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III. Monetary and Fiscal Policy in the Keynesian Model (Sec. 11.3)
1. Monetary policy in the Keynesian IS-LM model
a. The Keynesian FE line differs from the classical model in two respects
(1) 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 in
the classical model
the classical model
b. Since prices are sticky in the short run in the Keynesian model, the price level doesn’t
adjust to restore general equilibrium
(1) 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
(2) This represents the assumption that firms meet the demand for their products by
adjusting employment
Numerical Problem 2 and Analytical Problems 1 and 2 use the Keynesian IS-LM model.
c. Analysis of an increase in the nominal money supply (Figure 11.4)
(1) LM curve shifts down from LM1 to LM2
(2) Output rises and the real interest rate falls
(3) Firms raise employment and production due to increased demand
(4) The increase in money supply is an expansionary monetary policy (easy money); a
decrease in money supply is contractionary monetary policy (tight money)
(5) Easy money increases real money supply, causing the real interest rate to fall to clear
the money market
(a) The lower real interest rate increases consumption and investment
(b) With higher demand for output, firms increase production and employment
(6) Eventually firms raise prices, the LM curve shifts back to its original level, and
general equilibrium is restored
(7) Thus money is neutral in the long run, but not in the short run
Data Application
For a discussion of how monetary policy affects different parts of the economy, see the article by
David Reifschneider, Robert Tetlow, and John Williams, “Aggregate Disturbances, Monetary
Policy, and the Macroeconomy: The FRB/US Perspective” Federal Reserve Bulletin, January 1999.
The article discusses the Federal Reserve Board’s new model of the economy.
1. We can do the same analysis in the AD-AS framework, as was done in text Figure 9.14
2. The main difference between the Keynesian and classical approaches is the speed of price
adjustment
3. The effect of a 10% increase in money supply is to shift the AD curve up by 10%
a. Thus output rises in the short run to where the SRAS curve intersects the AD curve
4. So in the Keynesian model, money is not neutral in the short run, but it is neutral in the
long run
Numerical Problem 4 uses the Keynesian AD-AS framework.
Theoretical Application
Some Keynesians don’t agree with the view presented in the textbook that a change in monetary
1. The effect of increased government purchases (Figure 11.5)
Figure 11.5
a. A temporary increase in government purchases shifts the IS curve up
b. In the short run, output and the real interest rate increase
c. The multiplier, Y/G, tells how much increase in output comes from the increase in
2. The effect of lower taxes
a. Keynesians believe that a reduction of (lump-sum) taxes is expansionary, just like an
increase in government purchases
b. Keynesians reject Ricardian equivalence, believing that the reduction in taxes increases
1. Keynesians think aggregate demand shocks are the primary source of business cycle
fluctuations
2. Aggregate demand shocks are shocks to the IS or LM curves, such as fiscal policy, changes in
desired investment arising from changes in the expected future marginal product of capital,
3. A recession is caused by a shift of the aggregate demand curve to the left, either from the IS
curve shifting down, or the LM curve shifting up
4. The Keynesian theory fits certain business cycle facts
a. There are recurrent fluctuations in output
b. Employment fluctuates in the same direction as output
c. Money is procyclical and leading
d. Investment and durable goods spending is procyclical and volatile
5. Procyclical labor productivity and labor hoarding
a. As discussed in Sec. 11.1, firms may hoard labor in a recession rather than fire workers,
because of the costs of hiring and training new workers
b. Such hoarded labor is used less intensively, being used on make-work or maintenance
tasks that don’t contribute to measured output
1. Keynesians favor government actions to stabilize the economy
2. Recessions are undesirable because the unemployed are hurt
3. Suppose there’s a shock that shifts the IS curve down, causing a recession (Figure 11.7;
like text Figure 11.8)
Figure 11.7
a. If the government does nothing, eventually the price level will decline, restoring general
4. Using monetary or fiscal policy to restore general equilibrium has the advantage of acting
quickly, rather than waiting some time for the price level to decline
5. But the price level is higher in the long run when using policy than it would be if the
government took no action
6. The choice of monetary or fiscal policy affects the composition of spending
a. An increase in government purchases crowds out consumption and investment spending,
7. Difficulties of macroeconomic stabilization
a. Macroeconomic stabilization is the use of monetary and fiscal policies to moderate the
business cycle; also called aggregate demand management
b. In practice, macroeconomic stabilization hasn’t been terribly successful
c. One problem is in gauging how far the economy is from full employment, since we can’t
1. Until the mid-1970s, Keynesians focused on demand shocks as the main source of business
cycles
2. But the oil price shock that hit the economy beginning in 1973 forced Keynesians to
reformulate their theory
3. Now Keynesians concede that supply shocks can cause recessions, but they don’t think
supply shocks are the main source of recessions
4. An adverse oil price shock shifts the FE line left (Figure 11.8; like text Figure 11.9)
Figure 11.8
a. The average price level rises, shifting the LM curve up (from LM1 to LM2), because the
large increase in the price of oil outweighs the menu costs that would otherwise hold
prices fixed
1. Until recently, classicals and Keynesians used very different models
2. Recently, each group has incorporated ideas from the other group; Keynesian economists
began using DSGE models and classicals began using sticky prices and imperfect
3. Economists were able to reconcile aggregative models with models of microeconomic
foundations
4. Classicals and Keynesians still disagree about the speed of wage and price adjustment and
the role of government policy, but now speak the same language in modeling the economy
1. Nominal wages could be rigid because of long-term contracts between firms and unions
2. With nominal-wage rigidity, the short-run aggregate supply curve slopes upward instead of
being horizontal
3. Even so, the main results of the Keynesian model still hold
B. The short-run aggregate supply curve with labor contracts
1. U.S. labor contracts usually specify employment conditions and the nominal wage rate for
three years
2. Employers decide on workers’ hours and must pay them the contracted nominal wage
3. The result is an upward-sloping short-run aggregate supply curve
a. As the price level rises, the real wage declines, since the nominal wage is fixed
1. Money isn’t neutral in this model, because as the money supply increases, the AD curve
shifts along the fixed (upward-sloping) SRAS curve (Figure 11.9; like text Figure 11.A.1)
2. As a result, output and the price level increase
3. Over time, workers will negotiate higher nominal wages and the SRAS curve will shift left to
restore general equilibrium
4. Thus money is nonneutral in the short run but neutral in the long run
5. There are several objections to this theory
a. Less than one-sixth of the U.S. labor force is unionized and covered by long-term wage
contracts; however, some nonunion workers get wages similar to those in union contracts,
and other workers may have implicit contracts that act like long-term contracts
b. Some labor contracts are indexed to inflation, so the real wage is fixed, not the nominal
1. First, calculate the effect on the intercept of the IS curve, IS, of a change in G
a. IS (c0 i0 G cYt0)/(cr ir) (11.C.1)
2. Second, calculate the effect on Y of a change in IS
a. The AD curve intersects the SRAS curve at
l
3. Finally, combine both effects
a. Substituting (11.C.2) in (11.C.4) we get
Y/G 1/[(cr ir)(IS LM)] (11.C.5)
b. This is the government purchases multiplier
c. The multiplier is positive, since all the terms in it are positive; it may be greater or less
1. We can do the same analysis in the AD-AS framework, as was done in text Figure 9.14
2. The main difference between the Keynesian and classical approaches is the speed of price
adjustment
3. The effect of a 10% increase in money supply is to shift the AD curve up by 10%
a. Thus output rises in the short run to where the SRAS curve intersects the AD curve
4. So in the Keynesian model, money is not neutral in the short run, but it is neutral in the
long run
Numerical Problem 4 uses the Keynesian AD-AS framework.
Theoretical Application
Some Keynesians don’t agree with the view presented in the textbook that a change in monetary
1. The effect of increased government purchases (Figure 11.5)
Figure 11.5
a. A temporary increase in government purchases shifts the IS curve up
b. In the short run, output and the real interest rate increase
c. The multiplier, Y/G, tells how much increase in output comes from the increase in
2. The effect of lower taxes
a. Keynesians believe that a reduction of (lump-sum) taxes is expansionary, just like an
increase in government purchases
b. Keynesians reject Ricardian equivalence, believing that the reduction in taxes increases
1. Keynesians think aggregate demand shocks are the primary source of business cycle
fluctuations
2. Aggregate demand shocks are shocks to the IS or LM curves, such as fiscal policy, changes in
desired investment arising from changes in the expected future marginal product of capital,
3. A recession is caused by a shift of the aggregate demand curve to the left, either from the IS
curve shifting down, or the LM curve shifting up
4. The Keynesian theory fits certain business cycle facts
a. There are recurrent fluctuations in output
b. Employment fluctuates in the same direction as output
c. Money is procyclical and leading
d. Investment and durable goods spending is procyclical and volatile
5. Procyclical labor productivity and labor hoarding
a. As discussed in Sec. 11.1, firms may hoard labor in a recession rather than fire workers,
because of the costs of hiring and training new workers
b. Such hoarded labor is used less intensively, being used on make-work or maintenance
tasks that don’t contribute to measured output
1. Keynesians favor government actions to stabilize the economy
2. Recessions are undesirable because the unemployed are hurt
3. Suppose there’s a shock that shifts the IS curve down, causing a recession (Figure 11.7;
like text Figure 11.8)
Figure 11.7
a. If the government does nothing, eventually the price level will decline, restoring general
4. Using monetary or fiscal policy to restore general equilibrium has the advantage of acting
quickly, rather than waiting some time for the price level to decline
5. But the price level is higher in the long run when using policy than it would be if the
government took no action
6. The choice of monetary or fiscal policy affects the composition of spending
a. An increase in government purchases crowds out consumption and investment spending,
7. Difficulties of macroeconomic stabilization
a. Macroeconomic stabilization is the use of monetary and fiscal policies to moderate the
business cycle; also called aggregate demand management
b. In practice, macroeconomic stabilization hasn’t been terribly successful
c. One problem is in gauging how far the economy is from full employment, since we can’t
1. Until the mid-1970s, Keynesians focused on demand shocks as the main source of business
cycles
2. But the oil price shock that hit the economy beginning in 1973 forced Keynesians to
reformulate their theory
3. Now Keynesians concede that supply shocks can cause recessions, but they don’t think
supply shocks are the main source of recessions
4. An adverse oil price shock shifts the FE line left (Figure 11.8; like text Figure 11.9)
Figure 11.8
a. The average price level rises, shifting the LM curve up (from LM1 to LM2), because the
large increase in the price of oil outweighs the menu costs that would otherwise hold
prices fixed
1. Until recently, classicals and Keynesians used very different models
2. Recently, each group has incorporated ideas from the other group; Keynesian economists
began using DSGE models and classicals began using sticky prices and imperfect
3. Economists were able to reconcile aggregative models with models of microeconomic
foundations
4. Classicals and Keynesians still disagree about the speed of wage and price adjustment and
the role of government policy, but now speak the same language in modeling the economy
1. Nominal wages could be rigid because of long-term contracts between firms and unions
2. With nominal-wage rigidity, the short-run aggregate supply curve slopes upward instead of
being horizontal
3. Even so, the main results of the Keynesian model still hold
B. The short-run aggregate supply curve with labor contracts
1. U.S. labor contracts usually specify employment conditions and the nominal wage rate for
three years
2. Employers decide on workers’ hours and must pay them the contracted nominal wage
3. The result is an upward-sloping short-run aggregate supply curve
a. As the price level rises, the real wage declines, since the nominal wage is fixed
1. Money isn’t neutral in this model, because as the money supply increases, the AD curve
shifts along the fixed (upward-sloping) SRAS curve (Figure 11.9; like text Figure 11.A.1)
2. As a result, output and the price level increase
3. Over time, workers will negotiate higher nominal wages and the SRAS curve will shift left to
restore general equilibrium
4. Thus money is nonneutral in the short run but neutral in the long run
5. There are several objections to this theory
a. Less than one-sixth of the U.S. labor force is unionized and covered by long-term wage
contracts; however, some nonunion workers get wages similar to those in union contracts,
and other workers may have implicit contracts that act like long-term contracts
b. Some labor contracts are indexed to inflation, so the real wage is fixed, not the nominal
1. First, calculate the effect on the intercept of the IS curve, IS, of a change in G
a. IS (c0 i0 G cYt0)/(cr ir) (11.C.1)
2. Second, calculate the effect on Y of a change in IS
a. The AD curve intersects the SRAS curve at
l
3. Finally, combine both effects
a. Substituting (11.C.2) in (11.C.4) we get
Y/G 1/[(cr ir)(IS LM)] (11.C.5)
b. This is the government purchases multiplier
c. The multiplier is positive, since all the terms in it are positive; it may be greater or less
