Keynesianism: The Macroeconomics of Wage and Price Rigidity (Ch. 11 Study Notes)

Keynesianism: The Macroeconomics of Wage and Price Rigidity

Introduction

This chapter explores the Keynesian perspective on macroeconomic fluctuations, focusing on the role of wage and price rigidity in explaining unemployment and business cycles. The Keynesian model contrasts with the classical model by emphasizing the importance of aggregate demand shocks and the slow adjustment of prices and wages.

Business Cycles in the Keynesian Model

Aggregate Demand Shocks as the Main Source of Fluctuations

• Keynesian business cycle theory posits that aggregate output demand shocks are the primary source of business cycles, rather than supply shocks (as in the classical model).

• Aggregate demand shocks are changes that shift the IS or LM curves, such as:

  • Fiscal policy changes (government spending or taxes)

  • Monetary policy changes (money supply)

  • Changes in desired investment (e.g., marginal product of capital)

  • Changes in desired savings (e.g., consumer confidence)

• Recession in the Keynesian Model: A recession occurs when the aggregate demand curve shifts left, due to IS shifting down or LM shifting up.

• This model fits certain business cycle facts:

  • Recurrent fluctuations in output

  • Procyclical employment (employment rises and falls with output)

  • Money is procyclical and leading (money supply often changes before output does)

Graphical Representation

• IS-LM and AS-AD diagrams are used to illustrate how a negative demand shock (e.g., a drop in consumer confidence) shifts the IS curve left, reducing output and increasing unemployment.

• Figure 11.7: Shows a recession arising from an aggregate demand shock, with the IS curve shifting left and equilibrium output falling below full employment.

Price Stickiness

Definition and Importance

• Price stickiness is the tendency of prices to adjust slowly to changes in the economy.

• Empirical data suggest that money is not neutral in the short run, so Keynesians reject the classical model's assumption of rapid price adjustment.

• Keynesians developed the idea of price stickiness to explain why monetary policy can affect real output and employment.

Sources of Price Stickiness

• Menu costs: The costs associated with changing prices (e.g., printing new menus or catalogs).

• Monopolistic competition: Many markets are characterized by firms with some price-setting power.

• In perfect competition, prices adjust quickly and firms are price takers ($P = MC$).

• In monopolistic competition, sellers can set prices and tend to:

  • Set prices in nominal terms and maintain them

  • Adjust output to meet demand at the fixed nominal price

  • Only adjust prices when costs or demand change significantly

• Firms set prices as a markup over marginal cost: $P = (1 + \eta)MC$

Implications for Output and Labor Demand

• If demand increases, firms hire more workers and increase output at the fixed price.

• Output can differ from full-employment output ($Y_{FE}$) when prices have not adjusted.

• Effective labor demand curve: Shows how much labor is needed to produce the output demanded. It is upward sloping: higher output requires more labor.

Objections to the Keynesian Model

• Are prices as sticky as the model assumes?

• Empirical research shows businesses change prices frequently for specific products, but aggregate price adjustment to demand shocks is slow.

Real-Wage Rigidity and Unemployment

Role of Wage Rigidity

• Wage rigidity is important in explaining unemployment in the Keynesian model.

• In the classical model, unemployment is due to mismatches between workers and firms.

• Keynesians argue that recessions lead to substantial cyclical unemployment due to rigid real wages.

Reasons for Real-Wage Rigidity

• For unemployment to exist, the real wage must exceed the market-clearing wage.

• Minimum wage laws and labor unions can contribute, but most U.S. workers are not covered by these.

• The efficiency wage model explains why firms may pay above-market wages:

  • Higher wages motivate workers to work harder ("carrot") and discourage shirking ("stick").

  • Effort depends on the real wage; the effort curve is S-shaped: effort rises with wage up to a point, then flattens.

Employment and Unemployment in the Efficiency Wage Model

• At the efficiency wage, there is excess supply of labor (unemployment).

• Plants that pay higher wages (e.g., Henry Ford in 1914) experience less shirking and higher productivity.

• The model can be adjusted to allow the efficiency wage to decline in recessions, as the threat of job loss increases worker effort.

Efficiency Wages and the Full-Employment Line (FE)

• The FE line is vertical, as in the classical model, since full-employment output is determined in the labor market.

• In the Keynesian model, changes in labor supply do not affect the FE line, but changes in productivity do.

• Keynesian full employment: efficiency wage line intersects the labor demand curve.

Formulas and Relationships

• Production function: $Y = A K^{\alpha} L^{1-\alpha}$

• Marginal product of labor: $MPL = \frac{\partial Y}{\partial L}$

• Labor demand increases with productivity ($A$) or capital ($K$).

Monetary Policy in the Keynesian Model

Effects of Changes in the Money Supply

• An increase in the nominal money supply shifts the LM curve to the right.

• This raises output and lowers the real interest rate in the short run, increasing consumption and investment.

• In the long run, prices rise, the LM curve shifts back, and equilibrium is restored (money is neutral in the long run).

• Expansionary monetary policy: Increase in money supply (easing)

• Contractionary monetary policy: Decrease in money supply (tightening)

Comparison: Keynesian vs. Misperception Theory

• Keynesian: Aggregate supply (AS) shifts due to actual price adjustment.

• Misperception theory: AS shifts due to price expectation adjustment to catch up with actual price change.

Fiscal Policy in the Keynesian Model

Government Purchases

• A temporary increase in government purchases shifts the IS curve up/right.

• In the short run, output and the real interest rate increase.

• The multiplier ($\Delta Y / \Delta G$) measures how much output increases for a given increase in government spending.

• Keynesian multiplier: $Y = C + I + G (+ NX)$

• Keynesian: G (and C) rise → output demand rises → labor demand rises

• Classical: G rises → (if future taxes rise) labor supply rises

Tax Policy

• Lower taxes increase private consumption share in output.

• Keynesians reject Ricardian equivalence: a tax cut increases private consumption, reduces national saving, and shifts IS right.

• Rising government purchases increase the government share in output.

Stabilization Policy

Macroeconomic Stabilization

• Stabilization policy uses monetary and fiscal policy to moderate the business cycle (aggregate demand management).

• Keynesians favor active government and central bank intervention, as recessions are undesirable due to unemployment.

• Example: A negative shock to consumer confidence shifts IS left, causing recession.

Policy Scenarios

• Scenario 1: Government does nothing. In the long run, the price level declines and equilibrium is restored, but output and employment may remain below full employment for some time.

• Scenario 2: Increase money supply, shifting LM right.

• Scenario 3: Increase government purchases, shifting IS right.

• Using policy acts quickly, but results in a higher price level in the long run compared to doing nothing.

• Fiscal expansion can crowd out private consumption and investment due to higher real interest rates; higher taxes may also reduce consumption.

Difficulties of Macroeconomic Stabilization

• Uncertainty about the economy's distance from full employment

• Uncertainty about the quantitative impact of policy

• Policy lags: time required for policies to take effect and for forecasts to be accurate

• Debate: "Fine-tune" the economy vs. only combat major recessions

Supply Shocks in the Keynesian Model

Adverse Supply Shocks

• Until the 1970s, demand shocks were seen as the main source of business cycles.

• Example: 1973 oil price shock (adverse supply shock)

• An adverse supply shock shifts the FE line left, raises the price level, and can shift LM up, causing a Keynesian recession (output falls, inflation and interest rates rise).

• If the shock is permanent, stabilization policy is less effective; if temporary, expansionary policy can help but risks higher inflation.

Financial Frictions and Business Cycles

Role of Financial Frictions

• Financial frictions are impairments to the efficient functioning of financial markets (e.g., increased asymmetric information).

• Effects of increased financial frictions:

  • Real interest rate faced by households and businesses rises (even if central bank rate falls)

  • Spending by households and businesses falls

  • Credit spreads widen, leading to a leftward shift in IS (and AD) curves

• Example: 2007-2009 financial crisis—credit spreads rose sharply, offsetting the fall in the federal funds rate, so real interest rates for borrowers did not fall, leading to recession.

Comparison of Keynesian and Real Business Cycle Models

Key Differences

• Keynesian model: Emphasizes demand shocks, wage/price rigidity, and the role of policy.

• Real Business Cycle (RBC) model: Emphasizes supply shocks, flexible prices/wages, and market clearing.

• In the Keynesian model, changes in labor supply do not affect the FE line; in the classical model, labor supply equals labor demand.

• Short-run AS is more flexible in the RBC model; in the Keynesian model, it is sticky and rotates as prices become more flexible.

Summary Table: Keynesian vs. Classical (RBC) Model

Feature	Keynesian Model	Classical (RBC) Model
Main Source of Fluctuations	Aggregate demand shocks	Aggregate supply (productivity) shocks
Price/Wage Adjustment	Sticky in short run	Flexible
Role of Policy	Active stabilization recommended	Limited role for policy
Unemployment	Cyclical, due to wage rigidity	Frictional/structural, due to mismatches
Money Neutrality	Not neutral in short run	Neutral

Conclusion

The Keynesian model provides a framework for understanding how wage and price rigidity can lead to persistent unemployment and output fluctuations in response to demand shocks. It highlights the importance of stabilization policy, while also acknowledging the practical difficulties and limitations of such interventions.