Lecture Outline

• Keynesian macroeconomics
– Nominal wage rigidities
– Real wage rigidities
• Nominal wage rigidities
– The sticky wage model
• Sticky prices
– Sticky-price model
• Money in the classical model
– Algebraic Version of AD-AS Model with
Misperceptions
 Central Ideas of Keynesian
Macroeconomics
• Wages and prices don’t adjust quickly to
restore general equilibrium
• The economy may be in disequilibrium for
long periods of time
• The government should act to stabilize the
economy
• Rigidities can be real and/or nominal
 Central Ideas of Keynesian
Macroeconomics
• Nominal rigidities: Keynesians explain
non-neutrality of money with nominal
rigidities
– Nominal price rigidity
– Nominal wage rigidity
• Real rigidities: Keynesians explain
unemployment with real wage rigidity
 Nominal Wage Rigidity - The
Sticky-wage Model
• Assumes that firms and workers negotiate
contracts and fix the nominal wage before
they know what the price level will turn out to
be.
• The nominal wage they set is the product of a
target real wage and the expected price level:
Target
e
real
W  ω P wage
W Pe
 ω
P P
 The sticky-wage model
W Pe
ω
P P
If it turns out that then
e Unemployment and output are
P P at their natural rates.
Real wage is less than its target,
e
P P so firms hire more workers and
output rises above its natural rate.
e Real wage exceeds its target,
P P so firms hire fewer workers and
output falls below its natural rate.
Figure 11.A.1 Monetary nonneutrality
with long-term contracts
In the short run, at
point F, money is
not neutral.
However, at point
H, nominal wages
and prices have
both increased by
the same
percentage, so
that the real wage
W/P is the same
as it was initially
and money is
neutral in the long
run.
 The sticky-price model
• Reasons for sticky prices:
– long-term contracts between firms and
customers
– menu costs
– firms not wishing to annoy customers with
frequent price changes
• Assumption:
– Firms set their own prices
(e.g., as in monopolistic competition).
 Sources of price stickiness
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 + )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 haven’t adjusted
Table 11.1 Average Times Between Price
Changes for Various Industries
Table 11.2 Frequency of Price Adjustment
Among Interviewed Firms
 The sticky-price model
• An individual firm’s desired
price is p  P  a (Y Y )
where a > 0.
Suppose two types of firms:
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
before they know how P and Y will turn out:
p  P e  a (Y e Y e )
 The sticky-price model
p  P e  a (Y e Y e )
• Assume sticky price firms expect that
output will equal its natural rate. Then,
p Pe
• To derive the aggregate supply curve, we
first find an expression for the overall price
level.
• Let s denote the fraction of firms with
sticky prices. Then, we can write the
overall price level as…
 The sticky-price model
e
P  sP  (1  s )[P  a (Y Y )]

price set by sticky price set by flexible

price firms price firms

• Subtract (1s )P from both sides:

sP  s P e  (1  s )[a(Y Y )]
• Divide both sides by s :
e  (1  s ) a 
P  P    (Y  Y )
 s 
 The sticky-price model
e  (1  s ) a 
P  P    (Y Y )
 s 
• High P e  High P
If firms expect high prices, then firms that
must set prices in advance will set them high.
Other firms respond by setting high prices.
• High Y  High P
When income is high, the demand for goods
is high. Firms with flexible prices set high
prices.
The greater the fraction of flexible price firms,
the smaller is s and the bigger is the effect
of Y on P.
 The sticky-price model
e  (1  s ) a 
P  P    (Y Y )
 s 

• Finally, derive AS equation by solving

for Y :
Y  Y   (P  P e ),

s
where  
(1  s )a
 An Algebraic Version of the
Classical AD-AS Model with
Misperceptions
A) The aggregate demand curve
1. From Appendix 9.A, the AD curve is
Y  [IS – LM  (1/lr ) (M/P)]/[IS  LM] (10.A.1)
B) The aggregate supply curve (SRAS)
1. Based on the misperceptions theory:
Y  Y  b(P – Pe) (10.A.2)
 An Algebraic Version of the
Classical AD-AS Model with
Misperceptions
C) General equilibrium
1. The AD curve intersects the SRAS curve at the point found by setting the right-hand sides of
Eqs. (10.A.1) and (10.A.2) equal and rearranging terms to get
a2P2  a1P – a0  0 (10.A.3)
where a2  (IS  LM)b, a1  (IS  LM)( Y – bPe) – IS  LM, and a0  M/lr

1M
 IS   LM 
lr P
 IS   LM
Y b P P e
 
 An Algebraic Version of the Classical
AD-AS Model with Misperceptions

1
  IS   LM  P  M  Y   IS   LM  P  b  IS  LM  P 2  b  IS  LM  P e P
lr

1
b   IS   LM  P    IS   LM   Y  bP    IS   LM  P  M  0
2 e

l r

a2 a1 a0
 An Algebraic Version of the
Classical AD-AS Model with
Misperceptions
The solution for P is given by the quadratic formula,


P    a1  a12  4a2 a0   /2a2
1/ 2
(10.A.4)
 
3. Then output is determined by taking this value of P and using it in Eqs. (10.A.1) or (10.A.2)
4. It’s easy to see that an increase in the nominal money supply increases a0 and thus P
5. If the increase in money supply in unanticipated, so that Pe doesn’t change, then output rises
in the short run, according to Eq. (10.A.2)
6. In the long run, of course, P  Pe, so from Eq. (10.A.2), Y  Y