Economics Chapter 11 The Keynesian Theory Fits Certain Business Cycle

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Chapter 11

Keynesianism: The Macroeconomics

of Wage and Price Rigidity

◼ Learning Objectives

I. Goals of Chapter 11

A. Summarize the Keynesian explanations for real-wage rigidity (Sec. 11.1)

II. Notes to Eighth Edition Users

A. This chapter is little changed from the last edition

238 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

◼ Teaching Notes

I. Real-Wage Rigidity (Sec. 11.1)

A. Wage rigidity is important in explaining unemployment

1. In the classical model, unemployment is due to mismatches between workers and firms

2. Keynesians are skeptical, believing that recessions lead to substantial cyclical unemployment

B. Some reasons for real-wage rigidity

1. For unemployment to exist, the real wage must exceed the market-clearing wage

2. If the real wage is too high, why don’t firms reduce the wage?

a. One possibility is that the minimum wage and labor unions prevent wages from being

reduced

(1) But most U.S. workers aren’t minimum wage workers, nor are they in unions

C. The Efficiency Wage Model

1. Workers who feel well treated will work harder and more efficiently (the “carrot”); this is

Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 239

4. The effort curve, plotting effort against the real wage, is S-shaped

a. At low levels of the real wage, workers make hardly any effort

D. Wage determination in the efficiency wage model

1. Given the effort curve, what determines the real wage firms will pay?

2. To maximize profit, firms choose the real wage that gets the most effort from workers for

E. Employment and Unemployment in the Efficiency Wage Model

1. The labor market now determines employment and unemployment, depending on how far

240 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

2. 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

3. The difference between labor supply and labor demand is the amount of unemployment

4. The fact that there’s unemployment puts no downward pressure on the real wage, since firms

know that if they reduce the real wage, effort will decline

Analytical Problem 5 takes a more sophisticated look at the labor market, dividing it into one

sector with an efficiency wage and another sector in which the real wage equates labor demand

and supply.

5. Does the efficiency wage theory match up with the data?

a. It seems to have worked for Henry Ford in 1914

b. Plants that pay higher wages appear to experience less shirking

F. Efficiency wages and the FE line

1. The FE line is vertical, as in the classical model, since full-employment output is determined

in the labor market and doesn’t depend on the real interest rate

Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 241

II. Price Stickiness (Sec. 11.2)

A. Price stickiness is the tendency of prices to adjust slowly to changes in the economy

1. The data suggest that money is not neutral, so Keynesians reject the classical model

(without misperceptions)

Theoretical Application

The idea that nominal wage contracts lead to a fixed nominal wage in a theoretical Keynesian

model was developed by Stanley Fischer, “Long-term Contracts, Rational Expectations, and the

B. Sources of price stickiness: Monopolistic competition and menu costs

1. Monopolistic competition

a. If markets had perfect competition, the market would force prices to adjust rapidly; sellers

are price takers, because they must accept the market price

e. Menu costs and price stickiness

(1) The term menu costs comes from the costs faced by a restaurant when it changes

Theoretical Application

One of the first articles to present the combination of monopolistic competition and menu costs

f. Empirical evidence on price stickiness

(1) Industrial prices seem to be changed more often in competitive industries, less often

in more monopolistic industries (Carlton study)

242 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

(2) Blinder and his students found a high degree of price stickiness in their survey of

firms

(a) The main reason for price stickiness was managers’ fear that if they raised their

(5) But some of the measured price stickiness is because of sales; when you look at price

changes excluding sales, prices change on average every 11 months (Nakamura–

Steinsson)

(6) Relative prices may respond quickly to supply or demand shocks for a particular

good, but the price level may change slowly to changes in monetary policy (Boivin–

Theoretical Application

Modern Keynesian theory depends on monopoly power and the markup. Recently, however, this

view of the markup has been challenged. Empirical work has suggested that the markup is not

h. Effective labor demand

(1) The firm’s labor demand is thus determined by the demand for its output

(2) The effective labor demand curve, NDe(Y), shows how much labor is needed to

Empirical Application

Following up on the Bils-Klenow observation, economists at the Federal Reserve have

developed a sticky-price consumer price index, which might provide improved forecasts of

Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 243

Theoretical Application

The major articles underlying Keynesian theory are collected in the volume New Keynesian

III. Monetary and Fiscal Policy in the Keynesian Model (Sec. 11.3)

A. Monetary policy

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

Empirical Application

The theory of price stickiness leads to an empirical method of measuring inflation expectations.

Because some prices are sticky and others are more flexible, prices that are sticky seem likely to

244 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

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

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

Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 245

Figure 11.4

B. Monetary Policy in the Keynesian AD–AS framework

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

a. The classical model has fast price adjustment, so the SRAS curve is irrelevant

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

policy has no effect on the long-run aggregate supply curve. J. Bradford DeLong and Lawrence

H. Summers, “How Does Macroeconomic Policy Affect Output?” Brookings Papers on

246 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

C. Fiscal policy

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

d. When prices adjust, the LM curve shifts up and equilibrium is restored at the full-

employment level of output with a higher real interest rate than before

e. Similar analysis comes from looking at the AD–AS framework (Figure 11.6)

Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 247

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

IV. The Keynesian Theory of Business Cycles and Macroeconomic Stabilization (Sec. 11.4)

A. Keynesian business cycle theory

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

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

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

Theoretical Application

Several prominent macroeconomists discuss their views of the Keynesian model of business

cycles in a symposium in the Journal of Economic Perspectives, Winter 1993.

B. Macroeconomic stabilization

1. Keynesians favor government actions to stabilize the economy

248 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

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

equilibrium. But output and employment may remain below their full-employment levels

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

Analytical Problem 4 looks at the benefits of using government purchases to combat recessions.

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

Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 249

Analytical Problem 3 looks at how lags in the effect of policy can influence decisions about how

to use policy.

Policy Application

A general analysis of the possibility of using activist monetary policy, which contrasts the results

from classical and Keynesian theories, is Tom Stark and Herb Taylor, “Activist Monetary Policy

for Good or Evil? The New Keynesians vs. the New Classicals,” Federal Reserve Bank of

Philadelphia Business Review, March/April 1991.

C. Supply shocks in the Keynesian model

1. Until the mid-1970s, Keynesians focused on demand shocks as the main source of business

cycles

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

250 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

D. In Touch with Data and Research: DSGE Models and the Classical-Keynesian Debate

1. Until recently, classicals and Keynesians used very different models

the role of government policy, but now speak the same language in modeling the economy

V. Appendix 11.A: Labor Contracts and Nominal-Wage Rigidity

A. Some Keynesians think the nonneutrality of money is because of nominal-wage rigidity, not

nominal-price rigidity

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 to five years

C. Nonneutrality of money

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)

Figure 11.9

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

Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 251

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

Numerical Problem 5 is an exercise dealing with the rigid nominal-wage version of the

Keynesian model.

VI. Appendix 11.C: The Multiplier in the Short-Run Keynesian Model

A. The multiplier shows the change in output resulting from a one-unit change in government

purchases

1. First, calculate the effect on the intercept of the IS curve, IS, of a change in G



IS = (c0 + i0 + G − cYt0)/(cr + ir) (11.C.1)

Y = 



IS/(



IS +



LM) (11.C.4)

3. Finally, combine both effects

a. Substituting (11.C.2) in (11.C.4) we get

d. The multiplier will be large if the LM curve is flat (



LM is zero), since then the shift in the

IS curve has a large effect on output

(1) In this special case,

252 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

◼ Additional Issues for Classroom Discussion

1. Do Lags Eliminate the Effectiveness of Fiscal Policy?

Keynesian economists in the past have encouraged the use of fiscal policy to combat recession. They

believe that wages and prices do not adjust rapidly enough to bring the economy to full employment in a

reasonable period of time without the help of changes in government expenditures. However, fiscal policy

takes a long time to be implemented. Can we expect it to be effective in combating recessions?

Fiscal policy can’t be changed rapidly. When the economy goes into a recession, we usually don’t know it

until several months later. Once a recession has been identified, a program must be devised. The next step

2. Do Prices Adjust Slowly?

One of the main differences between Keynesians and classical economists is their disagreement over how

quickly prices adjust to changes in the economy. Which point of view seems more in line with what

happens in the economy?

In some markets, prices do adjust rapidly. This is particularly true in commodity markets such as those for

corn and wheat. It is also true for items such as gasoline. While gas stations are individualized by their

Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 253

3. The Interest Rate Forecast for 1993

In late 1992, private forecasters suggested that the Fed would need to raise interest rates in 1993 as the

economy expanded. This can be seen in Figure 11.10, in which the economy is initially in equilibrium

with the IS curve at IS0 and the LM curve at LM0. The forecast for 1993 was that the IS curve would shift

up and to the right to IS1. If the Fed maintained the real interest rate at r0, it would need to expand the

254 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

◼ Answers to Textbook Problems

Review Questions

1. The efficiency wage is the real wage that maximizes effort or efficiency per dollar of real wages. It

2. Full-employment output is the amount of output produced by firms with employment determined by

the labor demand curve at the point where the marginal product of labor equals the efficiency wage.

3. Price stickiness is the tendency of prices to adjust only slowly to changes in the economy. Keynesians

believe it is important to allow for price stickiness to explain why monetary policy is not neutral.

4. Menu costs are the costs of changing prices. Menu costs may lead to price stickiness in

monopolistically competitive markets but not in perfectly competitive markets, because a

monopolistically competitive firm’s demand is not as sensitive to the price as is a perfectly

5. In the Keynesian model, money is not neutral in the short run, but it is neutral in the long run. In

the short run, an increase in the money supply increases output and the real interest rate, while the

price level and real (efficiency) wage are unchanged. In the long run, however, only the price level

6. In the Keynesian model in the short run, output and the real interest rate increase due to an increase