Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 12 Keynesian Business Cycle Theory: Sticky Wages and Prices

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 12

Keynesian Business Cycle Theory: Sticky Wages and Prices

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-2

Chapter 12 Topics

• Construction of the Keynesian sticky wage model: labor market, aggregate supply, IS and LM curves, aggregate demand.

• Nonneutrality of money when wages are sticky.

• The Role of Government in the sticky wage model.

• A Keynesian sticky price model.


Figure 12.1 The Labor Market in the Keynesian Sticky Wage Model


Figure 12.2 The Labor Market in the Keynesian Sticky Wage Model When There Is Excess Demand


Figure 12.3 Construction of the Aggregate Supply Curve


Figure 12.4 The Effect of an Increase in W or a Decrease in z


Figure 12.5 The IS Curve


Figure 12.6 Money Demand, Money Supply, and the LM Curve


Figure 12.7 Determination of r and Y Given P


Figure 12.8 The Effect of an Increase in the Money Supply on the LM Curve


Figure 12.9 The Effect of an Increase in the Price Level on the LM Curve


Figure 12.10 A Positive Shift in Money Demand Shifts the LM Curve to the Left


Figure 12.11 The Aggregate Demand Curve


Figure 12.12 A Shift to the Right in the IS Curve Shifts the AD Curve to the Right


Figure 12.13 A Shift to the Right in the LM Curve Shifts the AD Curve to the Right


Figure 12.14 The Keynesian Sticky Wage Model


An Increase in the Money Supply

• The LM curve and AD curve shift to the right.

• The real interest rate falls, the price level rises, the real wage falls, firms hire more labor, real output increases, consumption rises, investment rises.

• Money is not neutral in the short run when nominal wages are sticky.


Figure 12.15 An Increase in the Money Supply in the Sticky Wage Model


Table 12.1 Data vs. Predictions of the Keynesian Sticky Wage Model with Monetary Shocks


Figure 12.16 Percentage Deviations from Trend in the Money Supply and Real GDP for the Period 1959–2006


Table 12.2 Data vs. Predictions of the Keynesian Sticky Wage Model with Investment Shocks


Figure 12.17 Real and Nominal Interest Rates, 1934–2006


Figure 12.18 An Increase in the Demand for Investment Goods in the Sticky Wage Model


Figure 12.19 Long-Run Adjustment of the Nominal Wage


The Role of Government Policy in the Sticky Wage Model

• Keynesian unemployment will be eliminated and economic efficiency restored in the long run when nominal wages adjust to equate supply and demand in the labor market.

• In the short run, efficiency can be restored through appropriate monetary or fiscal policy in the sticky wage model.

• Monetary or fiscal policy needs to act quickly enough, and given the right information, to have the predicted effects.


Figure 12.20 Stabilization Policy in the Sticky Wage Model–Monetary Policy


Figure 12.21 Stabilization Policy in the Sticky Wage Model–Fiscal Policy


Sticky Price Model

• Firms do not change their nominal prices in the short run, as this is too costly.

• If demand rises, then firms satisfy this demand by increasing output.


Figure 12.22 The Keynesian Sticky Price Model


Equation 12.1

The quantity of employment N must be consistent with the quantity of output Y and the production function:


Equation 12.2

Employment is then an increasing function of Y/z and K.


Figure 12.23 Determination of Employment in the Sticky Price Model


Figure 12.24 The Effect of an Increase in Total Factor Productivity on Employmentin the Sticky Wage Model

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Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 12 Keynesian Business Cycle Theory: Sticky Wages and Prices