Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity Learning Objectives

Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity „ Learning Objectives I. Goals of Chapter 11 A) Present the central ideas of Keynesian macroeconomics 1. Wages and prices don’t adjust quickly to restore general equilibrium 2. The economy may be in disequilibrium for long periods of time 3. The government should act to stabilize the economy B) Discuss the potential causes of wage and price rigidity II. Notes to Fifth Edition Users A) More recent evidence on sticky prices is discussed in Section 11.2 B) Box 11.2, “Japanese Macroeconomic Policy in the 1990s” was deleted C) An application on “The Zero Bound” was added, which explains the concern that monetary policymakers will face as interest rates approach zero D) A new Box 11.2 on “DSGE Models and the Classical-Keynesian Debate” was added „ Teaching Notes I. Real-Wage Rigidity (Sec. 11.1) A) Wage rigidity is important in explaining unemployment 1. In the classical model, unemployment is due to mismatches between workers and firms 2. Keynesians are skeptical, believing that recessions lead to substantial cyclical employment 3. To get a model in which unemployment persists, Keynesian theory posits that the real wage is slow to adjust to equilibrate the labor market B) Some reasons for real-wage rigidity 1. For unemployment to exist, the real wage must exceed the market-clearing wage 2. If the real wage is too high, why don’t firms reduce the wage? a. One possibility is that the minimum wage and labor unions prevent wages from being reduced (1) But most U.S. workers aren’t minimum wage workers, nor are they in unions (2) The minimum wage would explain why the nominal wage is rigid, but not why the real wage is rigid (3) This might be a better explanation in Europe, where unions are far more powerful 226 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition b. Another possibility is that a firm may want to pay high wages to get a stable labor force and avoid turnover costs—costs of hiring and training new workers c. A third reason is that workers’ productivity may depend on the wages they’re paid—the efficiency wage model C) The Efficiency Wage Model 1. Workers who feel well treated will work harder and more efficiently (the “carrot”); this is Akerlof’s gift exchange motive 2. Workers who are well paid won’t risk losing their jobs by shirking (the “stick”) 3. Both the gift exchange motive and shirking model imply that a worker’s effort depends on the real wage (Figure 11.1) Figure 11.1 4. The effort curve, plotting effort against the real wage, is S-shaped a. At low levels of the real wage, workers make hardly any effort b. Effort rises as the real wage increases c. As the real wage becomes very high, effort flattens out as it reaches the maximum possible level D) Wage determination in the efficiency wage model 1. Given the effort curve, what determines the real wage firms will pay? 2. To maximize profit, firms choose the real wage that gets the most effort from workers for each dollar of real wages paid 3. This occurs at point B in Figure 11.1, where a line from the origin is just tangent to the effort curve 4. The wage rate at point B is called the efficiency wage 5. The real wage is rigid, as long as the effort curve doesn’t change Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 227 E) Employment and Unemployment in the Efficiency Wage Model 1. The labor market now determines employment and unemployment, depending on how far above the market-clearing wage is the efficiency wage (Figure 11.2) Figure 11.2 2. The labor supply curve is upward sloping, while the labor demand curve is the marginal product of labor when the effort level is determined by the efficiency wage 3. The difference between labor supply and labor demand is the amount of unemployment 4. 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 Analytical Problem 5 takes a more sophisticated look at the labor market, dividing it into one sector with an efficiency wage and another sector in which the real wage equates labor demand and supply. 5. Does the efficiency wage theory match up with the data? a. It seems to have worked for Henry Ford in 1914 b. Plants that pay higher wages appear to experience less shirking c. But 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 d. It is possible to jazz up the model to allow for the efficiency wage to change over time (1) Workers would be less likely to shirk and would work harder during a recession if the probability of losing their jobs increased (2) This would cause the effort curve to rise and may cause the efficiency wage to decline somewhat (3) This would lead to a lower real wage rate in recessions, which is consistent with the data F) Efficiency wages and the FE line 1. The FE line is vertical, as in the classical model, since full-employment output is determined in the labor market and doesn’t depend on the real interest rate 2. But in the Keynesian model, changes in labor supply don’t affect the FE line, since they don’t affect equilibrium employment 228 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition 3. A change in productivity does affect the FE line, since it affects labor demand Numerical Problem 1 looks at the determination of the efficiency wage and employment. II. Price Stickiness (Sec. 11.2) A) Price stickiness is the tendency of prices to adjust slowly to changes in the economy 1. The data suggest that money is not neutral, so Keynesians reject the classical model (without misperceptions) 2. Keynesians developed the idea of price stickiness to explain why money isn’t neutral 3. An alternative version of the Keynesian model (discussed in Appendix 11.A) assumes that nominal wages are sticky, rather than prices; that model also suggests that money isn’t neutral Theoretical Application The idea that nominal wage contracts lead to a fixed nominal wage in a theoretical Keynesian model was developed by Stanley Fischer, “Long-term Contracts, Rational Expectations, and the Optimal Money Supply Rule,” Journal of Political Economy, February 1977, pp. 191–205, and John B. Taylor, “Aggregate Dynamics and Staggered Contracts,” Journal of Political Economy, February 1980, pp. 1–23. But empirical analysis casts doubt on the theory, as shown by Shaghil Ahmed, “Wage Stickiness and the Non-neutrality of Money: A Cross-Industry Analysis,” Journal of Monetary Economics, 1987, pp. 25–50. B) Sources of price stickiness: Monopolistic competition and menu costs 1. Monopolistic competition a. If markets had perfect competition, the market would force prices to adjust rapidly; sellers are price takers, because they must accept the market price b. In many markets, sellers have some degree of monopoly; they are price setters under monopolistic competition c. Keynesians suggest that many markets are characterized by monopolistic competition d. In monopolistically competitive markets, sellers do three things (1) They set prices in nominal terms and maintain those prices for some period (2) They adjust output to meet the demand at their fixed nominal price (3) They readjust prices from time to time when costs or demand change significantly e. Menu costs and price stickiness (1) The term menu costs comes from the costs faced by a restaurant when it changes prices—it must print new menus (2) Even small costs like these may prevent sellers from changing prices often (3) Since competition isn’t perfect, having the wrong price temporarily won’t affect the seller’s profits much (4) The firm will change prices when demand or costs of production change enough to warrant the price change Theoretical Application One of the first articles to present the combination of monopolistic competition and menu costs as the cause of price stickiness was N. Gregory Mankiw, “Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly,” Quarterly Journal of Economics, May 1985, pp. 529–537. Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 229 f. Empirical evidence on price stickiness (1) Industrial prices seem to be changed more often in competitive industries, less often in more monopolistic industries (Carlton study) (2) Blinder and his students found a high degree of price stickiness in their survey of firms (Table 11.1) (a) The main reason for price stickiness was managers’ fear that if they raised their prices, they’d lose customers to rivals (3) But catalog prices also don’t seem to change much from one issue to the next and often change by only small amounts, suggesting that while prices are sticky, menu costs may not be the reason (Kashyap) (4) Price stickiness may not be pervasive, as prices change on average every 4.3 months (Bils-Klenow) (5) Relative prices may respond quickly to supply or demand shocks for a particular good, but the price level may change slowly to changes in monetary policy (BoivinGiannoni-Mihov), so in our macroeconomic model, the assumption of price stickiness is useful g. Meeting the demand at the fixed nominal price (1) Since firms have some monopoly power, they price goods at a markup over their marginal cost of production: P = (1 + η)MC (11.1) (2) If demand turns out to be larger at that price than the firm planned, the firm will still meet the demand at that price, since it earns additional profits due to the markup (3) Since the firm is paying an efficiency wage, it can hire more workers at that wage to produce more goods when necessary (4) This means that the economy can produce an amount of output that is not on the FE line during the period in which prices haven’t adjusted h. Effective labor demand (1) The firm’s labor demand is thus determined by the demand for its output e (2) The effective labor demand curve, ND (Y ), shows how much labor is needed to produce the output demanded in the economy (Figure 11.3) Figure 11.3 (3) It slopes upward from left to right because a firm needs more labor to produce additional output 230 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition Theoretical Application The major articles underlying Keynesian theory are collected in the volume New Keynesian Economics, edited by N. Gregory Mankiw and David Romer, Cambridge, Massachusetts: MIT Press, 1991. The main topics covered are costly price adjustment, the staggering of wages and prices, imperfect competition, coordination failures, the labor market, the credit market, and the goods market. III. Monetary and Fiscal Policy in the Keynesian Model (Sec. 11.3) A) Monetary policy 1. Monetary policy in the Keynesian IS-LM model a. The Keynesian FE line differs from the classical model in two respects (1) The Keynesian level of full employment occurs where the efficiency wage line intersects the labor demand curve, not where labor supply equals labor demand, as in the classical model (2) Changes in labor supply don’t affect the FE line in the Keynesian model; they do in the classical model b. Since prices are sticky in the short run in the Keynesian model, the price level doesn’t adjust to restore general equilibrium (1) Keynesians assume that when not in general equilibrium, the economy lies at the intersection of the IS and LM curves, and may be off the FE line (2) This represents the assumption that firms meet the demand for their products by adjusting employment Numerical Problem 2 and Analytical Problems 1 and 2 use the Keynesian IS-LM model. c. Analysis of an increase in the nominal money supply (Figure 11.4) 1 2 (1) LM curve shifts down from LM to LM (2) Output rises and the real interest rate falls (3) Firms raise employment and production due to increased demand (4) The increase in money supply is an expansionary monetary policy (easy money); a decrease in money supply is contractionary monetary policy (tight money) (5) Easy money increases real money supply, causing the real interest rate to fall to clear the money market (a) The lower real interest rate increases consumption and investment (b) With higher demand for output, firms increase production and employment (6) Eventually firms raise prices, the LM curve shifts back to its original level, and general equilibrium is restored (7) Thus money is neutral in the long run, but not in the short run Data Application For a discussion of how monetary policy affects different parts of the economy, see the article by David Reifschneider, Robert Tetlow, and John Williams, “Aggregate Disturbances, Monetary Policy, and the Macroeconomy: The FRB/US Perspective” Federal Reserve Bulletin, January 1999. The article discusses the Federal Reserve Board’s new model of the economy. Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity Figure 11.4 B) Monetary Policy in the Keynesian AD-AS framework 1. We can do the same analysis in the AD-AS framework, as was done in text Figure 9.14 2. The main difference between the Keynesian and classical approaches is the speed of price adjustment a. The classical model has fast price adjustment, so the SRAS curve is irrelevant b. In the Keynesian model, the short-run aggregate supply (SRAS) curve is horizontal, because monopolistically competitive firms face menu costs 3. The effect of a 10% increase in money supply is to shift the AD curve up by 10% a. Thus output rises in the short run to where the SRAS curve intersects the AD curve b. In the long run the price level rises, causing the SRAS curve to shift up such that it intersects the AD and LRAS curves 4. So in the Keynesian model, money is not neutral in the short run, but it is neutral in the long run 231 232 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition Numerical Problem 4 uses the Keynesian AD-AS framework. Theoretical Application Some Keynesians don’t agree with the view presented in the textbook that a change in monetary policy has no effect on the long-run aggregate supply curve. J. Bradford DeLong and Lawrence H. Summers, “How Does Macroeconomic Policy Affect Output?” Brookings Papers on Economic Activity 2: 1988, pp. 433–480, argue that macroeconomic stabilization policy, including monetary policy, can change the full-employment rate of output. They cite data showing the asymmetric response of output to policy changes, suggesting that better stabilization policies can increase the average level of output. C) Fiscal policy 1. The effect of increased government purchases (Figure 11.5) Figure 11.5 a. A temporary increase in government purchases shifts the IS curve up b. In the short run, output and the real interest rate increase c. The multiplier, ∆Y/∆G, tells how much increase in output comes from the increase in government spending (1) Keynesians think the multiplier is bigger than 1, so that not only does total output rise due to the increase in government purchases, but output going to the private sector increases as well (2) Classical analysis also gets an increase in output, but only because higher current or future taxes caused an increase in labor supply, a shift of the FE line (3) In the Keynesian model, the FE line doesn’t shift, only the IS curve does d. When prices adjust, the LM curve shifts up and equilibrium is restored at the fullemployment level of output with a higher real interest rate than before Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 233 e. Similar analysis comes from looking at the AD-AS framework (Figure 11.6) Figure 11.6 2. The effect of lower taxes a. Keynesians believe that a reduction of (lump-sum) taxes is expansionary, just like an increase in government purchases b. Keynesians reject Ricardian equivalence, believing that the reduction in taxes increases consumption spending, reducing desired national saving and shifting the IS curve up c. The only difference between lower taxes and increased government purchases is that when taxes are lower, consumption increases as a percentage of full-employment output, whereas when government purchases increase, government purchases become a larger percentage of full-employment output IV. The Keynesian Theory of Business Cycles and Macroeconomic Stabilization (Sec. 11.4) A) Keynesian business cycle theory 1. Keynesians think aggregate demand shocks are the primary source of business cycle fluctuations 2. Aggregate demand shocks are shocks to the IS or LM curves, such as fiscal policy, changes in desired investment arising from changes in the expected future marginal product of capital, changes in consumer confidence that affect desired saving, and changes in money demand or supply 3. A recession is caused by a shift of the aggregate demand curve to the left, either from the IS curve shifting down, or the LM curve shifting up 4. The Keynesian theory fits certain business cycle facts a. There are recurrent fluctuations in output b. Employment fluctuates in the same direction as output c. Money is procyclical and leading d. Investment and durable goods spending is procyclical and volatile (1) This is explained by the Keynesian model if shocks to investment and durable goods spending are a main source of business cycles (2) Keynes believed in “animal spirits,” waves of pessimism and optimism, as a key source of business cycles 234 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition e. Inflation is procyclical and lagging (1) The Keynesian model fits the data on inflation, because the price level declines after a recession has begun, as the economy moves toward general equilibrium 5. Procyclical labor productivity and labor hoarding a. As discussed in Sec. 11.1, firms may hoard labor in a recession rather than fire workers, because of the costs of hiring and training new workers b. Such hoarded labor is used less intensively, being used on make-work or maintenance tasks that don’t contribute to measured output c. Thus in a recession, measured productivity is low, even though the production function is stable d. So labor hoarding explains why labor productivity is procyclical in the data without assuming that recessions and expansions are caused by productivity shocks Theoretical Application Several prominent macroeconomists discuss their views of the Keynesian model of business cycles in a symposium in the Journal of Economic Perspectives, Winter 1993. B) Macroeconomic stabilization 1. Keynesians favor government actions to stabilize the economy 2. Recessions are undesirable because the unemployed are hurt 3. Suppose there’s a shock that shifts the IS curve down, causing a recession (Figure 11.7; like text Figure 11.8) Figure 11.7 a. If the government does nothing, eventually the price level will decline, restoring general equilibrium. But output and employment may remain below their full-employment levels for some time b. The government could increase the money supply, shifting the LM curve down to move the economy to general equilibrium c. The government could increase government purchases to shift the IS curve back up to restore general equilibrium 4. Using monetary or fiscal policy to restore general equilibrium has the advantage of acting quickly, rather than waiting some time for the price level to decline Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 235 5. But the price level is higher in the long run when using policy than it would be if the government took no action 6. The choice of monetary or fiscal policy affects the composition of spending a. An increase in government purchases crowds out consumption and investment spending, because of a higher real interest rate b. Tax burdens are also higher when government purchases increase, further reducing consumption Analytical Problem 4 looks at the benefits of using government purchases to combat recessions. 7. Difficulties of macroeconomic stabilization a. Macroeconomic stabilization is the use of monetary and fiscal policies to moderate the business cycle; also called aggregate demand management b. In practice, macroeconomic stabilization hasn’t been terribly successful c. One problem is in gauging how far the economy is from full employment, since we can’t measure or analyze the state of the economy perfectly d. Another problem is that we don’t know the quantitative impact on output of a change in policy e. Also, because policies take time to implement and take effect, using them requires good forecasts of where the economy will be six months or a year in the future; but our forecasting ability is quite imprecise Analytical Problem 3 looks at how lags in the effect of policy can influence decisions about how to use policy. f. These problems suggest that policy shouldn’t be used to “fine tune” the economy, but should be used to combat major recessions Policy Application A general analysis of the possibility of using activist monetary policy, which contrasts the results from classical and Keynesian theories, is Tom Stark and Herb Taylor, “Activist Monetary Policy for Good or Evil? The New Keynesians vs. the New Classicals,” Federal Reserve Bank of Philadelphia Business Review, March/April 1991. 8. Application: The Zero Bound a. The Japanese economy slumped in the 1990s, with growth near zero (1) Japan was in a liquidity trap (2) Nominal interest rates became essentially zero (text Fig. 11.9) (3) Since nominal interest rates can’t go below zero, monetary policy was ineffective b. Bernanke suggested three strategies for dealing with the zero bound (1) Affect interest rate expectations by committing to keep short-term interest rates low for a long period; which was implemented by the Fed in 2003 (text Fig. 11.10) (2) Influence the yield curve by buying long-term securities (rather than short-term securities) with open-market operations (3) Increase the size of the central bank’s balance sheet (quantitative easing) c. Bernanke argued that the central bank should take these steps early, before the public thinks the central bank cannot help the economy 236 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition C) Supply shocks in the Keynesian model 1. Until the mid-1970s, Keynesians focused on demand shocks as the main source of business cycles 2. But the oil price shock that hit the economy beginning in 1973 forced Keynesians to reformulate their theory 3. Now Keynesians concede that supply shocks can cause recessions, but they don’t think supply shocks are the main source of recessions 4. An adverse oil price shock shifts the FE line left (Figure 11.8; like text Figure 11.11) Figure 11.8 1 2 a. The average price level rises, shifting the LM curve up (from LM to LM ), because the large increase in the price of oil outweighs the menu costs that would otherwise hold prices fixed b. The LM curve could shift farther than the FE line, as in the figure, though that isn’t necessary c. So in the short run, inflation rises and output falls d. There’s not much that stabilization policy can do about the decline in output that occurs, because of the lower level of full-employment output e. Inflation is already increased due to the shock; expansionary policy to increase output would increase inflation further D) Box 11.2: DSGE Models and the Classical-Keynesian Debate 1. Until recently, classicals and Keynesians used very different models 2. Recently, each group has incorporated ideas from the other group; Keynesian economists began using DSGE models and classicals began using sticky prices and imperfect competition 3. Economists were able to reconcile aggregative models with models of microeconomic foundations 4. Classicals and Keynesians still disagree about the speed of wage and price adjustment and the role of government policy, but now speak the same language in modeling the economy Chapter 11 V. Keynesianism: The Macroeconomics of Wage and Price Rigidity 237 Appendix 11.A: Labor Contracts and Nominal-Wage Rigidity A) Some Keynesians think the nonneutrality of money is because of nominal-wage rigidity, not nominal-price rigidity 1. Nominal wages could be rigid because of long-term contracts between firms and unions 2. With nominal-wage rigidity, the short-run aggregate supply curve slopes upward instead of being horizontal 3. Even so, the main results of the Keynesian model still hold B) The short-run aggregate supply curve with labor contracts 1. U.S. labor contracts usually specify employment conditions and the nominal wage rate for three years 2. Employers decide on workers’ hours and must pay them the contracted nominal wage 3. The result is an upward-sloping short-run aggregate supply curve a. As the price level rises, the real wage declines, since the nominal wage is fixed b. As the real wage declines, firms hire more workers and thus increase output C) Nonneutrality of money 1. Money isn’t neutral in this model, because as the money supply increases, the AD curve shifts along the fixed (upward-sloping) SRAS curve (Figure 11.9; like text Figure 11.A.1) Figure 11.9 2. As a result, output and the price level increase 3. Over time, workers will negotiate higher nominal wages and the SRAS curve will shift left to restore general equilibrium 4. Thus money is nonneutral in the short run but neutral in the long run 5. There are several objections to this theory a. Less than one-sixth of the U.S. labor force is unionized and covered by long-term wage contracts; however, some nonunion workers get wages similar to those in union contracts, and other workers may have implicit contracts that act like long-term contracts b. Some labor contracts are indexed to inflation, so the real wage is fixed, not the nominal wage; however, most contracts aren’t completely indexed c. The theory predicts that real wages will be countercyclical, but in fact they are procyclical; however, if there are both aggregate supply shocks and aggregate demand shocks, real wages may turn out on average to be procyclical, but could still be countercyclical for demand shocks 238 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition Numerical Problem 5 is an exercise dealing with the rigid nominal-wage version of the Keynesian model. VI. Appendix 11.B: The Multiplier in the Short-Run Keynesian Model A) The multiplier shows the change in output resulting from a one-unit change in government purchases 1. First, calculate the effect on the intercept of the IS curve, αIS, of a change in G a. αIS = (c0 + i0 + G – cYt0)/(cr + ir) same as (9.A.15) b. If G increases by ∆G, ∆αIS = ∆G/(cr + ir) 2. Second, calculate the effect on Y of a change in αIS a. The AD curve intersects the SRAS curve at Y = [αIS – αLM + (1/ A r)(M/ P )]/[βIS + βLM] (11.B.1) (11.B.2) (11.B.3) same as (9.A.27) b. From (11.B.3), ∆Y = ∆αIS/(βIS + βLM) (11.B.4) 3. Finally, combine both effects a. Substituting (11.B.2) in (11.B.4) we get ∆Y/∆G = 1/[(cr + ir)(βIS + βLM)] (11.B.5) b. This is the government purchases multiplier c. The multiplier is positive, since all the terms in it are positive; it may be greater or less than one d. The multiplier will be large if the LM curve is flat (βLM is zero), since then the shift in the IS curve has a large effect on output (1) In this special case, ∆Y/∆G = 1/[1 – (1 – t)cY] (11.B.6) (2) For example, if the MPC is cY = 0.8 and t = 0.25, then the multiplier is 2.5 e. The multiplier will be small if the LM curve is steep (βLM is large) „ Additional Issues for Classroom Discussion 1. Do Lags Eliminate the Effectiveness of Fiscal Policy? Keynesian economists in the past have encouraged the use of fiscal policy to combat recession. They believe that wages and prices do not adjust rapidly enough to bring the economy to full employment in a reasonable period of time without the help of changes in government expenditures. However, fiscal policy takes a long time to be implemented. Can we expect it to be effective in combating recessions? Fiscal policy can’t be changed rapidly. When the economy goes into a recession, we usually don’t know it until several months later. Once a recession has been identified, a program must be devised. The next step is to convince the legislature that the expansionary program is necessary and to gain agreement on its specific provisions. Only once the necessary laws are passed can the program be implemented. Changes in taxes are implemented relatively rapidly, but if changes in expenditures are passed, more time is needed. The government may contract with the private sector, but it must often request and evaluate bids and select someone to administer the program before the funds can be spent. When the government itself supervises the program, new workers must be hired and trained. In either case, a period of several months if not a year or more is required before the program can be implemented. Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 239 Since 1950, business cycle contractions have averaged eleven months. To pass through all the stages outlined above and for fiscal policy to take effect seems to exceed the eleven months of an average contraction. Some recessions are even shorter; for example, the 1980 recession lasted only six months, entirely too short a period of time for discretionary fiscal policy to have an impact. In fact, government intervention may actually make the economic situation worse. If a stimulus package is implemented after the recession is over, it may result in upward pressure on prices and encourage a boom and bust cycle rather than long-term sustainable growth. 2. Do Prices Adjust Slowly? One of the main differences between Keynesians and classical economists is their disagreement over how quickly prices adjust to changes in the economy. Which point of view seems more in line with what happens in the economy? In some markets, prices do adjust rapidly. This is particularly true in commodity markets such as those for corn and wheat. It is also true for items such as gasoline. While gas stations are individualized by their location and service, prices still change frequently. On the other hand, many prices are changed only infrequently. The text mentions such items as magazines and items sold through catalogs. While the authors point out that the monetary cost of such price changes is generally small, there may be other costs that are more important. Changing prices may encourage rivals to change their prices, too, and thus set off price wars that damage most competitors. The airline industry is noted for frequent price changes and destructive competition. In addition, an increase in price above the customary cost may cause consumers to rethink old habits and move to other products. Your students may wish to discuss whether they side with the Keynesians or the classicals on the question of price rigidity. In looking at price movements, it is probably important that discussants explicitly define which goods’ prices are being discussed, since this may be critical in determining an individual’s point of view. 3. The Interest Rate Forecast for 1993 In late 1992, private forecasters suggested that the Fed would need to raise interest rates in 1993 as the economy expanded. This can be seen in Figure 11.10, in which the economy is initially in equilibrium 0 0 with the IS curve at IS and the LM curve at LM . The forecast for 1993 was that the IS curve would shift 1 up and to the right to IS . If the Fed maintained the real interest rate at r0, it would need to expand the 1 money supply to shift the LM curve to LM , which would increase output beyond the full-employment level. To prevent this, the Fed would have to allow interest rates to rise to r1. Figure 11.10 240 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition However, in early 1993, President Clinton announced a contractionary fiscal policy. This had the effect of 2 shifting the IS curve to IS . It also meant that the Fed would not need to raise interest rates, because the IS curve would no longer be shifting to the right beyond the full-employment point. Maintaining the initial 2 level of the real interest rate at r0 meant increasing the money supply, so the LM curve shifted to LM . Forecasters anticipated this, and responded to President Clinton’s announcement by changing their forecasts of interest rates, holding them constant throughout the year. „ Answers to Textbook Problems Review Questions 1. The efficiency wage is the real wage that maximizes effort or efficiency per dollar of real wages. It assumes that workers will exert more effort, the higher the real wage. The real wage will remain rigid even if there is an excess supply of labor, because firms won’t reduce the wage they pay; doing so would reduce their profits, since workers wouldn’t work as hard. 2. Full-employment output is the amount of output produced by firms with employment determined by the labor demand curve at the point where the marginal product of labor equals the efficiency wage. A productivity shock does not lead to a change in the efficiency wage, since it does not affect work effort. But it does affect the marginal product of labor, so employment changes. A beneficial productivity shock, for example, leads to an increase in employment. Both the employment increase and the increase in productivity lead to an increase in full-employment output. Labor supply changes have no effect on the efficiency wage or employment; they simply affect the amount of unemployment. So they have no impact on full-employment output. 3. Price stickiness is the tendency of prices to adjust only slowly to changes in the economy. Keynesians believe it is important to allow for price stickiness to explain why monetary policy is not neutral. 4. Menu costs are the costs of changing prices. Menu costs may lead to price stickiness in monopolistically competitive markets but not in perfectly competitive markets, because a monopolistically competitive firm’s demand is not as sensitive to the price as is a perfectly competitive firm’s demand. Monopolistically competitive firms may meet the demand at a fixed price when demand increases, because price exceeds marginal cost, so that profits still rise, and because the cost of changing prices may exceed the additional profit earned from doing so. A perfect competitor would lose all of its customers if its price were a little above the price charged by its competitors. But a monopolistically competitive firm would lose only some of its customers in this case. 5. In the Keynesian model, money is not neutral in the short run, but it is neutral in the long run. In the short run, an increase in the money supply increases output and the real interest rate, while the price level and real (efficiency) wage are unchanged. In the long run, however, only the price level is changed, with no change in output, the real interest rate, or the real wage. In the basic classical model, money is neutral in both the short run and the long run, so only the price level is affected by a change in the money supply, just as in the long-run Keynesian model. The extended classical model with misperceptions is similar to the Keynesian model. In the short run, an increase in the money supply increases output and the real interest rate, just as in the Keynesian model. However, unlike the Keynesian model, the price level rises, as does the real wage. The long run of the extended classical model is identical to the classical model or the long run of the Keynesian model—only the price level is affected. 6. In the Keynesian model in the short run, output and the real interest rate increase due to an increase in government purchases. In the long run, the real interest rate is higher, but output returns to its fullemployment level. Since the real interest rate is higher in the long run, investment is lower and consumption is lower. Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 241 7. In response to a recession, policymakers can (1) make no change in macroeconomic policy, (2) increase the money supply, or (3) increase government purchases. If they make no change in macroeconomic policy, then during the recession output is below its fullemployment level. Over time, the price level will decline to restore equilibrium. In the long run, the price level will be lower and employment will return to the full-employment level. If policymakers increase the money supply, the economy returns to full employment without a change in the price level. The composition of output is the same as when the economy returns to full employment without monetary or fiscal policy. If policymakers increase government purchases, again the economy returns to full-employment equilibrium without a change in the price level. However, the higher real interest rate caused by the expansionary fiscal policy reduces consumption and investment, and the higher taxes to pay for the government spending also reduce consumption relative to either the situation in which monetary policy is used, or in which there is no policy response at all. There are practical difficulties with increasing the money supply or increasing government purchases to return the economy to full employment. It is difficult to tell how far the economy is below full employment to know the right amount of fiscal or monetary stimulus to apply. We do not know exactly how much output will increase in response to a monetary or fiscal expansion. And since these policies take time to implement and more time to affect the economy, we really need to know where the economy will be six months or a year from now, not just where it is today, but such knowledge is very imprecise. 8. Employment is procyclical because a contractionary aggregate demand shock reduces both output and employment. Money is procyclical because price stickiness means that an increase in the money supply increases output as the aggregate demand curve moves along the flat, short-run, aggregate supply curve. Inflation is procyclical, because in a recession the price level declines over time to restore general equilibrium. Investment is procyclical for two reasons. First, shifts in the expected future marginal product of capital are important causes of cycles, shifting the IS and AD curves, thus affecting output in the same direction. Also, a shift in the LM curve leads to a change in the real interest rate, moving investment in the same direction as the change in output. 9. The Keynesian theory assumes that demand shocks cause most cyclical fluctuations. This means that during expansions when employment rises, average labor productivity declines, so it is countercyclical. But the business cycle fact is that average labor productivity is mildly procyclical. However, if labor hoarding occurs, so that a given measured amount of employment produces less output during recessions and more output during expansions, then measured average labor productivity would be procyclical. 10. In Keynesian analysis, a supply shock may reduce output in two ways: (1) a reduction in output, because the supply shock reduces the marginal product of labor, shifting the FE line to the left; and (2) a further reduction in output if the supply shock is something like an oil price shock that is large enough to cause many firms to raise prices, shifting the LM curve up and to the left so much that it intersects the IS curve to the left of the FE line. Supply shocks create problems for stabilization policy because: (1) policy can do nothing to affect the location of the FE line; and (2) using expansionary policy risks worsening the already-high rate of inflation. 242 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition Numerical Problems 1. The following table shows the real wage (w), the effort level (E ), and the effort per unit of real wages (E/w). w E E/w 8 10 12 14 16 18 7 10 15 17 19 20 0.875 1.00 1.25 1.21 1.19 1.11 The firm will pay a wage of 12, since that wage provides the maximum effort per unit of the real wage (E/w = 1.25). The firm will employ 88 workers, since that is the number of workers for which w = MPN. As long as the supply of labor exceeds the demand for labor, labor supply has no effect on the firm’s decision. 2. d d (a) The IS curve is found from the equation Y = C + I + G = 130 + 0.5(Y – 100) – 500r + 100 – 500r + 100, or 0.5Y = 280 – 1000r, or Y = 560 – 2000r. The LM curve comes from the equation M/P = L, which in this case is 1320/P = 0.5Y – 1000r, or Y = (2640/P) + 2000r. (b) At full employment, Y = 500. Using this in the IS curve gives 500 = 560 – 2000r, which has the solution r = 0.03. Plugging the values for Y and r in the LM curve gives 500 = (2640/P) + (2000 × 0.03), or 440 = 2640/P, which has the solution P = 6. Then consumption is C = 130 + 0.5(Y – 100) – 500r = 130 + 0.5(500 – 100) – (500 × 0.03) = 315. Investment is I = 100 – (500 × 0.03) = 85. 1 2 (c) If desired investment increases to 200 – 500r, the IS curve shifts from IS to IS in Figure 11.11. d d This can be seen in the equation Y = C + I + G = 130 + 0.5(Y – 100) – 500r + 200 – 500r + 100, or 0.5Y = 380 – 1000r, or Y = 760 – 2000r. In the short run, the price level remains fixed at 6, so 1 the LM curve remains at LM . With the price level equal to 6, the LM curve has the equation Y = (2640/P) + 2000r = 440 + 2000r. The IS and LM curves intersect where 760 – 2000r = 440 + 2000r, or 320 = 4000r, which has the solution r = 0.08. At r = 0.08, output is given from the IS curve as Y = 760 – 2000r = 760 – (2000 × 0.08) = 600. Then consumption is C = 130 + 0.5 (Y – 100) – 500r = 130 + 0.5(600 – 100) – (500 × 0.08) = 340. Investment is I = 200 – 500r = 200 – (500 × 0.08) = 160. Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 243 Figure 11.11 1 2 In the long run, the price level rises to shift the LM curve from LM to LM to restore equilibrium. The IS curve is given by the equation Y = 760 – 2000r. At full employment, Y = 500, so the IS curve is 500 = 760 – 2000r, or 2000r = 260, which has the solution r = 0.13. The LM curve is given by the equation Y = (2640/P) + 2000r, or 500 = (2640/P) + (2000 × 0.13), or 240 = 2640/P, which has the solution P = 11. Then consumption is C = 130 + 0.5(500 – 100) – (500 × 0.13) = 265. Investment is I = 200 – 500r = 200 – (500 × 0.13) = 135. 3. d d The IS curve is Y = C + I + G = [600 + 0.8(Y – 1000) – 500r] + [400 – 500r]+ 1000, so 0.2Y = 1200 – 1000r. This is plotted in Figure 11.12. Figure 11.12 e Since π = 0, the nominal interest rate (i) equals the real interest rate (r). 244 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition (a) Can the economy reach full employment? Since full-employment output is Y = 8000, for the economy to be on the IS curve, 0.2Y = 1200 – 1000r, so (0.2 × 8000) = 1200 – 1000r, or 1000r = –400, so r = i = –.4. But since the nominal interest rate can’t be negative, this isn’t possible. Thus, the requirement that i be non-negative means that there’s no way to satisfy the goods market equilibrium condition at full employment. Assuming that the result is that i = 0 and that output is determined along the IS curve means that 0.2Y = 1200 – (1000 × 0), so Y = 6000. Note that this is the best result possible, no matter what the money supply is, so monetary policy can’t restore full employment. (b) To restore full employment while the nominal interest rate is zero clearly requires a shift in the IS curve. If we return to the original derivation and put G in the equation instead of using the original value of G = 1000, we get: d d Y = C + I + G = [600 + 0.8(Y – 1000) – 500r] +[400 – 500r]+ G, so 0.2Y = 200 + G – 1000r. To get Y = 8000 and r = 0, we have 0.2 × 8000 = 200 + G – (1000 × 0), so G = 1400. Then the IS curve 2 1 is 0.2Y = 1600 – 1000r. This is plotted in Figure 11.13 as IS , while the original IS curve is IS . Figure 11.13 Thus, raising G to 1400 can generate full employment, if the money supply is chosen so that the LM curve intersects the IS curve at the right point. Note that taxes are 1000, so the government must run a large budget deficit. What must the money supply be? Since P = 2, we need money supply (M/P) = money demand (L), so M/2 = 0.5Y – 200i = (0.5 × 8000) – (200 × 0) = 4000, so M = 8000. This situation is quite similar to the situation in Japan in the 1990s and suggests that to get out of the liquidity trap, Japan will need to use expansionary monetary policy, along with expansionary fiscal policy. Chapter 11 d Keynesianism: The Macroeconomics of Wage and Price Rigidity 245 d 4. (a) The IS curve is given by Y = C + I + G = 300 + 0.5(Y – 100) – 300r + 100 – 100r + 100 = 450 + 0.5Y – 400r. This can be rewritten as 0.5Y = 450 – 400r, or Y = 900 – 800r. The LM curve is M/P = L, or 6300/P = 0.5Y – 200r. To find the aggregate demand curve, substitute the LM curve into the IS curve to eliminate r. To do this, multiply both sides of the LM curve by 4 to get 25,200/P = 2Y – 800r, or 800r = 2Y – (25,200/P). Then substitute this in the IS curve: Y = 900 – 800r = 900 – [2Y – (25,200/P)]. This can be rewritten as 3Y = 900 + (25,200/P), or Y = 300 + (8400/P). (b) With P = 15, the AD curve is Y = 300 + (8400/15) = 860. From the IS curve, 860 = 900 – 800r, which has the solution r = 0.05. Consumption is C = 300 + 0.5(860 – 100) – (300 × 0.05) = 665. Investment is I = 100 – (100 × 0.05) = 95. (c) In the long run, Y = 700. From the IS equation, 700 = 900 – 800r, which has the solution r = 0.25. The LM curve then is 6300/P = (0.5 × 700) – (200 × 0.25) = 300, which has the solution P = 21. Consumption is C = 300 + 0.5(700 – 100) – (300 × 0.25) = 525. Investment is I = 100 – (100 × 0.25) = 75. 5. (a) Setting w = MPN, w = 10/ N . This is the labor demand curve. (b) At W = 20, w = W/P = 20/P. Since labor demand is given by w = 10/ N , then 20/P = 10/ N , or 2 N = P. (c) Y = 20 N = 10P, or P = (1/10) Y, as shown in Figure 11.14 by the SRAS curve. Figure 11.14 (d) The IS curve is Y = 120 – 500r. The LM curve is M/P = 0.5Y – 500r, which can be rewritten as 500r = 0.5Y – (M/P). Plugging the LM curve into the IS curve to eliminate r gives Y = 120 – 500r = 120 – [0.5Y – (M/P)]. This can be rewritten as 1.5Y = 120 + (M/P). This is the AD curve. With M = 300, the AD curve is 1.5Y = 120 + (300/P), or Y = 80 + (200/P). The AD curve is shown in Figure 11.14. 246 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition (e) To find the intersection of the SRAS curve (Y = 10P) and the AD curve [Y = 80 + (200/P)], find 2 the price level such that 10P = 80 + (200/P). This can be rewritten as 10P – 80P – 200 = 0, or as 2 P – 8P – 20 = 0. This can be factored as (P – 10)(P + 2) = 0. The nonnegative root is P = 10. At P = 10, from the SRAS curve, Y = 10 P = 10 × 10 = 100. On the IS curve, 100 = 120 – 500r, or r = 0.04. Since P = 2 N , or 10 = 2 N , then N = 5, or N = 25. The real wage is w = 20/P = 20/10 = 2. (f) When the money supply falls to 135, the AD curve becomes 1.5Y = 120 + (135/P), or Y = 80 + (90/P). The AD curve intersects the SRAS curve where 10P = 80 + (90/P). This can be rewritten 2 2 as 10P – 80P – 90 = 0, or P – 8P – 9 = 0. This can be factored as (P – 9)(P + 1) = 0, which has the nonnegative solution P = 9. From the SRAS curve, Y = 10P = 10 × 9 = 90. From the IS curve 2 2 90 = 120 – 500r, which has the solution r = 0.06. Since P = 2 N , N = (P/2) = 4.5 = 20.25. The real wage is w = W/P = 20/9 = 2 2/9. 6. d d (a) Y = C + I + G = [325 + 0.5(1000 – 150) – 500r] + [200 – 500r] + 150, so 1000r = 100, so r = 0.10. M/P = L, so 6000/P = 0.5Y – 1000r = (0.5 × 1000) – (1000 × 0.10) = 400, so P = 15. C = 325 + 0.5(Y – T) – 500r = 325 + 0.5(1000 – 150) – (500 × .10) = 700. I = 200 – 500r = 200 – (500 × .10) = 150. (b) αIS = (c0 + i0 + G – cYt0)/(cr + ir) = [325 + 200 + 150 – (0.5 × 150)]/(500 + 500) = 0.6. βIS = [1 – (1 – t)cY]/(cr + ir) = [1 – (1 – 0) 0.5]/(500 + 500) = .0005. αLM = A 0 / A r – πe= 0/1000 – 0 = 0. βLM = A Y / A r = 0.5/1000 = .0005. A r = 1000. (c) Since P = 15 at full employment, then Y = 1000 and r = 0.10. (d) αIS = (c0 + i0 + G – cYt0)/(cr + ir) = [325 + 200 + 250 – (0.5 × 150)]/(500 + 500) = 0.7. M/P = 6000/15 = 400. Y = [αIS – αLM + (1/ A r )(M/P)]/[βIS + βLM] = [0.7 – 0 + (400/1000)]/(.0005 + .0005) = 1.1/.001 = 1100. (e) ∆Y/∆G = 1/[(cr + ir)(βIS + βLM)] = 1/[(500 + 500)(.0005 + .0005)] = 1. The result is the same as in part (d). In part (d), ∆Y = 100 when ∆G =100, so ∆Y/∆G = 1. Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 247 Analytical Problems 1. In Figures 11.15 and 11.16, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change. Figure 11.15 Figure 11.16 248 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition (a) In Figure 11.15, the increase in tax incentives increases investment, shifting the IS curve up and 1 2 1 2 to the right from IS to IS in Figure 11.15(a), and shifting the AD curve from AD to AD in Figure 11.15(b). The short-run equilibrium is at point B. Output increases, the real interest rate increases, employment increases, and the price level is unchanged. 1 2 To restore long-run equilibrium, the price level rises, shifting the LM curve from LM to LM in 1 2 Figure 11.15(a) and the short-run aggregate supply curve from SRAS to SRAS in Figure 11.15(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is higher, employment is the same, and the price level is higher. 1 (b) In Figure 11.16, the increase in tax incentives increases saving—shifting the IS curve from IS to 2 1 2 IS in Figure 11.16(a), and shifting the AD curve from AD to AD in Figure 11.16(b). The shortrun equilibrium is at point B. Output decreases, the real interest rate decreases, employment decreases, and the price level is unchanged. 1 2 To restore long-run equilibrium, the price level declines, shifting the LM curve from LM to LM 1 2 in Figure 11.16(a) and the short-run aggregate supply curve from SRAS to SRAS in Figure 11.16(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is lower, employment is the same, and the price level is lower. (c) A wave of investor pessimism reduces investment. This shifts the IS curve down and to the left and the AD curve down and to the left, having the same result as in problem part (b). (d) An increase in consumer confidence increases consumption spending, shifting the IS curve up and to the right and the AD curve up and to the right, with the same result as in problem part (a). 2. In Figures 11.17–11.20, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change. (a) In Figure 11.17, when banks pay a higher interest rate on checking accounts, the demand for 1 2 money rises, shifting the LM curve up and to the left from LM to LM in Figure 11.17(a). As a 1 2 result, the AD curve shifts down and to the left from AD to AD in Figure 11.17(b). The new short-run equilibrium occurs at point B, where output is lower, the real interest rate is higher, employment is lower, and the price level is unchanged. 2 3 In the long run, the price level decreases to shift the LM curve from LM to LM , which is the same 1 as LM , to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts 1 2 down from SRAS to SRAS . At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is lower. Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 249 Figure 11.17 (b) In Figure 11.18, the introduction of credit cards reduces the demand for money—shifting the 1 2 LM curve down and to the right from LM to LM in Figure 11.18(a). As a result, the AD curve 1 2 shifts from AD to AD in Figure 11.18(b). The new short-run equilibrium occurs at point B, where output is higher, the real interest rate is lower, employment is higher, and the price level is unchanged. 250 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition 2 3 In the long run, the price level increases to shift the LM curve from LM to LM , which is the 1 same as LM , to restore equilibrium at point C. As a result, the short-run aggregate supply curve 1 2 shifts up from SRAS to SRAS . At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is higher. Figure 11.18 1 2 (c) In Figure 11.19, the reduction in agricultural output shifts the FE curve to the left from FE to FE , 1 2 and shifts the LRAS line from LRAS to LRAS . The rise in agricultural prices increases the price 1 2 level, so the short-run aggregate supply curve shifts up from SRAS to SRAS . Also, the rise in the 1 2 price level shifts the LM curve up and to the left from LM to LM . The short-run equilibrium is at Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 251 point B, assuming that the LM curve shifts so much that it intersects the IS curve to the left of the FE line. At point B, compared to the starting point, output is lower, the real interest rate is higher, employment is lower, and the price level is higher. Figure 11.19 If the water shortage persists, a new long-run equilibrium occurs at point C. To get to this 2 3 equilibrium, the price level must decline, shifting the LM curve from LM to LM , and the short2 3 run aggregate supply curve from SRAS to SRAS . Relative to point B, the new equilibrium has a higher output level, a lower real interest rate, higher employment, and a lower price level. (Relative to the initial equilibrium at point A, output and employment are lower, and the real interest rate and the price level are higher.) When the water shortage is over, then the economy goes back to point A in the long run, with no permanent effects. 252 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition (d) In Figure 11.20, the beneficial supply shock makes more production possible at full employment, 1 2 so the FE line shifts to the right in Figure 11.20(a) from FE to FE , and the LRAS line shifts from 1 2 LRAS to LRAS in Figure 11.20(b). There is no immediate change in the price level, so the LM 1 1 curve remains at LM and the short-run aggregate supply curve remains at SRAS . The shift of the FE curve does not affect aggregate demand in the short run: output, the real interest rate, and the price level are all unchanged in the short run. The shift in the production function shifts the effective labor demand curve and reduces employment in the short run. Figure 11.20 1 2 If the supply shock persists, prices will decline, so the LM curve will shift from LM to LM and the 1 2 SRAS curve will shift from SRAS to SRAS . As shown in the diagrams, the economy reaches a new equilibrium at point C, with a higher output level, a lower real interest rate, and a lower price level. When the supply shock disappears, the economy returns to its equilibrium at point A. Chapter 11 3. Keynesianism: The Macroeconomics of Wage and Price Rigidity 253 A lag in the impact of policy of six months, which is about the time it takes firms to adjust prices, could cause policy to be destabilizing. That is, monetary policy may be pushing the economy away from equilibrium. To see this, suppose the economy is in a recession at point A in Figure 11.21. The short-run aggregate 1 1 supply curve SRAS intersects the aggregate demand curve AD at point A, to the left of the long-run aggregate supply curve LRAS. Suppose the Fed engages in expansionary monetary policy to try to 1 2 shift the aggregate demand curve from AD to AD in six months, to push the economy to point B. But 1 2 the recession leads firms to reduce their prices, dropping the SRAS curve from SRAS to SRAS . In the absence of monetary policy action, the economy would get back to full employment because of the fall in the price level to point C. But the Fed action leads to a new equilibrium at point D. So the Fed causes the economy to overshoot the equilibrium point. The result may be to exaggerate the business cycle, pushing output too high in expansions. Then if the Fed responds to an expansion by using contractionary monetary policy, it may overshoot on the other side, causing a new recession. Figure 11.21 If the Fed could forecast recessions well, it could stabilize the economy by using monetary policy appropriately before a recession begins. Or if the Fed’s policy takes effect before firms adjust prices, then it can also help stabilize output by shifting the AD curve before the SRAS curve shifts. 4. An increase in government purchases shifts the IS curve up and to the right and the AD curve up and to the right to return the economy to full employment, instead of waiting for the price level to fall to get there. The advantage of doing so, according to Keynesians, is that full employment is restored quickly, whereas if the price level must adjust, it may take a long time for full employment to be restored. In the short run, the fiscal expansion does not affect the real wage, since it is an efficiency wage. However, it increases employment and it increases current and future taxes to pay for the higher government spending. The effect on consumption is ambiguous, with the rise in output raising consumption, while the rise in taxes reduces consumption. In the long run, at full employment, the lasting effects of the fiscal expansion are to decrease consumption, because of the higher real interest rate and the higher taxes, with more of the economy’s output devoted to government purchases and less to the private sector. Whether a program of fiscal stimulus in response to a recession is worthwhile depends on the benefits of the government purchases and on how long it takes the economy to return to a full-employment equilibrium by a change in the price level. The more beneficial are government purchases, the more likely such a program is to increase economic welfare. The longer the free market takes to restore equilibrium, the more likely such a program is to increase economic welfare. 254 5. Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition (a) In response to expansionary monetary policy, aggregate demand increases, increasing output and 1 2 labor demand. This causes the labor demand curve to shift from ND to ND in the primary labor market, shown in Figure 11.22. The result is an increase in employment and output with no change in the real wage in the primary labor market. Since more workers are now in the primary labor market, 1 2 the labor supply in the secondary labor market decreases from NS to NS . This causes an increase in the real wage, a decrease in employment, and a decrease in output in the secondary labor market. Figure 11.22 (b) Increased immigration has no effect in the primary labor market, since labor supply changes in general have no effect. In the secondary labor market, the immigration shifts the labor supply 1 2 curve to the right from NS to NS , causing a reduction in the real wage, increased employment, and increased output. However, to some extent these effects may be mitigated by the fact that increased immigration leads to increased aggregate demand, increasing labor demand in both the primary and secondary markets (Figure 11.23). Figure 11.23 Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 255 (c) If there is a shift in the effort curve, the efficiency wage rises in the primary labor market. Since effort exerted at the higher wage is the same as before the change, the shift in the effort curve has no impact on the marginal product of labor, so there is no shift in the labor demand curve. So the effect of the higher real (efficiency) wage is to reduce employment and thus output in the primary labor market. This means that labor supply in the secondary labor market increases, shifting the 1 2 labor supply curve from NS to NS . The real wage falls, employment rises, and output rises in the secondary labor market, as Figure 11.24 shows. Figure 11.24 (d) The productivity improvement shifts the labor demand curve to the right, so at the fixed real (efficiency) wage, firms demand more labor. Employment increases, so output increases in the primary labor market. The increase in employment in the primary labor market reduces the labor 1 2 supply in the secondary labor market, shifting the labor supply curve from NS to NS . This increases the real wage, and reduces employment and output in the secondary labor market. See Figure 11.25. Figure 11.25 256 Abel/Bernanke/Croushore • Macroeconomics, Sixth Edition (e) The productivity improvement in the secondary labor market has no effect on the primary labor market. In the secondary labor market, increased productivity increases the marginal product of 1 2 labor so that labor demand increases from ND to ND . The result is a higher real wage, higher employment, and increased output (Figure 11.26). Figure 11.26