New-Keynesian Theory of Aggregate Supply

Efficiency Wages

Learning Objectives

• Understand how efficiency wages affect the slope of the aggregate supply curve.

• Learn to derive the short run aggregate supply curve.

• Understand the relationship between the short run and long run aggregate supply curves.

• Learn why money is not neutral in the new-Keynesian model.

Aggregate Supply with Efficiency Wages

• The new-Keynesian theory of aggregate supply is based on the theory of efficiency wages.– Firms choose their wages to minimize the

wage bill and then choose employment to maximize profit.

– Nominal wages, however, are sticky; ie., they do not change as frequently as employment.

Y

L

Y

Y

Y

P

L

w/P

Y=F(L)

LS

w1/P1*

L1* 0

0

0

0

LD

P1

Y1*

Y1

U*

Y1L1

LS

Deriving the Modern Aggregate Supply Curve: Efficiency Wages

• We begin at the price level P1 where w1/P1* is the efficiency wage.

• At w1/P1*, the level of unemployment is at the natural rate of U*. – L1 people are employed and LS minus L1* are

unemployed.

• Output equals Y1 at the price level P1.

Y

L

Y

Y

Y

P

L

w/P

Y=F(L)

LS

w1/P1*

L1* L20

0

0

0

LD

P2

P1

w1/P2

Y1* Y2

AS

Y2

Y1

U*

U

Y1 Y2 L1 L2

Deriving the Modern Aggregate Supply Curve: Efficiency Wages

• Let the price level increase to P2 .• Since nominal wages do not change, the

real wage falls to w1/P2.• Firms try to hire more workers while

households send fewer workers to the labor market.

• Unemployment falls below U*.• Output rises to Y2 at the price level P2.

Y

L

Y

Y

Y

P

L

w/P

Y=F(L)

LS

w1/P1*

L3 L1* L20

0

0

0

LD

P2

P1

P3

w1/P2

Y3 Y1* Y2

AS

Y2

Y1

Y3

U*

U

w1/P3

U

Y3 Y1 Y2L3 L1 L2

Deriving the Modern Aggregate Supply Curve: Efficiency Wages

• Let the price level decrease to P3 .

• Since nominal wages do not change, the real wage rises to w1/P3.

• Firms reduce employment while households send more workers to the labor market.

• Unemployment rises above U*.

• Output falls to Y3 at the price level P3.

The Modern Aggregate Supply Curve: Efficiency Wages

• Summary:– When nominal wages are sticky, a rise in the

price level results in higher levels of output, and a fall in the price level results in lower levels of output.

– When we plot the price level/output combinations, we get an upward sloping aggregate supply curve.

– Nominal wage is constant on any given aggregate supply curve.

The Modern Aggregate Supply Curve: Efficiency Wages

• Summary:– When the real wage equals the efficiency wage,

unemployment is equal to its natural rate, and the quantity of output produced is called the “natural rate of output.”

– The natural rate of unemployment and output depend only on the fundamentals of the economy: preferences, endowments, and technology.

The Classical Model and the New-Keynesian Model: Summary

0 YY*

LRAS SRASP

AD1

AD2

Y1

P3

P2

P11

23

In the classical model, the aggregate supply curve is vertical.

As a result, any change in aggregate demand causes a change in only the price level.

In the new-Keynesian model, the aggregate supply curve is upward sloping in the short run.

As a result, any change in aggregate demand causes a change in both the price level and output.

Economic Policy

• Unlike the classical model according to new-Keynesian theory, the labor market may not always be in equilibrium.– When nominal wages are “sticky,” labor

demand can be less than labor supply. – As a result, it is possible for macroeconomic

stabilization policies to change the level of output in the short run.

Y

L

Y

Y

Y

P

L

w/P

Y=F(L)

LS

w1/P1

0

0

0

0

LD

Y1 Y*

SRAS

P1

AD1

LRAS

L1 L*

U*

The New-Keynesian Model

• We begin at the price level P1 where w1/P1* is the efficiency wage.

• At w1/P1*, the level of unemployment is at the natural rate of U*. – L1 people are employed and Ls minus L1 are

unemployed.

• Output equals Y1 at the price level P1.

Y

L

Y

Y

Y

P

L

w/P

Y=F(L)

LS

w1/P1

L2 0

0

0

0

LD

Y2 Y1 Y*

SRAS

L3

P1

AD1

LRAS

AD2

P2

L1

L1

w1/P2

1

2

L*

The New-Keynesian Model: The Non-Neutrality of Money

• Let the money supply contract, causing the aggregate demand curve to shift to the left.

• The price level falls to P2, and the real wage rises to w1/P2.

• Labor demand falls to L2while labor supply rises.

• Unemployment rises above the natural rate.

• Output falls to Y2.

Y

L

Y

Y

Y

P

L

w/P

Y=F(L)

LS

w1/P1*

0

0

0

0

LD

Y1 Y2 Y*

SRAS

P1

AD1

LRAS

L1 L2 L*

AD2

P2 w1/P2

2

1

The New-Keynesian Model: An Increase in the Money Supply

• Let the money supply increase, causing the aggregate demand curve to shift to the right.

• The price level rises to P2, and the real wage falls to w1/P2.

• Labor demand rises to L2 while labor supply responds with a lag.

• Unemployment falls below the natural rate.• Output rises to Y2.

The New-Keynesian Model: The Non-Neutrality of Money

• A change in the money supply does not cause all the variables to change in proportion because the nominal wage is slow to adjust.

• Rather, the change in the money supply causes a change in production and employment as well as a change in prices.

• In this model, the economy adjusts through changes in real variables as well as prices.

Unemployment and Okun’s Law

• The relationship between unemployment and GDP is expressed by Okun’s Law.

• Okun’s Law says that the percentage change in real GDP equals 3% - 2 times the change in the unemployment rate. Why?– GDP has grown over the long run by 3%, and Okun

found that for every 1% increase in unemployment real GDP growth fell by 2%.

• % /\ GDPreal = 3% - 2(8% - 6%) = -1%

Theory and Facts

• During the Depression, the price level fell by 30% and unemployment rose by 25%.

• During the 1930s, wages fell almost as much as prices.

• Keynesian economists argue that the fall in wages was slower than the fall in prices.

The Short-Run and the Long-Run

• The upward sloping aggregate supply curve is a short-run supply curve.

• Why?– As time passes, nominal wages will adjust to

the excess demand or excess supply.• If the real wage has fallen because of a rise in the

price level, nominal wages will rise.• If the real wage has risen because of a fall in the

price level, nominal wages will fall.

Getting from the Short Run to the Long Run

U3

U1*

U2

W1/P3

W1/P1

W1/P2

L0

LD

LS

w/P

L3 L1* L2

When the price level is P2, the real wageis too low and unemployment is belowthe natural rate.

Firms offer higher nominal wages, causing unemployment to rise.

When the price level is P3, the real wageis too high and unemployment is abovethe natural rate.

Firms offer lower nominal wages, causing unemployment to fall.

Moving to the Long Run

• If the economy continues to under-perform, unemployment will remain above the natural rate, and eventually nominal wages will fall.

• As nominal wages fall, production costs fall, causing the short run aggregate supply curve to shift to the right.

• Long run equilibrium is established at P0 and Y*.

Y

L

Y

Y

Y

P

L

w/P

Y=F(L)

LS

w1/P1

L2 0

0

0

0

LD

Y2 Y1 Y*

SRAS1

L3

P1

AD1

LRAS

AD2

P2

L1

L1

w1/P2

2

L*

SRAS3

SRAS2

3P0

Moving to the Long Run

• If the economy continues to out-perform, unemployment will remain below the natural rate and eventually nominal wages will rise.

• As nominal wages rise, production costs rise, causing the short run aggregate supply curve to shift to the left.

• Equilibrium is established at P0 and Y1, where w1/P1 equals w2/P0.

Y

L

Y

Y

Y

P

L

w/P

Y=F(L)

LS

w1/P1

0

0

0

0

LD

Y1 Y2 Y*

SRAS1

P1

AD1

LRAS

L1 L2 L*

AD2

P2 w1/P2 21

SRAS2

3P0