Lecture Slides on Chapter 12 of Abel, et. al. (6th Canadian ed.)

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Chapter 12
Keynesian Business
Cycle Analysis:
Non–Market-Clearing
Macroeconomics
Copyright © 2012 Pearson Education Inc.
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.

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12-2
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.

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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.

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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.

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The SRAS Curve and Labour
Contracts (continued)
Employers and workers form
rational price expectations.
 The price and nominal wage are
expected to be P0 and W0. The
expected real wage is W0/P0.

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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.

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The SRAS Curve and Labour
Contracts (continued)

A new expected real wage will be
set so as to clear the labour market.
Y  Y  b(P  P )
e

Y will differ from Y for the term of
the labour contract.
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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 ADe.

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12-9
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.

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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.

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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 shortrun but is neutral in the long-run.
 Wage stickiness prevents the
economy from reaching its general
equilibrium in the short run.

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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.

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Unanticipated Fiscal Policy
in the Keynesian Model

A temporary, unanticipated
increase in government purchases
increases the demand for goods
and reduces desired national
saving.
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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.

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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.

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Unanticipated Fiscal Policy
(continued)
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12-17
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.

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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.

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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.

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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).

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Criticisms (continued)
According to the model real wages
should be countercyclical.
 Keynesians respond by
incorporating productivity shocks
and by assuming price stickiness.

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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.

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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.
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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.

Y  Y  b(P  P )
e
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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.

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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.

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Monopolistic Competition
(continued)

Keynesians point out that a
relatively small part of the
economy is perfectly competitive.
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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.

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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.

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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.

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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.

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Meeting the Demand
(continued)
P  (1  η)MC

The economy can produce an
amount of output that is not on
the full-employment line.
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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.

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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.

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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.
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Keynesian Business Cycle
Theory (continued)

Inflation tends to slow during or
just after recessions because
demand pressure is low during
recessions.
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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.

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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.

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Macroeconomic Stabilization

According to Keynesians
recessions are undesirable,
employment can be below the
amount of labour that workers
want to supply.
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Macroeconomic Stabilization
(continued)

Average economic well-being
would be increased if governments
tried to reduce cyclical
fluctuations.
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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.

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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.
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Macroeconomic Stabilization
(continued)
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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.

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Difficulties of the Policy
(continued)
Monetary and fiscal policies have
lags.
 Policymakers should concentrate
only on fighting major recessions.

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Supply Shocks in the
Keynesian Model
In the 1970s Keynesian theory
failed to account for stagflation.
 The theory predicts that inflation
movements are procyclical.

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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.

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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.

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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.

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12-50
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