Topic 8 Flashcards
What do Keynesian’s present info on to show their dissatisfaction with the classical explanation of unemployement?
They present evidence that shows that during
recessions unemployed workers spend relatively little time searching for work
Rather than times of increased worker-job mismatch, Keynesian’s believe that…
Recessions are periods of low demand
for both output and workers
What is real wage rigidity?
the idea that the real wage moves too little to equilibrate the labor market
For unemployment to exist, what must be happening?
the real wage must exceed the market-clearing wage
I the real wage is too high, why don’t firms reduce the wage? (3)
- Minimum wage or labour unions
- To get a stable labour force and avoid turnover costs
- Worker’s productivity may depend on the wages they’re paid- the efficiency wage model
What are turnover costs?
costs of hiring and training new workers
Look at slides to see determination of the efficiency wage
To maximise profits in the efficiency wage model, where do firms set wages?
Choose real wage that gets the most effort from workers for each pound of real wages paid (E / w)
On a labour diagram, where is the efficiency wage set?
What does this result in?
Above market clearing wage.
Excess supply
What is different about a labour market diagram in the efficiency wage model?
The labor demand curve, 𝑵𝑫*, is the demand curve for labour in the efficiency wage model.
Continues to be identical to the MPN curve, however MPN also now depends on the worker’s effort, as well as the production function and capital stock.
In addition to an increase in productivity or in the capital stock increasing MPN, what else in the Keynesian model increases MPN?
Any change in the effort curve that leads to an increase in the optimal effort level E*
Using the efficiency wage model, what can we determine about employment?
The level of employment in the economy is determined by the labour demand
What is the full- employment level of employment in the Keynesian model?
The demand-determined level of employment 𝑁bar at the efficiency wage 𝑤∗
What is the amount of unemployment in the Keynesian model?
Difference between labour supply and labour demand- where efficiency wage is above classical equilibrium wage
What is the wage said to be at the efficiency wage? Why?
Rigid
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
What is a criticism of the efficiency wage model?
The real wage is fixed for no change in the effort curve.
The theory implies that the real wage is completely rigid, whereas the data suggests that the real wage
moves over time and over the business cycle
What is the response to the criticism of the efficiency wage model suggesting that wages are rigid?
It is possible to extend the basic Keynesian model to allow for changes in the
effort curve that bring changes in the efficiency wage over time
In a recession, what can we say about the real wage?
Workers work harder during a recession if the probability of losing their jobs increased.
It follows that the real wage necessary to obtain any specific level of effort will be lower during recessions.
This would cause the effort curve to shift up to the left hence the efficiency wage paid in recessions may be lower
Unlike the Classical model, what does not shift the FE line in the IS-LM model?
Changes in labour supply, since they do not affect equilibrium employment
How does an increase in productivity increase FE indirectly and directly?
Indirectly:
By increasing the marginal product of labor at any given level of employment. Increases labour demand
Directly:
A rise in productivity increases the amount of output that can be produced with any particular
amount of capital, labor and effort.
What type of unemployment is present in the Keynesian model?
Involuntary unemployment
What do Keynesian’s refer to rigidity of nominal prices as?
Price stickiness
What does price stickiness explain?
Money isn’t neutral because the price level cannot adjust immediately to offset changes in the money supply
Why do Keynesian’s say prices are sticky? (2)
In many markets, sellers have some degree of monopoly; they are price setters under
monopolistic competition
When firms change prices, they incur a cost, known as a menu cost
What is a menu cost?
Menu costs are the costs incurred by a business when it changes the prices it offers to its customers
In monopolistically competitive markets, sellers do three things…
They set prices in nominal terms and maintain those prices for some period
They adjust output to meet demand at their fixed nominal price
They readjust prices from time to time when costs or demand change significantly
(Pricing behaviour is profit maximisation)
What is a counterargument for menu costs causing price stickiness?
Menu costs seem to be rather small.
Why do menu costs cause price stickiness?
Menu costs are costs that do not occur if prices remain the same, therefore price rigidity occurs
When do firms change their prices?
When the loss of profit from setting the wrong price (which temporarily won’t affect their demand), is greater than the menu costs of changing price
Why are firms willing to meet demand at a fixed nominal price?
Since firms have monopoly power, they price goods at a markup over their marginal cost of production. So changes in demand will result in the firm changing output and not prices. They can change output by increasing labour.
Show a function for a price markup
p =n (1 + n)MC
Look at empirical evidence on price stickiness
When the firms are meeting extra demand at the fixed nominal price, what can firms do?
Since the firm is paying the efficiency wage and it is gaining extra profit from increased demand, it can hire more workers at that wage to produce more goods, since there is an excess supply of labour.
What is the macroeconomic implication of monopolistic firms meeting the demand at the fixed nominal price?
The economy can produce an amount of output that is not on the FE line during the period in which prices have’t yet completely adjusted. (prices are sticky in SR)
What is the effective labour demand ND^e?
Shows how much labour is needed to produce the output demanded
What does the effective labour demand give?
When the economy is not on the FE line and the price level is fixed, the effective labour demand gives the level of employment
In the SR, where is general equilibrium?
Where the IS and LM curves intersect
In the long-run, what do Keynesian’s say?
Money is neutral
Explain the IS-LM model from an increase in the money supply
LM curve shifts to the right.
Short run equilibrium where IS intersects LM curve- output over full employment level. This causes a fall in interest rates.
In the LR prices increase, shifting he LM curve left.
Now all three curves interest again.
Why do Keynesian’s promote government purchases?
Increases output/ Yad in the SR.
Suppose there is a recession, a shock that shifts the IS curve down, what are the options?
Government does nothing- eventually the price level will decline restoring general equilibrium.
The central bank could increase the money supply.
The government could increase government purchases.
What is the difference in the long-run situations between the government doing nothing, and the central bank increasing the money supply?
If the government do nothing, prices will fall causing LM to shift and in the LR prices are lower.
If the central bank increases the money supply, in the LR prices remain the same
What is macroeconomic stabilisation?
The use of monetary and fiscal polices to moderate the business cycle; also called aggregate demand management
What is an issue of macroeconomic stabilisation?
- Hard to gauge how far the economy os from full employment
- time lags
- Forecasting ability not always precise (covid, oil price shock)
- Where is inflation at and what do you wish for inflation?
What happens in an oil price shock? (negative supply shock)
FE shifts to the left and LM shifts to the left as oil prices increase and increase the price level.
If you want to assume recession, shift LM further so it does not create general equilibrium.
SR equilibrium where IS intersects LM2.
Price level fall in LR shifting LM to the right and restoring the general equilibrium.
Why is there not much stabilisation policy can do in an oil shock?
There is a fall in the FE, so attempting to expand the economy beyond the new full-employment will increase output only temporarily and worsen inflation.
What do Keynesians believe that a lump-sum reduction current taxes is the same as?
They believe it is expansionary
What does a tax cut do in the IS-LM model?
What does this mean Keynesians reject?
It will shift the IS curve up because they will increase their consumption.
The Ricardian equivalence proposition.
What is the main difference between a tax cut and increased government purchases|?
Tax cut increases the portion of full-employment output devoted to private consumption over government purchases
What do Keynesian economists think the main cause of fluctuations in the business cycle?
Aggregate demand shocks
Why do Keynesians say a change in MPK^f is not a supply shock?
Thought of as a technological shock as it involves a change in the future production function, However, because a change in 𝑀𝑃𝐾𝑓
shifts the IS curve but doesn’t affect the current FE line.
What do Keynesian’s believe attribute to recessions?
Not enough demand
What business cycle facts are consistent with Keynesian theory?
- In response to occasional aggregate demand shocks, there are recurrent fluctuations in output
- The theory correctly implies that employment will fluctuate in the same direction as output
- Because shocks to the money supply are nonneutral, the theory is consistent with the business cycle fact that money is procyclical and leading
- Investment and durable goods spending is strongly procyclical and volatile
- Inflation is procyclical and lagging: it tends to be slow during or just after recessions
What are animal spirits?
Waves of pessimism and optimism
What does the Keynesian theory not account for in terms of business cycles?
Procyclical labour productivity as they believe it is countercyclical.
To explain the procylical behaviour of average labour productivity, what have Keynesians done?
Modified model to include labour hoarding.
Firms may hoard labour in a recession rather than fire workers, because of the costs of hiring and training new workers.
Such hoarded labour is used less intensively
