# Real Wage and Nominal Price Stickiness in Keynesian Models

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1 Real Wage and Nominal Price Stickiness in Keynesian Models

2 1. Real wage stickiness and involuntary unemployment 2. Price stickiness 3. Keynesian IS-LM-FE and demand shocks 4. Keynesian SRAS, LRAS, FE and demand shocks

3 1 Real Wage Stickiness and Involuntary Unemployment 1.1 Equilibrium real wage 6= market-clearing real wage When the real wage is too high =) involuntary unemployment (not present in Classical model)

4 1.2 E ciency wages Assumptions Work e ort (E) is increasing in the real wage, initially at an increasing rate and eventually at a decreasing rate carrot or gift exchange motive - workers who feel well-treated by their employer want to do a good job in exchange stick - If the worker shirks on the job the employer can re him/her. And if the worker is not making any more than in alternative employment, he might not care much. However, if he is making more than he feels he could in an alternative job, he will work hard in order to keep this job.

5 Firm wants to maximize e ort per dollar spent on wages. The wage which achieves this maximum is the e ciency wage. Implications For either the carrot or stick motives to be operative, the e ciency wage must be above the market-clearing wage. Therefore, there will be excess labor supply, de ned as involuntary unemployment. The full equilibrium level of employment N (F E) is below the marketclearing level in the Classical model. Shifts in labor supply have no e ect on the e ciency wage, on N or F E in contrast to the Classical model.

6 The e ciency wage will respond to aggregate unemployment as the value of keeping the job increases with unemployment implying more work e ort for a given wage, allowing the e ciency wage to fall. 1.3 Models with labor contracts If nominal wage xed and not indexed for in ation, employment increases when real wage falls - not consistent with evidence If indexed, as in Europe, another reason for the real wage to be xed.

7 2 Price Stickiness 2.1 Perfect competition (Classical model) vs. Monopolistic competition (Keynesian model) Perfect competition - something like wheat, gold - homogeneous good traded on organized market - if producer raises his price above the market price, he sells nothing. price-taker Monopolistic competition - di erentiated goods - most goods we buy - if producer charges slightly higher price, some consumers will still buy his product. price-setter

8 Menu costs - small cost to changing price - reprinting menus or convincing consumers that you are being fair. If the di erence between optimal price and actual price is small, leave price unchanged. Change price only when this di erence becomes large relative to the size of menu costs or the di erence is expected to persist for a long enough time period. Empirical evidence - many prices are xed for periods of time - most prices are not as volatile as commodity prices Optimal price P = (1 + ) MC

9 where is the markup over marginal cost. Desired price is above marginal cost Firm produces all that is demanded at that price =) willing to do so as long as price is at least as large as marginal cost. Labor demand is determined by labor needed to produce output demanded. Why is the rm willing to produce and sell more at P as demand increases?

10 3 Keynesian IS-LM model No change in variables which shift IS or LM E ciency wages - FE does not shift with a change in labor supply - otherwise same as in Classical model Sticky prices - unless there is a large need for price to change, it does not respond immediately to a shock. Short-run equilibrium occurs at intersection of IS and LM and can be away from FE.

11 Prices eventually adjust if rms are producing away from Keynesian FE. Long-run equilibrium occurs at intersection of IS, LM, and FE.. An increase in demand (ex. M up, G up, T down) raises output. 4 Keynesian AS-AD SRAS is horizontal.

12 A shock representing a large need for price to change would shift SRAS immediately. Short-run equilibrium occurs at the intersection of SRAS and AD. SRAS moves slowly over time when the economy is away from FE. Long-run equilibrium occurs at the interection of SRAS, LRAS = Keynesian FE, and AD. An increase in demand (ex. M up, G up, T down) raises output

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