Keynesianism: the macroeconomics of wage & price rigidity Real Wage Rigidity ? Wage ridigity is important in explaining unemployment ? In the classical model, unemployment is due to mismatches between workers and firms ? Keynesians are skeptical, believing that recessions lead to substantial cyclical employment ? To get a model in which unemployment persists, Keynesian theory posits that the real wage is slow to adjust to equilibrate the labor market ? Some reasons for real-wage rigidity ? For unemployment to exist, the real wage must exceed the market-clearing wage ? If the real wage is too high, why don't firms reduce the wage? ? One possibility is that the minimum wage and labor unions prevent wages from being reduced ? But most U.S. workers aren't minimum wage workers, nor are they in unions ? The minimum wage would explain why the nominal wage is rigid, but not why the real wage is rigid ? This might be a better explanation in Europe, where unions are far more powerful ? If the real wage is too high, why don't firms reduce the wage? ? Another possibility is that a firm may want to pay high wages to get a stable labor force and avoid turnover costs - costs of hiring and training new workers ? A third reason is that workers' productivity may depend on the wages they're paid - the efficiency wage model ? The efficiency wage model ? Workers who feel well treated will work harder and more efficiently (the "carrot'); this is Akerlof's gift exchange motive ? Workers who are well paid won't risk losing their jobs by shirking (the "stick") ? Both the gift exchange motive and shirking model imply that a worker's effort depends on the real wage ? the effort curve, plotting effort against the real wage, is S-shaped ? At low levels of the real wage, workers make hardly any effort ? Effort rises as the real wage increases ? As the real wage becomes very high, effort flattens out as it reaches the maximum possible level ? Wage determination int he efficiency wage model ? Given the effort curve, what determines the real wage firms will pay? ? to maximize profit, firms choose the real wage that gets the most effort from owrkers for each dollar of real wages paid ? the real wage is rigid, as long as the effort curve doesn't change ? Employment and Unemployment int he Efficiency Wage Model ? The labor market now determines employment and unemployment, depending on how far above the market- clearing wage is the efficiency wage ? The labor supply curve is upward sloping, while the labor demand curve is the marginal product of labor when the effort level is determined by the efficiency wage ? The difference between labor supply and labor demand is the amount of unemployment ? The fact that there's unemployment puts no downward pressure ont he real wage, since firms knwo that if they reduce the real wage, effort will decline ? Does the efficicency wage theory match up with the data? ? Plants that pay higher wages appear do experience less shirking ? But the theory implie that the real wage is completely rigid, whereas the data suggests that the real wage moves over time and over the business cycle ? It is possible to jazz up the model to allow for the efficiency wage to chagne over time ? Workers would be less likely to shirk and would work harder during a recession if the probability of losing their jobs increased ? Thsi would cause the effort curve to rise and may cause the efficiency wage to decline somewhat ? This would lead to a lower real wage rate in recessions, which is consistent with the data ? Efficiency wages and the FE line ? The Fe line is vertical since full-employment output is determined in the labor market and doesn't depend on the real interest rate ? But in the Keynesian model, chagnes in labor supply don't affect the FE line, since they don't affect equilibrium employment ? a change in productivity does affect the FE line, since it affect labor demand Price Stickiness ? Price stickiness is the tendency of prices to adjust slowly to changes in the economy ? The data suggest that money is not neutral, so Keynesians reject the classical model (without misperceptions) ? Keynesians developed the idea of price stickiness to explain why money isn't neutral ? Sources of price stickiness: Monopolistic competition and menu costs ? Monopolistic competition ? If markets had perfect competition, the market would force prices to adjust rapidly; sellers are price takers, because they must accept the market price ? In many markets, sellers ahve some degree of monopoly; they are price setters under monopolistic competition ? Keynesians suggest that many markets are characterized by monopolistic competition ? Monopolistic competition ? In monopolistically competitive markets, sellers do three things ? They set prices in nomminal terms and maintain those prices for some period ? They adjust output to meet the demand at their fixed nominal price ? They readjust prices from time to time when costs or demand change significantly ? menu costs and price stickiness ? the term menu costs comes from the costs faced by a restaurant when it changes prices - it must print new menus ? even small costs like these may prevent sellers from changing prices often ? since competition isn't perfect, having the wrong price temporarily won't affect the seller's profits much ? the firm will change prices when demand or costs of production change enough to warrant the price change ? empirical evidence on price stickiness ? industrial prices seem to be changed more often incompetitive industries, less often in mroe monopolistic industries ? Binder and his students found a high degree of price stickiness in their survey of firms ? the main reason for price stickiness was managers' fear that if they raised their prices, they'd lose customers to rivals ? but catalog prices also don't seem to chagne much from one issue to the next and often change by only small amounts, suggesting that while prices are sticky, menu costs may not be the reason ? Meeting the demand at the fixed nominal price ? since firms have some monopoly power,t hey price goods at a markup over their marginal cost of production:P=(1+n)MC ? If dmeand turns out to be larger at that price than the firm planned, the firm will still meet the demand at that price, since it earns additional profits due to the markup ? since the firm is paying an efficiency wage, ti can hire more workers at that wage to produce moer goods when necessary ? this means that the economy can produce an amount of output that is not on the FE line during the period in which prices haven't adjusted ? Effective labor demand ? the firm's labor demand is thus determined by the demand for its output ? the effective labor demand curve shows hoe much labor is needed to produce the otuput demanded in the economy ? it slopes upward from left to right because a firm needs more labor to produce additional output Monetary & Fiscal Policy in the Keynesian Model ? Monetary policy ? monetary policy in the Keynesian IS-LM model ? the Keynesian FE line differs from the classical model in 2 respects ? the Keynesian level of full employment occurs where the efficiency wage line intersects the labor demand curve, not where labor supply equals labor demand, as int he classical model ? changes in labor supply don't affect the FE lin in the Keynesian model; they do in the classical model ? Since prices are sticky in the short run in the Keynesian model, the price level doesn't adjust to restore general equilibrium ? Keynesians assume that when not in general equilibrium, the economy lies at the intersection of the IS and LM curves, and may be off the FE line ? This represents the assumption that firms meet the demand for their products by adjusting employment ? Analysis of an increase in the nominal money supply ? LM curve shifts down ? Output rises and real interest rate falls ? firms raise employment and production due to increased demand ? the increase in money supply is an expansionary moentary policy; a decrease in money supply is contractionary monetary policy ? Easy money increases real money supply, causing the real itnerest rate to fall to clear the money market ? the lower real interest rate increases consumption and investment ? with higher demand for output, firms increase production and employment ? evenutually firms raise prices, the LM curve shifts back to its original level,a nd general equilibrium is restored ? thus money is neutral in the logn run, but not in the short run ? Monetary policy in the Keynesian AD-AS framework ? We can do the same analysis in the AD-AS framework ? The main difference between the Keynesian and classical approaches is the speed of price adjustment ? the classical model has fast price adjustment, so the SRAS curve is irrelevant ? In the Keynesian model, the short-run aggregate supply curve is horizontal, because monopolistically competitive firms face menu costs ? The effect of a 10% increase in money supply is to shift the AD curve up by 10% ? So in the Keynesian model, money is not neutral int he short run, but it is neutral in the long run ? Fiscal Policy ? the effect of increased government purchases ? A temporary increase in government purchases shifts the IS curve up ? in the short run, output and the rael itnerst rate increase ? the multiplier tells how much increase in government output comes from the increase in government spending ? When prices adjust, the LM curve shifts up and equilibrium is restored at the full-employment lefvel of output with a hgiher real interest rate than before ? the effect of lower taxes ? Keynesians belive that a reduction of taxes i expansionary, just ilke an incrase in government purchases ? Keynesians reject Ricardian equivalence, beliveing that the reduction in taxes increases consumption spending, reducing desired national saving and shifting the IS curve up
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