ECON 313: MACROECONOMICS I

W/C 19th October 2015

THE KEYNESIAN SYSTEM IV

Aggregate Demand and Supply

Dr. Ebo Turkson

The Keynesian Aggregate Demand Schedule Relaxing the Assumption of Fixed General Price level

Using the IS-LM Schedules to derive the AD Schedule

The Keynesian AD Schedule combined with Classical Theory of AS

A Contractual View of the Labour Market Sources of Wage Rigidities

A Flexible Price-Fixed Money Wage Model

Labour Supply and Variability in the Money Wage

The Effects of Shifts in the AS Schedule

Conclusion: Keynes Versus the Classics

Recall the essential notion embodied in the simple Keynesian model; For output to be at the equilibrium level AD=Y

Underlying this notion has always been the assumption that whatever the level of output that is demanded will be supplied at the given price. i.e. Supply is demand determined

This implied a horizontal AS schedule As we begin to vary price the AS will longer be

horizontal

0

P0

Real GDP

Fixed Price Keynesian AS Schedule

AS

The Keynesian Aggregate Demand Schedule

Focus: What is the relationship between the

price level and the level of output?

Approach: Study how changes in P affects

the level of output implied by the

simultaneous equilibrium in goods and

money markets (IS-LM)

The AD captures the effects of the price level on output. It is derived from the simultaneous equilibrium in the goods and money markets

Deriving the AD

Recall the equations for the IS and LM;

𝑟𝐼𝑆= 𝐶0−𝑐1𝑇+𝐼0+𝐺

𝑖1−

1−𝑐1

𝑖1Y

𝑟𝐿𝑀= −1

𝑏2

𝑀

𝑃+

𝑏1

𝑏2Y

Solving these two simultaneously yields the AD equation

Deriving the AD

𝐴𝐷: 𝑌= 1

1−𝑐1+𝑖1𝑏1𝑏2

[𝐶0 − 𝑐1𝑇 + 𝐼0 + 𝐺 +𝑖1

𝑏2(𝑀

𝑃)]

Generally the AD can be summarized as;

𝑌=f (𝑀

𝑃, G , T)

(+,+,-)

All the variables with the exception of P will either shifts the IS or LM and therefore the AD curve

The derivation of the aggregate demand

curve

An increase in the price level leads to a

decrease in output

P ( 𝑴 𝑷) EDM

ESB PB r (LM

shifts upwards to left)

Inv. AE Y

• Starting from the equilibrium conditions for the goods and financial markets, we have derived the aggregate demand relation.

• This relation implies that the level of output is a decreasing function of the price level. It is represented by a downward-sloping curve, called the aggregate demand curve.

• Changes in monetary or fiscal policy – or, more generally, in any variable other than the price level that shifts the IS or the LM curves – shift the aggregate demand curve.

Y YM

PG T

, ,

( , , )

Shifts of the aggregate demand curve

At a given price level, an increase in government spending increases output, shifting the aggregate

demand curve to the right. At a given price level, a decrease in nominal money decreases output,

shifting the aggregate demand curve to the left

The impact of policy actions on demand is not enough to know its effect on Output/GDP

It depends on the assumptions we make about the AS

The AS can be one of the following;

Vertical (Classical)

Horizontal (Keynesian Fixed-Price Model)

Upward sloping (Keynesian variable Price Model)

Given these possibilities the impact of policy on AD will have a different effect on Y and/or P.

The impact of policy actions on demand is not enough to know its effect on Output/GDP

It depends on the assumptions we make about the AS

The AS can be one of the following;

Vertical (Classical)

Horizontal (Keynesian Fixed-Price Model)

Upward sloping (Keynesian variable Price Model)

Given these possibilities the impact of policy on AD will have a different effect on Y and/or P.

Where do you think the truth lies?

Probably somewhere in between, meaning the AS is probably upward sloping.

Let us first look at the case where we have the Classical assumptions of AS.

In the Classical model, the full employment level (N0) is determined at the point where Ns and Nd are in equilibrium. (part a)

Notice that both Ns and Nd areexpressed as functions of the real wage (W/P).

What does this mean?

It means that if P changes, then W changes in the same proportion so that W/P is unchanged. (perfectly flexible W and P, and perfect information)

Equilibrium output (Y0) is then determined using the production function shown in part b.Figure 8.5 Classical Supply Assumptions

Figure 8.6 Effect of an Increase in Government

Expenditures with Classical Labor Market

Assumptions

In part a, an increase in

government expenditures shifts

the IS schedule to the right,

from, IS0 to IS1.

In part b the aggregate

demand schedule shifts to the

right from Yd0 to Yd

1.

The increase in aggregate demand causes the price level to rise from P0 to P1,

The increase in the price level “shifts” the LM schedule in part a from LM(M0/P0) to LM(M0/P1).

The level of output is unchanged at Y0.

Unlike the Classical Keynes believe that money wage does to fully adjust to keep the economy at full employment.

The classicals believed that money wage is perfectly flexible and that given labour demand and supply the money wage will adjust to any price changes such that the real wage is constant

Keynes believed that there are a variety of reasons why money wage will not quickly adjust to price changes

He believed that money wages could be flexible upwards but very rigid downwards.

Sources of Wage Rigidity

1. Workers will resist money cuts even if demand for labour falls ( i.e. increase in unemployment).

2. Wages are set by labour contracts (collective bargaining) often for 2 or 3 years and as such within that period if there is a fall in labour demand or general price level , money wages will not fall.

3. Even if there is no labour contracts, there is an implicit agreement between employers and employees to fix the money wages over some time period.

Even if the market conditions require for a cut employers will rather lay off some workers rather than reduce the money wages

According to Keynes the contractual view of the labour market makes it highly unlikely for money wages to be perfectly flexible as the classicals assumed.

Keynes assumed that although prices are free to vary, the money wage is fixed or at worse money wage will not fully adjust to prices

Keynes accepted the classical theory of labour demand;

W=MPN.P

Firms maximize profits by demanding labour up to the point where the cost of employing the last worker (W) equals the value of MP by that unit of labour (MPN.P)

Given labour SS it is the demand that is the constraining factor to output supply

Given labour SS it is labour DD that is the constraining factor to output supply and employment.

Thus the number of workers firms will hire and as such the amount of output they will supply depends on the price level.

Thus ;

When P (MPN. P) (MPN. P)>W Firms will Employment (N) because they add more to revenue than cost Given the Production function and constant productivity Y

Clearly indicating a positive relation between P and Y

Figure 8.8 The Keynesian Aggregate Supply

Curve When the Money Wage Is Fixed

Part a shows the levels of

employment N0, N1, N2 for

three successively higher

price levels P0, P1, P2.

Part b shows the levels of

output Y0, Y1, Y2 that will be

produced at these three

levels of employment.

In part c, we put together the

information in a and b to

show output supplied at each

of the three price levels.

Role of AS in Determining GDP response to AD Policy Shock

Real GDP

P0

AS2

P1

Y0

E

AS1

Y1

AD0

AS0

E0

Y2

E2

E1

P2

Classical theory of AS is fundamentally incompatible with the Keynesian

system

Expansionary Monetary Policy

Real GDP

r0

Y0

E

Y1

IS0

LM0(𝑴𝟎

𝑷𝟎)

E0

YC

E1

LM1(𝑴𝟏

𝑷𝟎)

LM2(𝑴𝟏

𝑷𝟏)

r1

rC

Expansionary Monetary Policy

Real GDP

P0

AS

P1

Y0

E

Y1

AD0

AD1

E0

YC

E1

Expansionary Monetary Policy

Contractionary Monetary Policy

Opposite is also true

M ( 𝑴 𝑷) ESM EDB PB r (LM

shifts downwards to left to LM1 and AD shifts

rightward) Y and P shifts LM upwards

towards original to LM2 r from rc to r1 Inv.

AE Y from Yc to Y1

Expansionary Fiscal Policy

Real GDP

r0

Y0

E

Y1

IS0

LM0(𝑴𝟎

𝑷𝟎)

E0

YC

E1

LM1(𝑴𝟎

𝑷𝟏)

r1

rC

IS1

Expansionary Fiscal Policy

Real GDP

P0

AS

P1

Y0

E

Y1

AD0

AD1

E0

YC

E1

Expansionary Monetary Policy

Contractionary Fiscal Policy

Opposite is also true

G Y Shifts in IS rightward r (because

YMD EDM ESB PB r)

Because IS shifts rightward AD also shifts rightward

P shifts LM upwards to LM1 r from rc to r1

Inv. AE Y from Yc to Y1

With the upward-sloping aggregate supply curve (Ys), at higher prices, output increases.

This appears to be the same as the fixed-wage case. We will see in the next diagram that there is a difference.

The upward-sloping (Ys) in the flexible wage case is based on the assumptions that knowledge is imperfect.

Workers base their wage expectations on past results: expectations are backward looking.

Thus the labor supply curve, Ns(Pe) does not change as price goes up because expectations are frozen.

Workers see the higher W and think they are better off, thus they are willing to work more

Because their perception is imperfect, the are actually worse off because as P, W/P.

Figure 8.11 The Keynesian Aggregate Supply

Curve When the Money Wage Is Variable

Part c combines the

information in parts a and b

to show the relationship

between the price level and

output.

If W is flexible, that implies

that the labor market is at

full employment, and any

further increase in demand

means W must if firms are

to hire more workers.

Part a shows the equilibrium

levels of employment N0, N1, N2,

corresponding to successively

higher values of the price level,

P0, P1, P2

Part b gives the level of output,

Y0, Y1, Y2 that will be produced at

each of these employment levels.

Figure 8.12 Keynesian Aggregate Supply Curves

for the Fixed- and Variable-Money-Wage Cases

In the variable wage case,

the Ns is low, thus there is

full employment at W0.

As P in the variable

wage case, firms must pay

higher W to attract

workers.

The rise in the money

wage in the variable-wage

case dampens the effect

on employment and

output from an increase

in price.

Thus the aggregate supply

schedule in part c is

steeper when the money

wage is variable than

when the it is fixed.

If wages are variable, a given increase in aggregate demand has a greater effect on price and a lesser effect on income.

Do you understand why?

If wages are rigid, a given increase in aggregate demand has a lesser effect on price and a greater effect on income

Do you understand why?

Figure 8.13 Price and Output Variations with

Shifts in Aggregate Demand and Supply

For changes in output that

result from shifts in the

aggregate demand schedule

along a fixed supply schedule, as

in part a, price and output move

in the same direction.

For output changes that result

from shifts in aggregate supply

along a fixed demand schedule,

as in part b, price and output

move in the opposite direction.

What are the policy implications

of a “stimulus package” that

stimulates AD, versus one that

stimulates AS?

Figure 8.14 Shift in the Aggregate Supply Schedule

with an Increase in the Expected Price Level

An increase in the

expected price level shifts

the labor supply schedule

to the left from Ns(Pe0) to

Ns(Pe1) in part a.

At a given price level, P0,

employment declines from

N0 to Nl, wage goes up

from W0 to W1, and

output falls from Y0 to Y1

(part b).

This decline in output for

a given price level is

reflected in a shift to the

left in the aggregate

supply schedule from

Ys(Pe0) to Ys(Pe

1) in part c.

An autonomous increase in the price of energy inputs shifts the aggregate supply schedule to the left from Ys

0(Pe0) to Ys

1(Pe0)

Output falls from Y0 to Y1 and the price level rises from P0 to P1.

As labor suppliers perceive the rise in the price level, the expected price level rises from Pe

0 to Pe1.

The aggregate supply schedule shifts farther to the left to Ys

1 (Pe1).

Output falls to Y2, and the price level rises to P2.

Figure 8.16 Effects of an Autonomous Increase in

the World Price of Energy Inputs

Figure 8.17 Classical and Keynesian

Aggregate Supply and Demand Curves

The Classical aggregate supply

schedule is vertical, whereas the

Keynesian aggregate supply schedule

slopes upward to the right.

The Classical aggregate demand

schedule depends only on the level of

the money supply (M0).

In the Keynesian system, aggregate

demand depends also on the levels of

fiscal variables (G0, T0), the level of

autonomous investment (I0), and

other variables.

Where to from here?

The Monetarist Counterrevolution