ECON 313: MACROECONOMICS I W/C 19 th October 2015 THE KEYNESIAN SYSTEM IV Aggregate Demand and Supply Dr. Ebo Turkson

Transcription

1 ECON 313: MACROECONOMICS I W/C 19 th October 2015 THE KEYNESIAN SYSTEM IV Aggregate Demand and Supply Dr. Ebo Turkson

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3 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

4 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

5 The Keynesian Aggregate Demand Schedule Fixed Price Keynesian AS Schedule P 0 AS 0 Real GDP

6 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)

7 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; r IS = C 0 c 1 T+I 0 +G i 1 1 c 1 i 1 r LM = 1 b 2 M P + b 1 b 2 Y Solving these two simultaneously yields the AD equation Y

8 Deriving the AD AD: Y= 1 1 c 1 +i 1 b1 b2 Generally the AD can be summarized as; [C 0 c 1 T + I 0 + G + i 1 b 2 ( M P )] 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

9 P ( M P ) EDM ESB P B r (LM shifts upwards to left) Inv. AE Y The derivation of the aggregate demand curve An increase in the price level leads to a decrease in output

10 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.

11 Y Y M P G 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

12 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.

13 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.

14 Figure 8.5 Classical Supply Assumptions Let us first look at the case where we have the Classical assumptions of AS. In the Classical model, the full employment level (N 0 ) is determined at the point where N s and N d are in equilibrium. (part a) Notice that both N s and N d are expressed 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 (Y 0 ) is then determined using the production function shown in part b.

15 In part a, an increase in government expenditures shifts the IS schedule to the right, from, IS 0 to IS 1. In part b the aggregate demand schedule shifts to the right from Y d 0 to Y d 1. Figure 8.6 Effect of an Increase in Government Expenditures with Classical Labor Market Assumptions The increase in aggregate demand causes the price level to rise from P 0 to P 1, The increase in the price level shifts the LM schedule in part a from LM(M 0 /P 0 ) to LM(M 0 /P 1 ). The level of output is unchanged at Y 0.

16 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.

17 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

18 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

19 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.

20 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

21 Part a shows the levels of employment N 0, N 1, N 2 for three successively higher price levels P 0, P 1, P 2. Part b shows the levels of output Y 0, Y 1, Y 2 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. Figure 8.8 The Keynesian Aggregate Supply Curve When the Money Wage Is Fixed

22 Role of AS in Determining GDP response to AD Policy Shock AS 2 AS 1 P 2 E 2 P 1 E 1 P 0 E E 0 AS 0 AD 0 Y 0 Y 1 Y 2 Real GDP Classical theory of AS is fundamentally incompatible with the Keynesian system

23 Expansionary Monetary Policy LM 0 ( M 0 P 0 ) LM 2 ( M 1 P 1 ) LM 1 ( M 1 P 0 ) r 0 E E 1 r 1 E 0 r C IS 0 Y 0 Y 1 Y C Real GDP

24 Expansionary Monetary Policy AS P 1 E 1 P 0 E E 0 AD 1 AD 0 Y 0 Y 1 Y C Real GDP

25 Expansionary Monetary Policy M ( M P ) ESM EDB P B r (LM shifts downwards to left to LM 1 and AD shifts rightward) Y and P shifts LM upwards towards original to LM 2 r from r c to r 1 Inv. AE Y from Y c to Y 1 Contractionary Monetary Policy Opposite is also true

26 Expansionary Fiscal Policy LM 1 ( M 0 P 1 ) LM 0 ( M 0 P 0 ) r 1 rc E 1 E 0 r 0 E IS 1 IS 0 Y 0 Y 1 Y C Real GDP

27 Expansionary Fiscal Policy AS P 1 E 1 P 0 E E 0 AD 1 AD 0 Y 0 Y 1 Y C Real GDP

28 Expansionary Monetary Policy G Y Shifts in IS rightward r (because Y M D EDM ESB P B r) Because IS shifts rightward AD also shifts rightward P shifts LM upwards to LM 1 r from r c to r 1 Inv. AE Y from Y c to Y 1 Contractionary Fiscal Policy Opposite is also true

29 With the upward-sloping aggregate supply curve (Y s ), 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 (Y s ) in the flexible wage case is based on the assumptions that knowledge is imperfect.

30 Workers base their wage expectations on past results: expectations are backward looking. Thus the labor supply curve, N s (P e ) 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.

31 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 N 0, N 1, N 2, corresponding to successively higher values of the price level, P 0, P 1, P 2 Part b gives the level of output, Y 0, Y 1, Y 2 that will be produced at each of these employment levels. Part c combines the information in parts a and b to show the relationship between the price level and output. Figure 8.11 The Keynesian Aggregate Supply Curve When the Money Wage Is Variable

32 In the variable wage case, the N s is low, thus there is full employment at W 0. 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. Figure 8.12 Keynesian Aggregate Supply Curves for the Fixed- and Variable-Money-Wage Cases

33 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

34 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 8.13 Price and Output Variations with Shifts in Aggregate Demand and Supply

35 An increase in the expected price level shifts the labor supply schedule to the left from N s (P e 0) to N s (P e 1) in part a. At a given price level, P 0, employment declines from N 0 to N l, wage goes up from W 0 to W 1, and output falls from Y 0 to Y 1 (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 Y s (P e 0) to Y s (P e 1) in part c. Figure 8.14 Shift in the Aggregate Supply Schedule with an Increase in the Expected Price Level

36 An autonomous increase in the price of energy inputs shifts the aggregate supply schedule to the left from Y s 0(P e 0) to Y s 1(P e 0) Output falls from Y 0 to Y 1 and the price level rises from P 0 to P 1. As labor suppliers perceive the rise in the price level, the expected price level rises from P e 0 to P e 1. The aggregate supply schedule shifts farther to the left to Y s 1 (P e 1). Output falls to Y 2, and the price level rises to P 2. Figure 8.16 Effects of an Autonomous Increase in the World Price of Energy Inputs

37 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 (M 0 ). In the Keynesian system, aggregate demand depends also on the levels of fiscal variables (G 0, T 0 ), the level of autonomous investment (I 0 ), and other variables. Figure 8.17 Classical and Keynesian Aggregate Supply and Demand Curves

38 Where to from here? The Monetarist Counterrevolution