Lecture 18The Keynesian ModelNoah WilliamsUniversity of Wisconsin - MadisonEconomics 312Spring 2010Williams Economics 312BackgroundJohn Maynard Keynes (1936) The General Theory ofEmployment, Interest, and Money. Interpreted by Hicks(1937).Original theory NOT general equilibrium. In particularviewed unemployment in the Great Depression as resultingfrom excess labor supply, due to rigid nominal wages.Reconciled (at least somewhat) with classical theory bySamuelson and Tobin in 1950s-1960s.Predominant view in macroeconomics through the 1960s.Challenged by Friedman and monetarists in 1960s, later byrational expectations models (Lucas, Kydland-Prescott).Later work in 1970s and 1980s on incorporatingmicro-foundations and building general equilibrium modelswith real and/or nominal rigidities: New Keynesianeconomics.Williams Economics 312The Basic Keynesian SetupPremise: Some prices or wages are fixed in the short-run.Implies that some markets need not clear.Money market: reacts quickly to information. Assume italways clears.Goods market: reacts somewhat more slowly, but assumeable to change production so it clears.Labor market: reacts most slowly. When economy out ofgeneral equilibrium, assume labor supply not equal to labordemand. Rigid nominal wage W = wP.Employment determined by labor demand. May haveexcess supply of labor, hence unemployment.Williams Economics 312Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-2Figure 12.1 The Labor Market in the Keynesian Sticky Wage ModelWilliams Economics 312The IS-LM-FE ModelDepict relationship between output and real interest ratevia three curves.IS (investment=savings) represents goods marketequilibrium. Re-labelling of output demand curve.LM (liquidity=money) represents money marketequilibrium for a given price. Assume expected inflationconstant, so R ≈ r.FE (full-employment) represents labor market equilibrium.Re-labelling of output supply curve.In short run with fixed prices/nominal wages, outputdetermined by intersection of IS and LM . In long run,prices/wages adjust so reach general equilibrium atintersection of IS-LM-FE.Williams Economics 312Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-7Figure 12.6 Money Demand, Money Supply, and the LM CurveWilliams Economics 312LMISrr*Y*YShort-run equilibrium in the Keynesian ModelWilliams Economics 312LMISYrLong-run equilibrium in the Keynesian ModelFEr*Y*Williams Economics 312Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-9Figure 12.8 The Effect of an Increase in the Money Supply on the LM CurveWilliams Economics 312Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-10Figure 12.9 The Effect of an Increase in the Price Level on the LM CurveWilliams Economics 312LM(P)ISYrShort-run Effect of Increase in Money SupplyFE LM’(P)M increaser*r’Y* Y’Williams Economics 312LM(P)=LM(P’)ISYrLong-run Effect of Increase in Money Supply:Money is neutral in the long-run. FE LM’(P)M increaseP increaser*r’Y* Y’Williams Economics 312Aggregate Demand and Supply CurvesCan define aggregate demand AD as demand for currentoutput dependent on price level. Derive by changing Pwhich shifts LM , trace out effect on Y for fixed IS.In discussion so far have considered horizontal (short-run)aggregate supply curve AS. With sticky prices (fixed inshort run), assume that producers meet whatever demandat the current price.Firms’ effective labor demand then determines output.With P =¯P fixed, AD determines Y . With currentK =¯K , find labor demand from productionY = F(¯K , N ) → N = F−1(Y ).In long-run prices adjust to clear labor market, so long-runaggregate supply curve is vertical: money is neutral inlong-run.Williams Economics 312Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-12Figure 12.11 The Aggregate Demand CurveWilliams Economics 312Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-13Figure 12.12 A Shift to the Right in the IS Curve Shifts the AD Curve to the RightWilliams Economics 312Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-14Figure 12.13 A Shift to the Right in the LM Curve Shifts the AD Curve to the RightWilliams Economics 312ADPP*SRASY*YShort-run equilibrium in the Keynesian Model:Sticky prices.Williams Economics 312Output, YF(K*,N)Labor, NOutput, YLabor, NProductionEffective Labor DemandWilliams Economics 312ADPP*SRASLRASY*YLong-run equilibrium in the Keynesian Model:Sticky prices.Williams Economics 312Price StickinessTendency of prices to adjust slowly in economy.Sources: Monopolistic competition and menu costs.Under perfect competition, market forces prices to adjustrapidly. But in many markets, sellers producedifferentiated goods with some market power: monopolisticcompetition. Sellers set prices.Menu costs: costs of changing prices may lead to pricestickiness. Even small costs like these may prevent sellersfrom changing prices often.Since competition isn’t perfect, having the wrong pricetemporarily won’t affect the seller’s profits much. The firmwill change prices when demand or costs of productionchange enough to warrant the price change.Williams Economics 312Empirical Evidence on Price StickinessIndustrial changed more often the more competitive is theindustry (Carlton).Catalog prices don’t seem to change much from one issueto the next. Menu costs may not be cause of stickiness(Kashyap).Bils-Klenow (2004): Half of all goods prices last more that5.5 months. Varies dramatically over types of goods,amount of competition in industry.Williams Economics 312Table 2 Monthly Frequency of Price Changes for Selected Categories % of Price Quotes with Price Changes % of Price Quotes with Price Changes, excluding observations with item substitutions All goods and services 26.1 (1.0) 23.6 (1.0) Durable Goods 29.8 (2.5) 23.6 (2.5) Nondurable Goods 29.9 (1.5) 27.5 (1.5) Services 20.7 (1.5) 19.3 (1.6) Food 25.3 (1.8) 24.1 (1.9) Home Furnishings 26.4 (1.8) 24.2 (1.8) Apparel 29.2 (3.0) 22.7 (3.1) Transportation 39.4 (1.8) 35.8 (1.9) Medical Care 9.4 (3.2) 8.3 (3.3) Entertainment 11.3 (3.5) 8.5 (3.6) Other 11.0 (3.3) 10.0 (3.3) Raw Goods 54.3 (1.9) 53.7 (1.7) Processed Goods 20.5 (0.8) 17.6 (0.7) Notes: Frequencies are weighted means of category components. Standard errors are in parentheses. Durables, Nondurables and Services coincide with U.S. National Income and Product Account