Econ 102 Fall 2006

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Econ 102 Fall 2006

• Lecture 3.2
• The Keynesian Theory of Aggregate Supply

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Outline

• This lecture introduces a modern interpretation
  of the Keynesian Theory of Aggregate Supply
• Three concepts
• Classical theory
• Keynesian theory
• New-Keynesian or neo-classical synthesis

We use these interchangeably in the lectures (but
not in the textbook)
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Keynes and the Classics

• Classical economists
• Flexible prices
• Rapid adjustment
• Markets work well
• Keynes
• Sticky prices
• Slow adjustment
• Markets work poorly

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Where the names come from (A) Classical
This is an interpretation of the classical theory
that we have already studied.
The price level
gdp
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Where the names come from (B) Keynesian
This is an interpretation of the Keynesian theory
that assumes a completely rigid price level
The price level
Some early interpretations of the General Theory
led to a supply curve like this
gdp
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Where the names come from (B) Keynesian

• Because the demand and supply of labor were not
  equal in Keynes theory- Keynes argued that
  unemployment is typically involuntary

This is involuntary unemployment
w/p
At this real wage the supply exceeds the demand
for labor.
L
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Where the names come from (C) New-Keynesian or
Neoclassical Synthesis
In the short run- the nominal wage is rigid. This
causes the supply curve to slope up
The price level
In the long run the nominal wage is flexible.
The long-run aggregate supply curve is vertical.
gdp
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Don Patinkin

• Patinkin interpreted Keynes in the context of
  general equilibrium theory
• Patinkins book Money Interest and Prices
  provides the framework for the idea that the
  nominal price level is slow to adjust to its
  equilibrium level.

Don Patinkin 1922--1995
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Summary of terminology

• In these lectures we will call a theory of
  aggregate supply Keynesian if the aggregate
  supply curve is not vertical for some period of
  time.
• We make no distinction between Keynesian,
  New-Keynesian and Neo-classical synthesis.

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Key Ideas

• The most important idea is there is a nominal
  rigidity in the system
• This is modeled by assuming that the money wage
  is set one period in advance
• The effect of this is that in the short run,
  monetary shocks have real effects on output.
• In the long-run however, the economy responds as
  in the classical model

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Assumptions (1)

• Firms and workers form a common expectation of
  the future absolute price level pE
• Firms and worker agree on a money wage w
• The real wage w/pE is such that the expected
  demand and supply of labor are equated

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Determination of the contract wage w
Supply of labor as a function of the expected
real wage
w /pE
The expected real wage
w /pE
Demand for labor as a function of the expected
real wage
This many workers are hired ex ante
L
Quantity of labor demanded and supplied
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Assumptions

• The contract gives the firm the right to
  determine employment during the term of the
  contract
• If there is a recession, workers may be laid off
  or put on reduced hours
• If there is a boom workers may be asked to work
  overtime

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Determination of Employment
The labor supply function becomes inoperative
once the contract has been signed
w /p
The actual real wage
w /pE
w /p
The labor demand function determines the quantity
of labor employed
L
This will be the quantity of labor employed if
ppE
Employment
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Determination of Employment if price is lower
than than pE
This is what happens if the price ex post p1 is
higher than the ex ante expected price pE
w /p
w /p1
The actual real wage
w /pE
w /p
This will be the quantity of labor employed
L1
L
Employment
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Determination of Employment if price is higher
than than pE
This is what happens if the price ex post p2 is
higher than the ex ante expected price pE
w /p
The actual real wage
w /pE
w /p
This will be the quantity of labor employed
w /p2
L
L2
Employment
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Deriving the Equations

• In the next few slides we will use the algebraic
  example from last week to derive the LR and SR
  Aggregate Supply Curves for the New-Keynesian
  Model

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Deriving the Long-Run New Keynesian Aggregate
Supply Curve
The Long Run New Keynesian Aggregate Supply Curve
(LRAS) is the quantity of output supplied, as a
function of the ex post price, in an economy in
which there is no uncertainty and hence PtPE
and AtAE .
.
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Recall from the last lecture
The contract wage depends on expected TFP and on
the expected price level.
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The employment schedule
The ex-post profit maximizing rule (as a function
of the contract wage)
The ex-post profit maximizing rule (as a function
of beliefs about P and A)
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But if
Expectations are realized
Labor employed will depend only on expected
productivity
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And from the production function
The production function (the quadratic example)
This is the long-run supply curve
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LRAS
The price level
The long run aggregate supply curve for our
example
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Deriving the Short-Run New-Keynesian Aggregate
Supply Curve
The Short Run New Keynesian Aggregate Supply
Curve (SRAS) is the quantity of output supplied,
as a function of the ex post price, in an economy
with uncertainty.
.
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The employment schedule from the last lecture
The ex-post profit maximizing rule (as a function
of beliefs about P and A)
Put this into the production function
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SRAS contd.
To give..
Remember that
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Using this expression
To give..
This is the New-Keynesian SRAS Curve
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SRAS
The price level
The short-run aggregate supply curve for our
example
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The Keynesian Short-Run Aggregate Supply Curve

• The Keynesian Short-Run aggregate supply curve
  slopes up because the nominal wage is set in
  advance by contract
• In the short-run the nominal wage cannot adjust
  and the supply curve slopes up as a function of p
• In the long-run the nominal wage CAN adjust and
  the supply curve is vertical as in the classical
  model

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Keynesian Aggregate Supply Step 1
Step 1 The demand and supply of labor determine
gdp
gdp
a) The expected real wage
Employment
gdp
b) The number of workers hired L
w/p
The price level
c) The long-run aggregate supply curve y
L
y
Employment
gdp
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Keynesian Aggregate Supply Step 2
Step 2 Add the aggregate demand curve
gdp
gdp
a) Determine pE
b) Determine w
gdp
Employment
w/p
w pE
The price level
w/pE
PMv
y
pE
Employment
gdp
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Keynesian Aggregate Supply Step 3
gdp
gdp
The Keynesian long-run supply curve
Employment
gdp
w/p1
The price level
p2
The real wage
The Keynesian short-run supply curve
w/pE
pE
p1
w/p2
Employment
y2
y1
gdp
yE
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Classical theory and the Neutrality of Money
(Review)

• If there is a positive shock to the money supply
  in the Classical theory
• All nominal magnitudes increase in proportion to
  the shock
• All real magnitudes remain unaffected

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Keynesian theory

• In the Keynesian theory it is important to
  distinguish between shocks that are anticipated
  and shocks that are unanticipated

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Keynesian theory and unanticipated shocks

• If there is a positive unanticipated shock to the
  money supply in the Keynesian theory
• The nominal wage is fixed by contract
• The real wage falls
• Employment increases
• Output increases

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Keynesian theory and anticipated shocks

• If there is a positive anticipated shock to the
  money supply in the Keynesian theory
• All nominal magnitudes increase in proportion to
  the shock
• All real magnitudes remain unaffected
• The response of the system is exactly as in the
  classical theory

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Keynesian theory and an unanticipated monetary
shock
gdp
gdp
A positive unanticipated monetary shock causes
output to be temporarily above y
Employment
gdp
The price level
The real wage
w/pE
pE
Employment
y1
gdp
L1
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Keynesian theory and an anticipated monetary shock
gdp
gdp
A positive anticipated monetary shock is written
into nominal contracts
Employment
gdp
Expected aggregate demand tomorrow
pE
The price level
The real wage
w/pE
Aggregate demand today
Employment
y
L
gdp
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Summary of Lecture

• Important idea when money enters the system it
  takes time for all prices to adjust
• In the short run (when shocks are unanticipated)
  money has real effects
• In the long run (when shocks are anticipated)
  money is neutral
• Contract theory formalizes this idea

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Reading and problems for study

• Textbook Chapter 8
• Notes on Aggregate Supply (on the Web)
• Problems from the notes on the web