Principles of Economics and Finance (7QQMO200)

MSc in Financial Policy & Regulation

King’s Business School
King’s College London
G. Chortareas

Lecture Notes: Lecture 4

This set of notes follows the text of Abel, Bernanke, Croushore Chapters/sections 9.6,

10.1,11.1,11.2

7QQMO200 Principles of Economics and Finance

A General Framework for Macroeconomic Analysis: The AD-AS Model

Aggregate Demand and Aggregate Supply

A. We use the IS-LM model to develop the AD-AS model

The two models are equivalent
Depending on the issue, one model or the other may prove more useful
a. IS-LM relates the real interest rate to output
b. AD-AS relates the price level to output

B. The aggregate demand curve

1. The AD curve shows the relationship between the quantity of goods demanded
and the price level when the goods market and asset market are in equilibrium
a. So the AD curve represents the price level and output level at which the IS
and
AM curves intersect (see Figure)

1
r

7QQMO200 Principles of Economics and Finance

b. The AD curve is unlike other demand curves, which relate the quantity
demanded of a good to its relative price; the AD curve relates the total
quantity of goods demanded to the general price level, not a relative price

c. The AD curve slopes downward because a higher price level is associated with
lower real money supply, shifting the LM curve up, raising the real interest
rate, and decreasing output demanded

2
Factors that shift the AD curve
Any factor that causes the intersection of the IS and LM curves to shift to the left
causes the AD curve to shift down and to the left; any factor causing the IS-
LM intersection to shift to the right causes the AD curve to shift up and to the
right
For example, a temporary increase in government purchases shifts the IS curve
up and to the right, so it shifts the AD curve up and to the right as well (Figure
below)

7QQMO200 Principles of Economics and Finance

Factors that shift the AD curve

3
 Factors that shift the IS curve up and to the right and thus the AD curve up and
to the right as well
(a) Increases in future output (Y^\ wealth, government purchases (G), or
the expected future marginal productivity of capital (MPK')
(b) Decreases in taxes (Γ) if Ricardian equivalence doesn’t hold, or the
effective tax rate on capital (r)
Factors that shift the LM curve down and to the right and thus the AD curve up
and to the right as well
(a) Increases in the nominal money supply (M) or in expected inflation

7QQMO200 Principles
(b) Decreases in of rate
the nominal interest Economics
on money (i ) or and
the real Finance
m

demand for money

4
The aggregate supply curve
1. The aggregate supply curve shows the relationship between the price level and the
aggregate amount of output that firms supply
2. In the short run, prices remain fixed, so firms supply whatever output is demanded
a. The short-run aggregate supply curve is horizontal (Figure bellow)

7QQMO200 Principles of Economics and Finance

Full-employment output is not affected by the price level, so the long-run aggregate
supply curve (LRAS) is a vertical line at F= F in Figure above.

Factors that shift the aggregate supply curves

The SRAS curve shifts whenever firms change their prices in the short run Factors
like increased costs of producing goods lead firms to increase prices, shifting
SRAS up
Factors leading to reduced prices shift SRAS down
Anything that increases F shifts the LRAS curve right; anything that decreases F
shifts LRAS left
Examples include changes in the labor force or productivity changes that
affect labor demand

Equilibrium in the AD-AS model

5
 1. Short-run equilibrium: AD intersects SRAS
2. Long-run equilibrium: AD intersects LRAS
Also called general equilibrium
AD, LRAS, and SRAS all intersect at same point

7QQMO200 Principles of Economics and Finance

If the economy is not in general equilibrium, economic forces work to restore

general equilibrium both in AD-AS diagram and IS-LM diagram.

The Real Business Cycle Theory (Sec. 10.1)

A. Introduction to real business cycle theory
Two key questions about business cycles
What are the underlying economic causes?
What should government policymakers do about them?
Any business cycle theory has two components
A description of the types of shocks believed to affect the economy the most
A model that describes how key macroeconomic variables respond to economic
shocks
Real business cycle (RBC) theory (Kydland and Prescott)
Real shocks to the economy are the primary cause of business cycles Examples:
Shocks to the production function, the size of the labor force, the real quantity of
government purchases, the spending and saving decisions of consumers (affecting
the IS curve or the FE line)

The largest role is played by shocks to the production function, which the text

6
 has called supply shocks, and RBC theorists call productivity shocks

The recessionary impact of an adverse productivity shock

Real wage, employment, output, consumption, and investment decline, while
the real interest rate and price level rise. So an adverse productivity shock
causes a recession (output declines), whereas a beneficial productivity
shock causes a boom (output increases); but output always equals full-
employment output

Real business cycle theory and the business cycle facts

7QQMO200 Principles
The RBC theory is consistent ofbusiness
with many Economics
cycle facts: and Finance
If the economy is continuously buffeted by productivity shocks, the theory
predicts recurrent fluctuations in aggregate output, which we observe
The theory correctly predicts procyclical employment and real wages

The theory correctly predicts procyclical average labor productivity. If

booms were not due to productivity shocks, we would expect average
labor productivity to be countercyclical because of diminishing
marginal productivity of labor.

The theory predicts countercyclical movements of the price level, which seems
to be inconsistent with the data
Digression:

The “bible” of empirical work on RBC models is by Robert King, Charles Plosser, and
Sergio Rebelo of the University of Rochester, “Production, Growth and Business
Cycles: Technical Appendix,” May 1987. This is an appendix to two articles published
in the Journal of Monetary Economics in 1989 that have become the cornerstone for
subsequent empirical work using the RBC approach. The appendix explains in detail
how the RBC model is analyzed and calibrated, and it describes computer programs
written for the software package MATLAB.

7
Keynesianism: The Macroeconomics of Wage and Price Rigidity

Real-Wage Rigidity

A. Wage rigidity is important in explaining unemployment

In the classical model, unemployment is due to mismatches between workers and
firms
Keynesians are skeptical, believing that recessions lead to substantial cyclical
unemployment
Keynesians view equilibrium as a situation in which there is no upward or
7QQMO200
downward pressure on Principles
wages of Economics and Finance
To get a model in which unemployment persists, Keynesian theory posits that the
real wage is slow to adjust to equilibrate the labor market

Some reasons for real-wage rigidity

For unemployment to exist, the real wage must exceed the market-clearing wage
If the real wage is too high, why don’t firms reduce the wage?
One possibility is that the minimum wage and labor unions prevent wages from being
reduced
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
A third reason is that workers’ productivity may depend on the wages they’re paid—the
efficiency wage model

The Efficiency Wage Model

Workers who feel well treated will work harder and more efficiently (the “carrot”);
this is Akerlof s gift exchange motive
Workers who are well paid will not risk losing their jobs by shirking (the “stick”)
Both the gift exchange motive and shirking model imply that a worker’s effort
depends on the real wage (Figure below)

8
 7QQMO200 Principles of Economics and Finance

The effort curve, plotting effort against the real wage, is S-shaped
At low levels of the real wage, workers make hardly any effort
Effort rises as the real wage increases
As the real wage becomes very high, effort flattens out as it reaches the maximum
possible level

B. Wage determination in the efficiency wage model

Given the effort curve, what determines the real wage firms will pay?
To maximize profit, firms choose the real wage that gets the most effort from
workers for each dollar of real wages paid
This occurs at point B in Figure 11.1, where a line from the origin is just tangent to
the effort curve
The wage rate at point B is called the efficiency wage
The real wage is rigid, as long as the effort curve does not change

C. Employment and Unemployment in the Efficiency Wage Model

The labor market now determines employment and unemployment, depending on
how far above the market-clearing wage is the efficiency wage (Figure below)

9
 The labor supply curve is upward sloping, while the labor demand curve is the
7QQMO200 Principles of Economics and Finance
marginal product of labor when the effort level is determined by the efficiency
wage
The difference between labor supply and labor demand is the amount of
unemployment
The fact that there is unemployment puts no downward pressure on the real wage,
since firms know that if they reduce the real wage, effort will decline

Price Stickiness (Sec. 11.2)

A. Price stickiness is the tendency of prices to adjust slowly to changes in the economy
The data suggest that money is not neutral, so Keynesians reject the classical model
(without misperceptions)
Keynesians developed the idea of price stickiness to explain why money is not
neutral
An alternative version of the Keynesian model assumes that nominal wages are
sticky, rather than prices; that model also suggests that money is not neutral

10
 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.

7QQMO200 Principles of Economics and Finance

Sources of price stickiness: Monopolistic competition and menu costs
Monopolistic competition
If markets had perfect competition, the market would force prices to adjust
rapidly; sellers are price takers, because they must accept the market price
In many markets, sellers have some degree of monopoly; they are price setters
under monopolistic competition
Keynesians suggest that many markets are characterized by monopolistic
competition
In monopolistically competitive markets, sellers do three things
They set prices in nominal terms and maintain those prices for some period
They adjust output to meet the demand at their fixed nominal price
They readjust prices from time to time when costs or demand change
significantly
Menu costs and price stickiness
The term menu costs comes from the costs faced by a restaurant when it
changes prices—it must print new menus
Even small costs like these may prevent sellers from changing prices often
Since competition is not perfect, having the wrong price temporarily will not
affect the seller’s profits much
The firm will change prices when demand or costs of production change
enough to warrant the price change

11
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.

Empirical evidence on price stickiness

Blinder and his students found a high degree of price stickiness in their

7QQMO200
survey of firms
Principles of Economics and Finance
The main reason for price stickiness was managers’ fear that if they raised
their prices, they would lose customers to rivals
But catalog prices also do not 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)
Price stickiness may not be pervasive, as prices change on average every
4.3 months (Bils-Klenow)

But some of the measured price stickiness is because of sales; when you
look at price changes excluding sales, prices change on average every 11
months (Nakamura-Steinsson)
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 (Boivin-Giannoni-Mihov), so in our macroeconomic
model, the assumption of price stickiness is useful

Meeting the demand at the fixed nominal price

Since firms have some monopoly power, they price goods at a markup over
their marginal cost of production:

P = (l + f)MC

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

Since the firm is paying an efficiency wage, it can hire more workers at that

12
 wage to produce more goods when necessary
This means that the economy can produce an amount of output that is not on
the FE line during the period in which prices have not adjusted

Effective labor demand

The firm’s labor demand is thus determined by the demand for its output
The effective labor demand curve, NDe(Y), shows how much labor is needed
to produce the output demanded in the economy (Figure below)

7QQMO200 Principles of Economics and Finance

It slopes upward from left to right because a firm needs more labor to produce
additional output.

13