X. Neoclassical synthesis

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X. Neoclassical synthesis
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X.1 Keynes vs. real world
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Keynes theory

• Macroeconomics
• Equilibrium with unemployment
• Incompatibility with standard microeconomics
• It is NOT General Theory, but theory for
  economies in depression
• The existence of equilibrium in a strict sense
  - depends on assumption of rigid nominal wage

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Keynes AD and AS

• AD (for simplicity, still assume pe0, i.e. ir)
• in LVII, slide 39, substitute (5) and (6) into
  (1),
• Solve (4) for dr
• and substitute into (1) as well we obtain
• AS in the same slide, substitute (3) into (2)
  (and dK0)
• In AD schedule, increase of P implies decrease of
  Y, in AS schedule, increase of P implies increase
  of Y

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Keynes equilibrium and policies

• In the more general Keynesian model, we can
  construct standard AD and AS schedules
• Equilibrium AD x AS intersection
• However, equilibrium determined by position of AD
  and does not have to correspond to full
  employment one
• Keynesian policies shifting AD to the position
  where it determines equilibrium at full employment

P
AS
AD2
AD1
Y
Y1
Yf
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Keynes true legacy for policies

• General acceptance of policy recommendations
• Capitalism does not have internal forces to
  produce at full employment (potential product)
  continuously
• The Governments can and should stimulate the
  aggregate demand to bring economies closer to
  full employment
• The General Theory (and its ISLM simplification)
  provides the tools fiscal and monetary policies

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First applications

• During WWII, both in UK and in the USA
• White Paper on Employment Policy
• William Beveridge Full Employment in a Free
  Society
• Oxford Institute of Statistics The Economics of
  Full Employment
• Policy British budget of 1941, US budgets since
  1942

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Keynes vs. real world (1)

• AD and AS above general version of Keynesian
  model, AS not very useful for practical for
  several reasons
• Nominal wage given, inflationary expectation also
  constant
• In the short-run prices and wages rigid for many
  reasons
• Informational problem, slow reaction of firms (do
  not change prices and wages instantaneously, etc.
  see next chapters)
• This is true for any point of business cycle, not
  only for depression
• Consequently, in the (very) short-run, wages and
  prices constant aggregate supply horizontal -
  SRAS

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Keynes vs. real world (2)

• In the real world the prices adjust and clear
  markets, even if in very short run sticky
• When capital fixed, then product given by
  employment, and when after full adjustment of
  prices and wages labor market is in equilibrium
  as well, then this (equilibrium) employment
  determines full employment and potential product
• Neoclassical synthesis in the long-run
  aggregate supply vertical (classical) - LRAS

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X.2 The first attempt downward nominal wage
rigidity

• Originally F.Modigliani (1944) downward wage
  rigidity
• Reasons for rigid wages in general
• Long-term wage contracts, implicit wage
  agreements, power of trade unions
• Some flexibility upward
• Intuitively if nominal wage rigid, then price
  increase lowers real wage ? firms increase
  employment ? product increases, i.e. demand
  increasing function of price

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Franco Modigliani

• 1918-2003, born in Rome, when young, immigrated
  to the USA
• MIT
• 1944 elements of neoclassical synthesis (PhD)
• 1953 new theory of consumption function (life
  cycle hypothesis)
• 1958 contribution to the theory of money,
  Modigliani-Miller theorem
• 1985 Nobel price in economics

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Model

• Only for situation when product smaller or equal
  to potential (full employment) product
• Labor market
• Either in equilibrium full employment and
  potential product
• Or product lower than potential, involuntary
  unemployment ? labor supply higher than demand
  and level of employment determined by demand
  (when , quantity realized on the market
  always equal to min (D,S))

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W/P
P
AS
E
E
N
Y
Y
N
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Wage rigidity weakness of the model

• Model explains the relation between the fall or
  increase of price and aggregate supply, when
  product lower or equal to potential one
• Does not consider the situation, when product
  temporarily increases above potential level
• Real wages move against business cycle

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X.3 Phillips Curve
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Dynamic adjustment

• Nominal wages arent downward rigid forever, but
  there is a slow adjustment (beyond the
  short-run) ? there is an adjustment of labor
  supply over particular moment of time
• 1958 A.W.Phillips The Relation between
  Unemployment and the Role of Change of Money
  Wages. British data.
• First investigation before Phillips Irving
  Fisher already in 1926
• Inverse relationship between unemployment and
  nominal wage change
• Phillips statistical fit for 1861-1913
• 1948-1957 data fitted to this curve very well,
  too

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Hypothesis

• High unemployment bargaining power of workers
  during wage negotiations is weak, firms are able
  to hire additional workers without offering much
  increase in nominal wage
• Low unemployment bargaining power of firms weak,
  as to hire more workers they must offer more
  substantial nominal wage increase
• Wage main component of prices
• Consequently high unemployment implies low
  inflation and vice versa

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Interpretation

• Data seemed to suggest that there is a negative
  relation between change of nominal wages and
  unemployment
• Two crucial questions
• Is this a stable, long-term relationship, valid
  for other countries as well (see US data on the
  next slide, for original Phillips data see
  Dornbush, Fischer,Startz in Literature to this
  Lecture)?
• Many empirical studies followed
• Theoretical explanation of this relationship
• Policy consequences
• As in the short run, change in wages determine
  inflation, is there a trade-off between inflation
  and unemployment that can be effectively used by
  policy makers to simultaneously achieve both low
  inflation and low unemployment?

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Phillips curve - concept

• Note here, in LX, we present original approach,
  as emerged after Philips article in 1958
• Define unemployment as u(NS-N)/NS
• Remember in K. model, we do not include labor
  supply function, but it exists, as NS(W/P)
• However, in a particular moment of time, real
  wage W/P real wage is known, so value of labor
  supply NS is known as well (but in general,
• N? NS)

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Phillips curve formalization (1)

• From above
• To simplify, suppose discrete time
• and after rearrangement
• Nominal wage in the next period is a function of
  current wage and a ratio current employment N and
  current labor supply NS

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Phillips curve formalization (2)

• In words wage in next period is equal wage in
  the current period, adjusted for the actual level
  of employment
• At full employment (NNS), next period wage
  equals current one
• If employment is above full employment, (NgtNS),
  wage in next period increases (and vice-versa)
• Speed of adjustment parameter e
• Formally at present, W, NS constant ? linear
  relation (WN line), with positive slope, between
  W1 and N
• e large, WN steep. ? small, WN approaches
  horizontal

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Wage adjustment
W1
WN2
WN1
WN3
N
NS
N2
N3
WN always passes through (NS,W)
If N?NS, WN shifts in time
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X.4 Dynamic aggregate supply
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From wages to prices

• Short-term labor costs - the only variable costs
• Price determined by current labor costs plus a
  mark-up z gt 0 (e.g. profit, embedded in price)
• Simplification (for this chapter only) -
  production function with fixed coefficients
• a ... labor productivity
• labor costs per unit of output (1/a).W
• Price (with incorporation of mark-up)

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Dynamic AS (1)

• Building blocks
• Phillips curve
• Link from wages to prices
• Additional assumption output and unemployment
  closely linked (in next Lectures Okuns law)
• , ?gt0
• Combining three equations above, see next slide

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Dynamic AS (2)

• Remember
• then combining the three equation and
• rearranging
• Simplifying as

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Dynamic AS (2)

• In words price in the next period is equal price
  in the current period, adjusted for the
  difference between actual output and full
  employment one
• Difference between actual output and Yf concept
  of output gap see future Lectures
• AS is very steep for ?gtgt0, very flat for ??0
• Dynamics AS shifts in time (always runs through
  point Yf,P) see next slide

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Dynamic aggregate supply
P1
DAS2
DAS
DAS3
Y
Yf
Y2
Y3
AS always passes through (Yf,P)
If Y?Yf, AS shifts in time
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X.5 Long term adjustment
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Adjustment (1)

• Assume starting point Yf at P1 P, different
  time periods and increase in nominal money.
• Very short run wages (and prices) dont have any
  time to adjust ? horizontal AS. An increase in
  nominal money leads to decrease in interest rate
  i and, because of the larger investment demand,
  leads to the increase of overall aggregate demand
  ? excess demand

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Adjustment (2)

• Short to medium run Excess demand ? firms intend
  to increase the production, hiring more people ?
  wages (and prices) slowly start to adjust (both
  nominal wage and price increase). An initial
  shift of AD (in the very short run) is partially
  offset, as in medium run, AS is positively sloped
• New (static) equilibrium, as intersection of AD
  and AS. Not a dynamic one, adjustment not
  finished yet
• W1 ? W and P1 ? P
• Medium and long run AS continues to shift to the
  left till the output doesnt fall back to Yf, but
  with higher price P
• Both static and dynamic equilibrium restored

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Medium- to long-term adjustment
LRAS
P
C
P
SRAS
B
P1
A
SRAS
P (P-1)
AD
Y
Y1
Y
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Adjustment - summary

• Aggregate demand both in short- and long-run
  decreasing function of price
• Aggregate supply
• In the long-run vertical at potential product,
  long-run aggregate supply (LRAS)
• In very short-run (ISLM) horizontal at fixed
  price, short-run aggregate supply (SRAS)
• In medium term positively sloped AS
• Shifts in AD
• In the long-run, do not change product, but
  over-all price level consistent with classical
  model
• In very short-run, do change the level of product
  (and employment), but price is fixed consistent
  with original version of Keynesian model

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Short-run shift of AD(external shock that
contracts AD)
P
SRAS
Y
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Long-run shifts of ADexternal shock that
contracts AD
LRAS
P
Y
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From short- to long-run (1)

• Short-run equilibrium
• AD equals AS, adjustment through quantities ? AS
  adjusts to AD
• Price fixed, equilibrium as state of rest, there
  can be excess supply on labor market (involuntary
  unemployment)
• Actual product can be lower than potential one
• Long-run equilibrium
• AD equals AS
• Simultaneous adjustment of all prices generates
  equilibrium on all markets
• Actual product equal to potential one

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Long-run equilibrium
P
LRAS
E
SRAS
AD
Y
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From short- to long-run (2)

• Intuitive interpretation
• Fixed price corresponds either to the depression
  (Keynes) or to very short-run, when prices (and
  wages) are fixed in all economies and at (almost)
  all situations (exceptions e.g.
  hyperinflations)
• Long-run equilibrium prices and wages had to
  react to changes in demand/supplies on all
  markets (including labor) and their adjustment
  cleared all markets simultaneously

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Adjustment in the long-run
P
LRAS
SRAS
A
Y
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X.6 Conclusions
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Neoclassical synthesis - summary

• Neoclassical synthesis in the short and medium
  run, a change of policy variables (e.g. G, M,
  T(.), etc.) can change (in the Keynesian
  tradition) the level of output. However, in the
  long run, there is always a built-in mechanism,
  which (in the classical tradition) brings the
  economy back to the full employment level of
  output, albeit with a different price level.

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Phillips curve implication

• There is a trade-off between inflation and
  unemployment
• Higher unemployment ? lower inflation and vice
  versa
• Trade off, combined Keynesian demand management
  of either fiscal or monetary nature, was
  perceived as a basis for Keynesian economic
  policy after first period of post-war
  reconstruction
• This initial belief to potential trade-off
  between unemployment and inflation, based on
  original Phillips curve, proved to be one of the
  biggest mistakes of modern macroeconomics
• Later lectures incorporation of inflationary
  expectations into Phillips curve

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Literature to Ch. X

• The Phillips curve, derivation of AS and dynamic
  adjustment explained here according Dornbusch,
  Fischer, Startz, Ch. 6
• Including the simplification when production
  function has fixed coefficients and depends on
  labor only
• Snowdon, B., Vane, H., Modern Macroeconomics,
  Edward Elgar Publishing, 2005., pp. 135 144
• More detailed, but simple and comprehensive
  explanation
• Downward wage rigidity Modigliani, F.,
  Liquidity- Preference and the Theory of Interest
  and Money, Econometrica XII (1944), pp. 45-88,
  reprinted in many Macroeconomic Readings
• It is always worth to read this original attempt
  to deal with Keynes
• General discussion of AD and AS in Keynesian
  model Sargent, Macroeconomics, Ch. 2