Keynesian Economics ILabor MarketAsymmetric Responses to Real Wage ChangesAsymmetry, ContinuedSlide 5Slide 6Some AccountingMore AccountingKeynes’ Initial AssumptionsIs C related to Income?Regression ResultsConsumption FunctionSaving and DissavingSaving FunctionNoteInvestmentPresent Value and MECCapital Market SequenceInvestment and the MECOriginal AE ModelSlide 21Slide 22Algebra of the ModelMultipliers (1)Multipliers (2)Multipliers (3)Fiscal PolicyAdding the Foreign SectorAdapting the MultiplierKeynesian Economics IKeynesian Economics IThe Keynesian System (I):The Role of Aggregate Demand2Labor MarketLabor MarketExcess supply and excess demand are not equally strong forces in the labor market. The supply of workers is such that firms can always get the labor they require (at some price), but workers can do nothing to promote their own employment. He argues that the supply curve of labor may have no influence on the observed volume of employment or wage. This is the process by which the labor market operates:1. Firms decide at the beginning of the period how much employment to offer at the going wage.2. Labor is given no opportunity to re-contract if fewer are hired than want to be.3. If, at the end of the production period, entrepreneurs sell all of their output they expected to sell (they operate in a world of great uncertainty), then they will have no reason to change their labor demands. Thus, if we did accept the labor supply curve and the partial equilibrium framework of the neoclassical theory, wages are sticky downward and employment is not always “full” because the adjustment mechanism presumed in the neoclassical theory is not present. Thus a Keynesian equilibrium may be reached, even though the marginal disutility of work lies well below the going wage.3Asymmetric Responses Asymmetric Responses to Real Wage Changesto Real Wage ChangesConsider the market response to a change in real wages. Specifically, what happens when real wages decline? Keynes argues that changes in real wages (w/p) can be accomplished in two ways. Nominal wages can be reduced, or the price level can rise. !But !It would be more appropriate to write:pwNpwNpwNpwNddss),( pwNNss),( pwNNdd4Asymmetry, ContinuedAsymmetry, ContinuedA price level increase is not a relative wage change. Firms, on the other hand, see price level increases as an opportunity for increased profits since the lags in the production process imply that the cost of inventories is at older, lower levels. Therefore, an increase in the price level is likely to meet with a greater positive response by firms than the negative response by workers (labor suppliers, i.e., households). Workers will resist reductions in their nominal wages. There are several reasons:•Reductions in wages are relative wage reductions.•Relative wage reductions damage the workers’ market power.•Relative wage reductions damage the workers’ self-image. A lower relative wage might be interpreted to mean an inferior worker.•Relative wage reductions damage the workers’ future earning potential.5Asymmetry, ContinuedAsymmetry, ContinuedNoN1NwN0dN1dN0sN1sNf6Asymmetry, ContinuedAsymmetry, ContinuedThus, to Keynes, full employment is that “situation in which aggregate employment is inelastic in response to an increase in the effective demand for its output.” He argues that if the expansion of aggregate demand leads to higher employment, then prior to the expansion involuntary unemployment must have prevailed. Therefore, this is consistent with the AD-AS diagram below.  This amounts to a refutation of Say’s Law based on asymmetry of wage and price responses.yfyPASAD7Some AccountingSome AccountingAssume a closed economy:Output = Aggregate Expenditure = National ProductY = E = C + I + G = C + Ir + GBut Y is also income, and from income we purchase consumer goods (C), save (S), or pay taxes (T), soY = C + S + TSo that C + S + T = C + I + GOrS + T = I + GWhich means that saving and taxes paid by the public must finance investment and government spending.8More AccountingMore AccountingSimilarly,C + Ir + G = Y = C + I + GOr, by canceling terms,Ir = IThis gives us three equivalent conditions for equilibrium in the Keynesian model:(1) Y = C + I + G(2) S + T = I + G(3) Ir = I9Keynes’ Initial AssumptionsKeynes’ Initial AssumptionsOn the short run, quantity adjustments are more important than price adjustments.Quantities demanded can change more rapidly than prices, which is why you can have temporary shortages of goods.So aggregate expenditure (demand) determines the volume of goods that firms sell.Producers, government, and consumers all make plans that may or may not be achieved.–In the short run, all plans are fixed, except for planned consumption expenditure because it alone varies with income.10Is C related to Income?Is C related to Income?010002000300040005000600070000 2000 4000 6000 8000 10000Real GDPConsumptionU.S. Annual Data, 1929 - 200111Regression ResultsRegression ResultsOver 99% of the variation in consumption expenditures is explained by GDP. (R2 = 99%)Slope is 0.67. –Roughly 67¢ out of every dollar of new income (GDP) is spent on consumption goods.This gives us good reason to suspect that Consumptions follows a relationship like: C = C0 + cY or C = C0 + cYd12Consumption FunctionConsumption FunctionC0YdCc = mpc = C/Yd = marginal propensity to consumeCYdC = C0 + mpc x YdOrC = C0 + cYd13Saving and DissavingSaving and DissavingPlanned CYdYd (if C = Yd)DissavingC > YdSavingYd > CYd1Yd* Yd2C14Saving FunctionSaving FunctionSince Y = C + S + TandYd = Y – TYd = C + SSo, if C = C0 + cYd, thenS = -C0 + (1-c)Yd, orS = S0 + sYd, or equivalentlyS = S0 + mps x Yd,where mps = marginal propensity to saveNote that: mps + mpc = 115NoteNoteIn the classical model:C = C(r)S = S(r)In the Keynesian model:C = C(Yd)S = S(Yd)16InvestmentInvestmentCapital goods have a long life.Capital goods take time to build.Large expenditure.Value of investment is related to the income stream it can generate over a very long time horizon.–This requires business people to form expectations about future business conditions and profitability.–Investment is inherently risky.As a result of these things, the investment expenditure tends to be erratic.17Present Value and MECPresent Value