Macroeconomic fluctuations, and the traditional Keynesian theory Nikolina Kosteletou 1 Keynesian theories: wage and price rigidities National and Kapodistrian University of Athens Department of Economics Master Program in Applied Economics UADPhilEcon

Effective demand Demand→ supply Nominal disturbances can have real effects. Supply adjusts to demand. Assumptions: – perfect competition in the goods and labor market. – fixed prices.

For the supply to increase after increase in demand: Departure from perfect competition, and equilibrium. If initially Equilibrium in the labor market Ms ↑ then demand ↑ Firms are not willing to employ more labor unless wages fall. Workers are not willing to supply more labor unless wages increase. →employment and output do not change.

For effectiveness of demand: wage – or- price stickiness. Departure from perfect competition. Initial disequilibrium. four cases: 1.Wage stickiness 2.Price stickiness, competitive labor market 3.Price stickiness, labor market imperfections 4.Sticky wages, labor market imperfections

Case 1: Wage stickiness (Keynes’ model) Static analysis (one period) Labor market: – Nominal wage is sticky (downwards) – wage is above the level that equates demand and supply Goods market: – Competitive markets, competitive firms – Prices flexible and

Production function: Y=F(L) F’>0 F’’<0 Firms hire labor to the point where W/P=MPL If demand for goods increases: – P ↑ and W/P ( ↓ ) – Employment and W/P move along the downward sloping demand for labor curve (MPL).

LSLS LDLD L A B The labor market with sticky wages, flexible prices and competitive products *Real wage is countercyclical unemployment C

Case 2: Price stickiness, flexible wages and competitive labor market Labor market: – Competitive labor market – Nominal wage flexible Goods market: – Incomplete nominal adjustment – Price stickiness – The firms have market power – They fix price above MC (MR>MC) – If demand ↑ output produced ↑ demand for labor ↑ – Nominal wage can be whatever for the firm, given the level of demand :

Demand for labor determines level of employment Effective demand for labor L Lo

If demand for goods increases demand for labor will increase L LoL1

Sticky prices, flexible wages, competitive labor market L LoL1 LSLS  Real wage is procyclical  There is no unemployment

Case 3: Price stickiness, flexible wages and labor market imperfections Labor market: – Labor market does not clear (in the Walrasian sense). – Real wage is above the level where demand for labor is equal to supply. – Firms pay more for efficiency reasons. Goods market: – Incomplete nominal adjustment. – Price stickiness. – … as in previous case

Efficiency wage Firms have a real wage function: They pay more than the equilibrium real wage rate. The real wage rate they pay is a positive function of the level of employment: w/P=ω(L) Unemployment If extra bonus is smaller the higher the level of employment, then unemployment falls as firms increase employment.:

Price stickiness, flexible wages and labor market imperfections L LoL1 LSLS  Real wage is procyclical  There is unemployment  Effective demand A B C

Case 4: wage stickiness, flexible prices and imperfect competition in the goods market Labor market: Nominal wage is rigid Goods market: – Imperfect competition – Price flexible – price is a markup over marginal cost – Firms have a mark up function.

Markup function:

L D (MPL/μ(L)) L *unemployment LSLS

If μ(L) is countercyclical: μ(L)↓ as demand for goods increases. Cases: MPL equally falls P remains constant→ the real wage is unaffected. Demand is effective, output can expand at no cost.

L D (MPL/μ(L)) L *Real wage is constant LSLS

If μ(L) is countercyclical: μ(L)↓ as demand for goods increases. MPL falls by more, P falls → the real wage increases Demand is effective, output can expand at no cost.

L D (MPL/μ(L)) L  unemployment  Unemployment falls as demand increases  As demand increases prices fall  Real wage is procyclical LSLS