconomic Readings –It is always worth to read this original attempt to deal with Keynes General discussion of AD and AS in Keynesian model: Sargent, Macroeconomics, Ch. 2

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