Lecture 9: Keynesian Models Professor Eric Sims University of Notre Dame Fall 2009 Sims (Notre Dame) Keynesian Fall 2009 1 / 23
Keynesian Models The de ning features of RBC models are: Markets clear Money neutral No role for stabilization (activist) policy Keynesian models (which in some sense pre-date RBC) di er: Markets don t always clear Money is not neutral There is a role for stabilization policy Sims (Notre Dame) Keynesian Fall 2009 2 / 23
Key Ingrediants There is a neoclassical backbone to Keynesian models household and rm optimization is all there But we throw in a key assumption: Sticky nominal wages, which prevent labor market clearing Motivation? Unions? Money Illusion? Sims (Notre Dame) Keynesian Fall 2009 3 / 23
Actors The actors in the economy are the same as before: Households: demand consumption and money, supply labor Firms: demand labor and investment, produce output Government: consumes some of output, prints money (both exogenous) We still have three markets: Labor market Goods market Money market Labor market is the key di erence Sims (Notre Dame) Keynesian Fall 2009 4 / 23
Household Problem The same as before! max c,l,c 0,l 0,M u(c) + v(l) + φ M + βu(c 0 ) + βv(l 0 ) P s.t. c + c0 1 + r + i M 1 + i P = wn + w 0 N 0 1 + r h = N + l h = N 0 + l 0 Sims (Notre Dame) Keynesian Fall 2009 5 / 23
Solution First order conditions, which are MRS = price ratio conditions, implicitly de ne a consumption demand function, labor supply function, and money demand function, as before: C = C (Y, Y 0, r) N = N s (w, Y 0, r) M = PL(Y, r + π 0 ) Sims (Notre Dame) Keynesian Fall 2009 6 / 23
Firms Firm problem also the same as before: max zf (K, N) wn I + 1 N,I,N 0 1 + r z 0 f (K 0, N 0 ) w 0 N 0 I 0 s.t. K 0 = I + (1 d)k Sims (Notre Dame) Keynesian Fall 2009 7 / 23
Solution First order conditions (which are marginal bene t = marginal cost conditions) implicity de ne a labor demand curve and investment demand curve: N = N d (w, z, K ) I = I d (z 0, r, K ) Sims (Notre Dame) Keynesian Fall 2009 8 / 23
Government The government chooses spending today, spending tomorrow, and the money supply today exogenously (G, G 0, and M) It has an intertemporal budget constraint that must be satis ed, so taxes adjust automatically to make it hold G + G 0 1 + r = T + T 0 1 + r As such, the model is completely Ricardian Sims (Notre Dame) Keynesian Fall 2009 9 / 23
Point of Departure The point of departure from the neoclassical benchmark is that the nominal wage is xed in the short run Real wage vs. nominal wage: w = W P W = W is exogenous Sims (Notre Dame) Keynesian Fall 2009 10 / 23
The Labor Market The nominal wage being sticky (i.e. exogenously xed), means that the labor market and money markets cannot simultaneously both clear We assume that the labor market fails to clear the money market and goods market will clear Firms are always on their labor demand curve This means that labor supply is essentially unimportant Sims (Notre Dame) Keynesian Fall 2009 11 / 23
Motivation Why assume that the labor market does not clear? Because it gives rise to unemployment, and it will break the classical dichotomy and will allow money to have real e ects De nition of unemployment Picture Sims (Notre Dame) Keynesian Fall 2009 12 / 23
Supply Side The labor supply curve is irrelevant we assume that we are on the labor demand curve. Fixed nominal wage is such that we are always above the market-clearing wage Given the exogenous variables, we read employment o of the labor demand curve Plug this into production function and we get output Sims (Notre Dame) Keynesian Fall 2009 13 / 23
The AS Curve The price level, P, which is an endogenous variable, will a ect the level of employment (and hence output) Why? For a xed nominal wage, W, an increase in the price level lowers the real wage Since the rm hires labor up until point at which marginal product equals real wage, increases in P will lead the rm to desire more employment More employment means more output Graphical Derivation The AS curve is the set of (P, Y ) pairs where consistent with the rm being on its labor demand curve and producing according to its production function, given W Sims (Notre Dame) Keynesian Fall 2009 14 / 23
The Demand Side The demand side is essentially the same But we want a relationship between Y and P, since that s what the AS curve is The AD curve is the set of (P, Y ) pairs consistent with goods and money market clearing Building blocks: IS (investment = savings) and LM (Liquidity = Money) curves Sims (Notre Dame) Keynesian Fall 2009 15 / 23
The IS Curve Set of (r, Y ) pairs consistent with agent optimization and goods market-clearing Identical to Y d curve! Shift variables: z 0, G, and K Sims (Notre Dame) Keynesian Fall 2009 16 / 23
The LM Curve Set of (r, Y ) pairs consistent with agent optimization and money market-clearing Depict money market equilibrium a little di erently demand a downward sloping function of r holding P xed Derivation Shift variables: M and π 0 Sims (Notre Dame) Keynesian Fall 2009 17 / 23
AD Curve Set of (P, Y ) pairs consistent with both goods and money market clearing (i.e. on both IS and LM curves) Derivation: changes in P a ect position of LM curve Shift variables: anything that shifts IS or LM Sims (Notre Dame) Keynesian Fall 2009 18 / 23
AD-AS Equilibrium On both the AS curve ( rms on labor demand curve and production function) and on AD curve (households and rms optimizing, goods and money markets clearing) Equilibrium: jointly determines r, P, and Y Money is not neutral! E ects of real shocks are di erent Sims (Notre Dame) Keynesian Fall 2009 19 / 23
Exogenous Shocks As before, shock the exogenous variables and see what happens to the endogenous variables Do increase in z, z 0, G, and M Sims (Notre Dame) Keynesian Fall 2009 20 / 23
Mechanisms The Keynesian sticky wage model is essentially built to accomodate demand shocks i.e. to allow them to have real e ects Two sources of demand shocks LM shocks (monetary policy), and IS shocks ( animal spirits (increase in z 0 ) or government spending) In neoclassical model money has no real e ects, and animal spirits shocks likely lead to decreases in output and, at the very least, negative co-movement The Keynesian model solves both of these issues, but at a cost The mechanism by which demand matters is through a countercyclical real wage (procyclical price level), which is itself counterfactual! Sims (Notre Dame) Keynesian Fall 2009 21 / 23
Optimal Policy In neoclassical model, there was no welfare motivation for endogenous policy Here there might be Suppose that animal spirits shocks are important IS shifts Suppose in neoclassical model this leads to no e ect on output How can policy restore the neoclassical level of output through countercyclical monetary or scal policies This kind of story is the nexus of the desirability of countercyclical policy or stabilization policy Sims (Notre Dame) Keynesian Fall 2009 22 / 23
Policies to Lower Unemployment Rate Policymakers may want to lower unemployment politically popular, evidence of ine ciency and failure of labor market to clear What s the tradeo? To get unemployment down in this model, policymakers must cause prices to rise So the tradeo is: lower unemployment means requires higher in ation if the lower unemployment is generated through activist policies Phillips Curve: π = π e a(u u ) Sims (Notre Dame) Keynesian Fall 2009 23 / 23