Transcript National Income Accounts

The Keynesian Model
Chapter 9

John Maynard Keynes and the General Theory
of Employment, Interest and Money

Derivation of the Keynesian AS
Crucial assumption:
If nd is less than ns, W does not fall
 Nominal wages are sticky downwards
(Fig. 9.1)
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We start from an initial given point (P0,Y0) in
the (P,Y) space.
Increase P0 to P1. If nd > ns, W increases so that
W/P remains the same.
W1/P1 = W0/P0 and we have now (P1,Y0).
Now, let us decrease P0 to P2. In the very short
run, the real wage W0/P2 is associated with nd<ns,
and the wage does not fall (Keynesian assumption).
Employment falls to nlow and we have ‘involuntary
unemployment’.
Y falls to Ylow .
Using (P0,Y0) and (P2,Ylow), we derive the
Keynesian AS.
Survival guide fro ISLM with
Keynesian AS
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Make all moves in the (i,Y) space and make all
shifts to IS and LM here.
Adjust Y (use the final value) in the (P,Y) space.
The AD shifts to keep Y in (I,Y) and (P,Y) spaces
consistent. Here, we get the final P and Y values.
Adjust the expenditure line. Determine if C and I
have changed. Also, determine what happens to
real wages. If nd < ns employment will fall. If nd > ns
nominal wages adjust to ensure that real wage
remains the same.
Interpret the results.
Policy Experiment I
 An increase in G (Fig. 9.2)
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The IS curve shifts to the right. Interest rates (i)
increase, Y increases to Y1.
In the (P,Y) space, the AD curve shifts to the
right. Inflation increases (to P1).
The expenditures line shifts up. C increases; I
falls. ns > nd (both at W0/P0 and W0/P1 ), so W does
not change and real wages fall but employment
increases. Note the Keynesian multiplier effect.
Results: An increase in G increases employment,
C and Y. But I and real wages fall.
Policy Experiment II

An increase in M (Fig. 9.3)
LM shifts to the right and interest rates decrease.
2. In the (P,Y) space, the AD curve shifts to the right.
Inflation increases (to P1) and Y increases.
3. The expenditures line shifts up. C and I increase.
ns > nd (both at W0/P0 and W0/P1 ), so W does not
change and real wages fall but employment
increases.
4. Results: A monetary expansion as a tool of
demand-side stabilization is effective in increasing
Y and employment.
 Overheating (Fig. 9.4)
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Policy Experiment III
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Engineering a soft-landing (Fig. 9.5)
Policymakers are trying to cool down the
overheated economy. The Fed contracts money.
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LM2 shifts to the left (to LM1) and interest rates increase to
ihigher. Y falls to Ymoderate. Since monetary policy works with a
significant and variable lag, this process can take from 6
months to 2 years (Milton Friedman).
In the (P,Y) space, the AD curve shifts to the left (Ymoderate).
Inflation falls (to Pmoderate).
The expenditures line shifts down. C falls as Y declines, and
I falls as a result of higher interest rates. Since P falls, real
wages increase and employment falls to nlower.
Results: If the economy can be stabilized at Ymoderate,
Pmoderate, and nlower, then we can have a successful softlanding. Because contractionary fiscal policies involve
longer-term decision making and longer implementation
lags, monetary contraction remains the policy of choice to
engineer a soft-landing.
Policy Experiment IV

Engineering a soft-landing (Fig. 9.6):
When low interest rates no longer work!
Assume that consumer and investor confidence levels have
fallen dramatically (e.g. as a result of SAP bubble).
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IS0 shifts to the left (to IS1) and interest rates and Y fall.
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The Fed increases M and lowers interset rates further to
revive Y. Interest rates are at ifinal (very low rates) and Y
stabilizes at Yfinal , which is still lower than the initial level,Y0.
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In the (P,Y) space, AD0 shifts to ADfinal and P falls to Pfinal .
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The expenditures line shifts down. Cfinal is lower than C0 ,
and Ifinal is lower than I0 (assuming the effect from the fall in
investor confidence dominates the effect from the fall in
interest rates). As P increases, real wages increase so
unemployment increases.
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Results: We get a situation similar to the liquidity trap.
Expansionary monetary policy is impotent! Example: The
U.S. by late 2008.
The Phillips Curve
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A negative relationship between the
rate of inflation and changes in
unemployment (published in a 1958
article by William Phillips).
 Consistent with the predictions of
the Keynesian model.
 Led to the (controversial) outputinflation tradeoff.
The Yield Curve and the Keynesian
Paradigm
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Upward slopping yield curve: Often, indicative of an
economy in the early stages of a sustained recovery.
As the AD increases (as a result fiscal or monetary
expansion), the rate of inflation is expected to increase so
lenders will incorporate this in their decisions of long term
loans (the Fisher effect). Thus, long-term rates are higher
than short term rates.
Inverted yield curve: Often, indicative of an impending
recession.
(See experiment III) When the Fed engineers soft-landing,
lenders see that short-term interest rates (controlled by the
Fed) are going up and so they expect a recession or at least
a slowdown of the economy. This will eventually decrease
the rate of inflation so expectation of less future inflation
leads to lower nominal long-term interest rates.
The Great Depression:
Four Policy Mistakes
Wage Floors
2. Tax Increases and Decreases in
Government Spending
3. Liquidity Crisis
4. The Smoot-Hawley Act of 1930
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Could a Great Depression happen again?
Discussion: Article 9.3