Transcript long run

XVII. New Keynesian
Economics
XVII.1 AD – AS model once again
• Aggregate demand : both in long and
short term decreasing function of price
• Aggregate supply
– In the long run – vertical at potential product
– In the short term – horizontal at the level of
fixed price
• Shifts of AD (because of monetary or
fiscal policy)
– In the long run does not change product, but a
price level
– In the short run changes product (and
employment), but price remains constant
AD shifts – short run
P
P1
E2
E1
SRAS
AD1
AD 2
Y2
Y1
Y
AD shifts - long run
LRAS
P
P1
E1
P2
E2
Yf
AD1
AD 2
Y
Long term equilibrium
P
LRAS
E
SRAS
AD
Yf
Y
From short to long run (1)
• Short run equilibrium:
– AD equals AS, quantity adjustment, AS adjusts
to AD
– Price fixed, equilibrium as state of rest, on the
labor market an excess supply might exist
(unemployment)
– Product might be lower than potential (natural)
• Long run equilibrium:
– AD equals AS
– Prices adjusted, so that on all markets supply
equals demand
– Product on potential (natural) level
From short to long run (2)
Intuitive interpretation:
• Fixed price: either depression (Keynes) or
a very short run, when prices (wages) are
sluggish in any economy and (almost) in
any situation (except e.g. hyperinflation)
• Long term equilibrium – prices and wages
had to react to changes in demand and
supply on various markets (including
labor market) and cleared the markets
through its adjustment
Aggregate supply in short to
medium run
• Adjustment process (from short to long
run) takes some time  question
– How is the aggregate supply specified in this
transition period?  increasing function of
price
• No unified theory till today
– Neoclassical synthesis: downward wage and
price rigidities (no market clearing)
– Phillips curve: adaptive expectations
hypothesis
– New Classical Economics: market clearing,
rational expectations, Lucas’ AS
– End of 1980s – revival of Keynes: “The New
Keynesian Economics” (NKE)
Another view on the same problem …
• In the very long run: economy always at natural
levels, AS vertical
• If AS positively sloped → money is not neutral, i.e.
increase of money supply increases output (and
price) and vice-versa
• Beginning of 1990s: NKE, 2 questions:
– Is money non-neutral? Do we build the theory that denies
classical dichotomy?
– Do real market imperfections determine economic
fluctuations
• The second question defines NKE: theoretical
explanation of market imperfections and the link to
deviations from natural values
– Prices are not fixed (adjust slowly, etc.) because of short run,
but because of market imperfections
– Not unified theory, rather many different models and in next
parts, Mankiw’s textbook is followed (see Literature)
XVII.2 Nominal wage rigidity
• Originally: F.Modigliani (1944) – downward
wage rigidity
• In general: wages rigid in both directions,
reasons:
– Long term wage contracts, eventually
implicit contracts, power of the unions
• Intuitively: if wages rigid, then price
increase lowers real wage  firms
increase employment  product
increases and supply increasing function
of the price
Wage: targeted and actual
Wage negotiations:
• Always negotiated nominal wage at the expected
price Pe , so both firms and workers have in mind
targeted real wage, so wT a W = wT . Pe
• Employment given by demand  firms then
decide according price P
- (W/P) = wT . (Pe /P)
– if P = Pe , then (W/P) = wT
– if P > Pe , then (W/P) < wT
– if P < Pe , then (W/P) > wT
– Unexpected growth of price means fall of real
wage  higher employment  higher product;
conversely, fall of price  lower product
Higher price  higher AS (and vice versa)
W/P
W1
P2
W1
P1
P
B
A
N2
N1
Y
AS
ND
N
 
Y=F K,N
Y1
Y2
N2
N1
N
P1
P2
A
B
Y2 Y1
Y
From wage to AS
• Difference between actual and expected
price reflects price movements
– One possible interpretation – if in moment
t, expectation equals price, than actual
price, determining real wage, is price in
moment t+1
• Generalization:

Y=Yf + P-P
e
,
 >0
• Counter cyclical movement of real wage
XVII.3 Wrong perception of price
level by workers
Starting assumption – firms always
know prices, workers only expect them
and will know real price only with a time
lag
D
D
N
=N
W P 
• Demand for labor
e
S
S
• Supply of labor N =N W P 
W W P
e
=
.
P
P
• Always P P P and ratio
reflects a degree of wrong perception of
price level by workers
e
e
Model (1)
• Demand for labor: decreasing
function of real wage
• Supply of labor: increasing function
of expected real wage, can be written
as




e

N =N W P =N W P . P P 
S
S
e
S
– Labor supply curve shifts according the
ratio P P e
• Model assumes simultaneous
clearing of all markets
Wrong price perception: price
increase
N1S
W/P
N S2
W P 1
W P 2
N D =N D W P 
N1
N2
N
• Demand –
decreasing function
of real wage
• Supply – increasing
function of W P .P P e 
• N1S initial supply
• Unexpected price
increase  labor
supply shifts to the
right  real wage fall
 new equilibrium
with higher
employment
Model (2)
• Price increase  employment
increase
• AD – increasing function of price
e
• In general again Y=Yf + P-P  ,  > 0
P
AS
Yf
Y
XVII.4 Incomplete price
information
Assumptions:
• No difference between firms and
workers
• On the markets, agents know
– Very well the price of goods they produce
– Not so well the price of most other goods
• Agents produce one good and
consume many goods
Basic idea
• Unexpected increase of overall price level,
then each agent
– As producer perceives the increase of the price
of “its” product and feel incentives to increase
production
– As a consumer doesn’t perceive the price
increase as an overall one, as he doesn’t know
all other prices
• In general – at change of absolute price
level agent wrongly assumes the change of
only relative prices (of “his” product) 
increases supply because of increase of
price
e
• Formally again Y=Yf + P-P ,  > 0
 
XVII.5 Sticky-Price Model
• Starting point: no perfect competition,
different reasons for prices being sticky →
firms are able to set their prices (at least to
some extent)
– i.e., firms have some degree of monopoly
• Two prices: overall level P, individual price of
the firm p
• p determined by P and by deviation of output
form natural level
– higher output → higher marginal costs → higher p
p = P + a(Y – Yf) , a>0
Sticky and flexible prices
• Firms are price setters and some of
them face sticky prices, some of them
face flexible prices, i.e. they must react
to change in demand, but can set their
price (do not take it from the market)
• Flexible prices: p = P + a(Y – Yf)
• Sticky prices: p = Pe , i.e. firms, when
setting a price that will remain sticky,
set the price to the expected overall
level
Price level determination
• Suppose that s – fraction of firms with
sticky prices (0<s<1)
• Overall price level – weighted average
of prices, set by the different groups of
firms:
P = sPe + (1-s)[P + s(Y-Yf)]
• Subtracting (1-s)P from both sides and
dividing by s:
P = Pe + [(1-s)a/s](Y-Yf)
Interpretation
• Pe high → P high: when firms with sticky
prices expect high prices, they set their price
high and contribute to the high overall price
level
• Output high → demand high → firms with
flexible prices set them high, again high
overall level P

Y  Yf   P  P
e

s
, 
1-s a
• Pro-cyclical movements of real wage
XVII.6 Summary
• Particular models of short term
aggregate supply differ, but do not
exclude each other exclusively
• All models generate AS that – in the
short run – is increasing function of
price


Y=Yf + P-P e ,  >0
Interpretation

Y=Yf + P-P
e
,
 >0
• Variations from potential (natural) product
are proportional to variations of actual price
from expected one
• Actual price higher than expected  product
higher than potential; and vice versa
• In graphical terms: short term AS is
1  slope
increasing,
• Expected price becomes a model parameter
– When actual and expected price equal, product
on potential level
– Change of expected price shifts AS curve
• Dynamics
AS in long and short term
P
LRAS
AS
Pe
Yf
Y
Literature to Ch. XVIII
• Mankiw, Macroeconomics, Ch.13
• Snowdon, Vane, Modern
Macroeconomics, Ch.7 Read parts 7.1 – 7.4.
In subsequent parts the NKE is discussed in much
more detail and from a slightly different angle
• See references in Snowdon and Vane