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# GRIPS Macroeconomics II

Fall II Semester, 2016
Lecture 2b: Determination of National Income  Keynesian Theory
Junichi Fujimoto
December 5, 2016

1

Keynesian AD and AS Curves (overview)

Let us review the gure from the last lecture.

Demand Side
Equilibrium in the
goods market

Equilibrium in the
money market

IS curve

LM curve

Supply Side
The LRAS is vertical, just like
in the classical theory （ Y =
Y*）
The SRAS is either horizontal (= P constant)
or upward sloping, due to insufficient price

Determination of national income (Keynesian)
Figure 1: Derivation of AD and AS curves (Keynesian theory)

2

Keynesian AS Curve: A Model of Sticky Wages

2.1 Timing

According to the Keynesian theory, the LRAS curve is vertical as in the classical model, but the SRAS curve is
generally upward sloping. An extreme case is where the SRAS curve is horizontal, which implies that there is no
price adjustment at all in the short run. There are several dierent models that explain why the SRAS curve is
upward sloping: here we will look at one of them, a model of sticky wages due to labor contracts. The timing
assumption of the model is as follows.
1. Ex ante optimization problem of the household (or worker) and the rm: the household and the rm have
the same expectation P E of the price level, and optimize taking P E as given. This yields the expected labor
demand and supply curves.
2. Signing the contract: The rm and the worker agree upon nominal wage w¯ , before the realization of the actual
price level P . Nominal wage w¯ is such that it equates the expected labor demand and supply obtained in step
1. According to the contract, the worker has an obligation to supply, at this contract wage w¯ , as much labor
as the rm demands ex post.
1

2. P 2 P Therefore. The ex post prot maximization problem of the rm is max Π L s.LED 1 Y E = LED − (LED )2 2 s. Firm's ex post optimization problem: After P has realized. hence 1−L= w ¯ 1 PE = . The rm chooses L such that the real wage w ¯ p = P Y − wL ¯ Y = 1 L − L2 2 equals the M P L.t. that the rm's ex ante prot maximization problem is given by max Π P E Y E − wLED = Y E . that of output). Solving this problem.2 Ex Ante Optimization Problem and the Contract Wage Suppose the household's ex ante utility maximization is given by max U 1 C E − (LES )2 2 = C E .3 Firm's Ex Post Optimization Problem Let P denote the realized price level.t. we obtain the expected labor supply curve LES = w .LES ≤ wLES P ECE s. the rm chooses the optimal level of employment (and accordingly. on the other hand. the contract wage w¯ that equates LES and LED is w ¯= 1 E P . 2 P (4) whereas the equilibrium level of output is ∗ YSR = 1 1 PE 2 (1 − ( ) ). 2 4 P 2 (5) . we obtain the expected labor demand curve LED = 1 − w . PE (1) Suppose. 2 (3) 2.3.t. PE (2) From (1) and (2). the equilibrium level of employment is L∗SR = 1 − 1 PE . Let us examine this through an example. Solving this problem.

4 The SRAS Curve The SRAS curve is given by 1 PE 2 1 (1 − ( ) ).t. This means that the gap between P E and P has no impact on the aggregate supply in the long run. and thus the rm can increase prots by increasing the labor input. 2. 3 . 2 4 P ∗ Y = YSR = (6) Note that Y is an increasing function of P . respectively. Since the nominal wage is xed at w¯ . The reason is as follows. the problems s.L = and L s. but in the short run. More formally. a fall in the real wage increases employment.5 The LRAS Curve In the long run. 2 3 . the larger the deviation of the aggregate supply from its long run level. under the prot maximization condition which equates the real wage and the M P L. the larger the gap between P E and P . PC 1 C − (L)2 2 ≤ wL max Π = P Y − wL Y = 1 L − L2 2 max U C. or equivalently. the household and the rm take P as given and solve. A rise in employment in turn increases output. it is likely that the contract wage is updated according to the realized price levelP . Thus. since the production function exhibits decreasing returns to scale (conrm that M P L is a decreasing function of L). that the SRAS curve is upward sloping.t. as in the analysis in the classical model. Actually solving the problem yields L∗LR = ∗ YLR = 1 . 8 These values are identical to what are obtained by substituting P E = P into (4) and (5). The solutions to these problems yield the labor demand and supply: the equilibrium wage is such that they are equal.P LRAS SRAS PE Y* Y Figure 2: Keynesian AS curves 2. a rise in P leads to a fall in the ex post real wage Pw¯ .