1. Chapter 12 Keynesian Business Cycle Analysis: Non–Market-Clearing Macroeconomics Copyright © 2012 Pearson Education Inc.

2. 12-2 Keynesian Approach to Business Cycles A central idea of Keynesianism is that wages and prices are “rigid” or “sticky”. As a result of wage and price rigidities the economy can be away from its general equilibrium for significant periods of time.

3. Copyright © 2012 Pearson Education Inc.12-3 Keynesian Approach to Business Cycles (continued) Keynesians: Stabilization policy can and should be used to reduce economic fluctuations. New Keynesians: Stabilization policy may be able to reduce economic fluctuations.

4. Copyright © 2012 Pearson Education Inc.12-4 Nominal-Wage Rigidity In developing their approach Keynesians rely heavily on the assumption of wage and price rigidities. Nominal-wage rigidity is a situation where nominal wages are slow to adjust to changes in labour demand and supply.

5. Copyright © 2012 Pearson Education Inc.12-5 The SRAS Curve and Labour Contracts Labour contracts: specify the nominal, as opposed to the real wage; specify employment conditions and nominal wages for an extended period; commit both sides to a nominal wage one to three years into the future.

6. Copyright © 2012 Pearson Education Inc.12-6 The SRAS Curve and Labour Contracts (continued) Employers and workers form rational price expectations. The price and nominal wage are expected to be P 0 and W 0. The expected real wage is W 0 /P 0.

7. Copyright © 2012 Pearson Education Inc.12-7 The SRAS Curve and Labour Contracts (continued) If P rises, W/P will be below expected, more N will be demanded, and more Y produced. Once the term of the contract expires, employees and firms renegotiate a new nominal wage.

8. Copyright © 2012 Pearson Education Inc.12-8 The SRAS Curve and Labour Contracts (continued) A new expected real wage will be set so as to clear the labour market. Y will differ from for the term of the labour contract.

9. Copyright © 2012 Pearson Education Inc.12-9 Price Expectations and the Keynesian SRAS Curve The SRAS must intercept LRAS at the expected price level. The rational price expectation is determined by the intersection of the LRAS and the expected position of AD e.

10. Copyright © 2012 Pearson Education Inc.12-10 Anticipated Monetary Policy in the Keynesian Model Anticipated changes in money supply: will have no effect on real variables; they are taken into account during nominal wage negotiations.

11. Copyright © 2012 Pearson Education Inc.12-11 Unanticipated Monetary Policy An unanticipated increase in the nominal money supply causes an unanticipated increase in aggregate demand. Firms respond to the lower real wage by hiring additional employees and by expanding output.

12. Copyright © 2012 Pearson Education Inc.12-12 Unanticipated Monetary Policy (continued) In the new labour contract the price expectations are revised to the new price level. Money is not neutral in the short- run but is neutral in the long-run. Wage stickiness prevents the economy from reaching its general equilibrium in the short run.

13. Copyright © 2012 Pearson Education Inc.12-13 Anticipated Fiscal Policy in the Keynesian Model For Keynesians anticipated fiscal policy has no impact on real variables. In the classical model fiscal policy always affects employment and output due to effects on wealth.

14. Copyright © 2012 Pearson Education Inc.12-14 Unanticipated Fiscal Policy in the Keynesian Model A temporary, unanticipated increase in government purchases increases the demand for goods and reduces desired national saving.

15. Copyright © 2012 Pearson Education Inc.12-15 Unanticipated Fiscal Policy (continued) IS and AD curves shift up and to the right, P increases, W/P is lower than expected, employment and output increase. As P rises LM curve shifts up and to the left.

16. Copyright © 2012 Pearson Education Inc.12-16 Unanticipated Fiscal Policy (continued) The labour supply and FE line are unaffected. In the long run, contracts are renegotiated. After the adjustment the output is unaffected, the price level and the interest rate rise.

17. Copyright © 2012 Pearson Education Inc.12-17 Unanticipated Fiscal Policy (continued)

18. Copyright © 2012 Pearson Education Inc.12-18 Comparing Monetary and Fiscal Policy Both fiscal and monetary policies are aggregate demand policies. Both policies, if unanticipated, affect output and employment in the short-run but are neutral in the long-run.

19. Copyright © 2012 Pearson Education Inc.12-19 Comparing Monetary and Fiscal Policy (continued) Easy fiscal policy expands output through the multiplier effect and despite the effect of fiscal policy on the interest rate. Easy fiscal policy increases interest rate and crowds out both consumption and investment spending.

20. Copyright © 2012 Pearson Education Inc.12-20 Comparing Monetary and Fiscal Policy (continued) Monetary policy does not affect consumption and investment spending in the long run. Unanticipated fiscal expansion, by causing real interest rates to increase, crowds-out consumption and investment spending.

21. Copyright © 2012 Pearson Education Inc.12-21 Criticisms of the Nominal Wage Rigidity Assumption Less than a third of the labour force in Canada is covered by contracts. Many labour contracts contain cost-of-living adjustments (COLAs).

22. Copyright © 2012 Pearson Education Inc.12-22 Criticisms (continued) According to the model real wages should be countercyclical. Keynesians respond by incorporating productivity shocks and by assuming price stickiness.

23. Copyright © 2012 Pearson Education Inc.12-23 Price Stickiness Models of nominal price rigidity: explain evidence of a procyclical movement of real wages; while also explaining how aggregate demand shocks can play an important role in explaining business cycles.

24. Copyright © 2012 Pearson Education Inc.12-24 Price Stickiness (continued) Prices are sticky because firms, after establishing a price for their output, find it is in their best interest not to adjust that price even though there has been a change in demand for their output.

25. Copyright © 2012 Pearson Education Inc.12-25 Price Stickiness (continued) Flexible-price firms respond to increases in aggregate demand by increasing price. Fixed-price firms respond to increases in aggregate demand by increasing output.

26. Copyright © 2012 Pearson Education Inc.12-26 Monopolistic Competition A price taker considers the market price as given. A price setter has some power to set price. Perfect competition is a situation in which all buyers and sellers are price takers.

27. Copyright © 2012 Pearson Education Inc.12-27 Monopolistic Competition Monopolistic competition is a situation in which individual producers can act as price-setters: there is some competition; but a number of sellers is smaller; and standardization of the product is imperfect.

28. Copyright © 2012 Pearson Education Inc.12-28 Monopolistic Competition (continued) Keynesians point out that a relatively small part of the economy is perfectly competitive.

29. Copyright © 2012 Pearson Education Inc.12-29 Monopolistic Competition (continued) A price-setter: sets a price in nominal terms for some period of time; meets the demand that is forthcoming at the fixed nominal price readjusts its price from time to time.

30. Copyright © 2012 Pearson Education Inc.12-30 Menu Cost and Price Setting A menu cost is a cost of changing prices. If the loss in profits is less than the cost of changing prices – menu cost – the firm will not change its price.

31. Copyright © 2012 Pearson Education Inc.12-31 Empirical Evidence of Price Stickiness Major reasons for price stickiness are menu costs and a reluctance of managers to lead price changes. A pass-through from the exchange rate to domestic prices is slow or incomplete.

32. Copyright © 2012 Pearson Education Inc.12-32 Meeting the Demand at the Fixed Nominal Price A monopolistically competitive firm charges a price higher than its marginal cost (at a markup). When prices are sticky, firms react to changes in demand by changing the amount of production, rather than changing prices.

33. Copyright © 2012 Pearson Education Inc.12-33 Meeting the Demand (continued) The economy can produce an amount of output that is not on the full-employment line.

34. Copyright © 2012 Pearson Education Inc.12-34 Keynesian Business Cycle Theory Keynesians believe that a primary source of business cycle fluctuations is unanticipated shifts in the aggregate demand curve – aggregate demand shocks. Keynesians attribute recessions to “not enough demand” for goods.

35. Copyright © 2012 Pearson Education Inc.12-35 Keynesian Business Cycle Theory (continued) The Keynesian theory accounts for several business cycle facts: fluctuations of Y in response to AD shocks; employment fluctuates in the same direction as Y; shocks to M are non-neutral, money is procyclical and leading.

36. Copyright © 2012 Pearson Education Inc.12-36 Keynesian Business Cycle Theory (continued) Cyclical behaviour of durable and investment goods can be explained if shocks to them are themselves a main source of cycles.

37. Copyright © 2012 Pearson Education Inc.12-37 Keynesian Business Cycle Theory (continued) Inflation tends to slow during or just after recessions because demand pressure is low during recessions.

38. Copyright © 2012 Pearson Education Inc.12-38 Procyclical Labour Productivity This approach has a problem explaining the fact that labour productivity is procyclical. If the production function is stable, increases in employment during booms should reduce average labour productivity, so it should be countercyclical.

39. Copyright © 2012 Pearson Education Inc.12-39 Procyclical Labour Productivity (continued) Firms may hoard labour during recessions and use it less intensively. So, labour productivity falls during a recession. Labour hoarding is found to be reduced in the last two recessions in Canada.

40. Copyright © 2012 Pearson Education Inc.12-40 Macroeconomic Stabilization According to Keynesians recessions are undesirable, employment can be below the amount of labour that workers want to supply.

41. Copyright © 2012 Pearson Education Inc.12-41 Macroeconomic Stabilization (continued) Average economic well-being would be increased if governments tried to reduce cyclical fluctuations.

42. Copyright © 2012 Pearson Education Inc.12-42 Macroeconomic Stabilization (continued) Without a stabilization policy, wages and prices will be eventually cut in the long-run. During this adjustment process economic well-being is reduced.

43. Copyright © 2012 Pearson Education Inc.12-43 Macroeconomic Stabilization (continued) If prices adjust slowly and the fiscal or monetary policies can be implemented quickly, the AD policy could move the economy back to full-employment output more quickly than otherwise.

44. Copyright © 2012 Pearson Education Inc.12-44 Macroeconomic Stabilization (continued)

45. Copyright © 2012 Pearson Education Inc.12-45 Difficulties of the Policy of Macroeconomic Stabilization Actual macroeconomic stabilization is less successful than Keynesian theory suggests: monetary and fiscal policies should be coordinated; depth of a recession is difficult to measure; the size of effects of monetary and fiscal policies is not known.

46. Copyright © 2012 Pearson Education Inc.12-46 Difficulties of the Policy (continued) Monetary and fiscal policies have lags. Policymakers should concentrate only on fighting major recessions.

47. Copyright © 2012 Pearson Education Inc.12-47 Supply Shocks in the Keynesian Model In the 1970s Keynesian theory failed to account for stagflation. The theory predicts that inflation movements are procyclical.

48. Copyright © 2012 Pearson Education Inc.12-48 Supply Shocks (continued) Keynesians admit that there can be occasional episodes when supply shocks play a primary role in economic downturns. An adverse supply shock reduces MPN and the demand for labour. The FE line and LRAS curve shift to the left.

49. Copyright © 2012 Pearson Education Inc.12-49 Supply Shocks (continued) The adjustment takes place slowly. In the long-run, full-employment output falls, the price level and the real interest rate increase.

50. Copyright © 2012 Pearson Education Inc.12-50 Supply Shocks (continued) In the situation of an adverse supply shock fiscal and monetary policies can offer little help. An unanticipated contractionary AD policy can reduce the size of the increase in the price level, but it can cause a fall in output below the new full-employment level.