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Keynesian View of the economy:

1. Assumptions:
§ Real wages are rigid (sticky) in the short-run (several months).
Labor markets do not adjust quickly to equilibrium.
§ Commodity prices are rigid (sticky) in the short-run (several months). Commodity markets do not adjust quickly to its equilibrium level.

2. Implications:
§ The economy can remain away from its general equilibrium (recession) for a significant period of time.
§ The government may be able to eliminate (or dampen) recessions using appropriate monetary and/or fiscal policies.

3. Why are real wages rigid?
§ Legal factors: minimum wage laws
§ Institutional factors: Unions tend to negotiate for above-equilibrium wages.
§ Firms willingly pay above-equilibrium real wages to keep their good workers, reduce turn-over costs (hiring and training costs), and attract better job applicants.
§ The Efficiency wage Theory: Firms willingly pay above-equilibrium real wages because real wages act as both "carrot" and "stick".
a. Carrot: well-paid workers take their job more seriously by putting more effort to it. (Akerlof's gift exchange motive).
b. Stick: well-paid workers are less likely to shirk because they do not want to lose their job.

4. How do firms set the efficiency wage:
§ The relation between real wages (w) and worker effort (E) is positive and S-shaped.
§ As real wages increase, workers' effort will first increase at a decreasing rate, then at an increasing rate, and finally, at a decreasing rate.
§ Profit-maximizing real wage: firms choose the real wage that results in the highest amount of work effort per dollar of real wages paid; that is (w/E) is the highest.

5. Employment and Unemployment in the Efficiency Wage Model
§ After firms set their efficiency real wage, they decide on how many workers they want to hire.
§ Start with a standard labor demand and labor supply diagram.
§ Set the efficiency wage, w*, as a horizontal line above the equilibrium real wage.
§ At w*, labor demand is N*, labor supply is Ns, and Ns-N* are unemployed.
§ N* is the full-employment level of employment in the efficiency-wage model.
§ N* is consistent with full-employment output, Y*.
§ FE and LRAS are vertical at Y* level of output.

6. Why are prices rigid?

a. Monopolistic competition
Most firms are monopolistic competitive; have market power; are price setters. They use markup pricing by setting the price of their product above marginal cost: P = (1+m) MC; and keep it at that level for some time. The parameter m is the markup.

b. Menu costs
Costly to change menu prices frequently (cost of printing, informing customers, …). Firms do not change their prices for several months (Carlton provides evidence)

Summary:
a. Firms fix real wages (w) and prices (p) for several months
b. Given the fixed price level, they produce the level of output (Y) which satisfies total demand (output is demand determined)
c. Given the fixed real wage, they hire enough workers (N) to produce the demanded output (effective labor demand)

7. Graphical Presentation of Keynesian Model:

§ FE and LRAS are found at the intersection of the efficiency wage and labor demand curves.
§ The labor market is represented by the effective labor demand curve (inverse of production function).
§ The short-run equilibrium (with fixed price level) is at the intersection of IS and LM. Thus, the economy does not have to be in a general equilibrium position.
§ The long-run equilibrium (with flexible prices) is at the intersection of IS/LM and the FE line (or AD and LRAS curves).

8. Application of Keynesian Model

I. Monetary Policy:
§ Start with the general equilibrium condition point A.
§ Consider a decrease in money supply from M0 to M1.

A. Short-run:
§ Real money supply (M/P) falls, real interest rate (r ) rises, LM shifts to the left.
§ The rise in r reduces the demand for C and I goods (movement on the IS).
§ The fall in C and I reduces aggregate demand (AD shifts left) and income.
§ The fall in income reduces national saving.
§ In the short-run P is fixed at P0, thus firms reduce output to meet the new lower demand.
§ The fall in demand also reduces the demand for workers. Thus employment falls and unemployment rises.

Short-run effects of a contractionary monetary policy:
Output: falls below Y*
Employment: falls below N*
Price level: remains unchanged
Interest rate: rises above r0
Consumption: falls below C0
Investment: falls below I0
National saving: falls below S0
Real wages: set by firms, remain unchanged.
Note:
The short-run effect may last a few months to several years.

B. Long-Run:
Long-run effects of are identical to those of classical.
§ The excess supply of goods and services reduces the price level.
§ The fall in P increases the real money supply (M/P) and shifts the LM to the right
§ The process continues until general equilibrium is achieved.

Long-run effects of a contractionary monetary policy:
Output: back to Y*
Employment: back to N*
Price level: falls
Interest rate: back to r0
Consumption: back to C0
Investment: back to I0
National saving: back to S0

Conclusions
§ Monetary policy is non-neutral in the short-run, as-long-as wages and prices are rigid, and neutral in the long-run, when wages and prices are flexible.

II. Fiscal Policy:
§ Start with the general equilibrium condition point A.
§ Consider a decrease in the government spending from G0 to G1.

A. Short-run:
§ National saving (S) rises, real interest rate (r ) falls, IS shifts down and to the left.
§ The fall in G reduces total demand for goods and services, and shifts the AD curve to the left.
§ The equilibrium output falls to Y1 which is less than Y*.
§ The fall in Y reduces money demand until the interest rate in the money and commodity markets equal.
§ The fall in Y reduces the demand for labor to N1.

Short-run effects of a contractionary fiscal policy:
Output: falls below Y*
Employment: falls below N*
Price level: remains unchanged
Interest rate: falls below r0
Consumption: falls below C0
Investment: falls below I0
National saving: falls below S0
Real wages: set by firms, remains unchanged

Note: Fiscal policy has a multiplier effect on output. $1 change in G increases Y by more than $1.

B. Long-Run:
Long-run effects of a contractionary fiscal policy are identical to those of classical.
§ The excess supply of goods and services reduces the price level.
§ The fall in P increases the real money supply (M/P) and shifts the LM to the right
§ The process continues until general equilibrium is achieved.

Long-run effects of a contractionary Fiscal policy:
Output: back to Y*
Employment: back to N*
Price level: falls
Interest rate: rise to r2
Consumption: falls because of the rise in r
Investment: falls because of the rise in r
National saving: rises because of the rise in r

Conclusions
§ Fiscal policy is non-neutral in the short-run, as-long-as wages and prices are rigid.
§ Fiscal policy does not affect the long-run levels of output (and employment) but affects the composition of output (public versus private goods).
§ A fall in government spending allows for more spending by the private sector.
§ A rise in government spending crowds out private spending.

§ Changes in income tax affect the economy by affecting after-tax income, consumption, and commodity market (IS curve) similar to changes in G

9. Application: Tight money and easy fiscal policy of 1981(Reagan Administration)

10. Keynesian Business Cycle Theory
a. Demand shocks are the primary cause of business cycles. They include
§ Shocks to IS: fiscal policy, sudden changes in C and I due to changes in consumer and business confidence, …
§ Shocks to LM: monetary policy, sudden changes in money demand

b. Changes in the private sector's spending habits can throw the economy away from its general equilibrium.

Since wages and prices are rigid, the economy may stay away from general equilibrium for a long time.

11. Macroeconomic Stabilization
How should policymakers respond to business cycles?

Starting from a general equilibrium position, suppose the economy is hit by waives of consumer and business pessimism, which results in a recession.

How should policymakers respond? Three possibilities:
1. Passive (hands off) policy: No change in monetary or fiscal policy; self-correction
2. Active monetary policy: an increase in money supply
3. Active fiscal policy: an increase in government spending or a cut in income taxes