4. New Keynesian AS Curves

Macroeconomics1Chapter V. AS-AD

4. New Keynesian AS curves

1) Assumptions

i)Rigidity of Nominal Wages;

In the New Keynesian model of labor market, the nominal wage is set at t-1 through labor contracts, and the level of employment is to be determined at time period t.

ii) Long-term Non-indexed Labor Contract: Just like the Keynesian AS curve model, the wages are set in advance through the long-term non-indexed contract.

iii) The labor contract sets nominal wages at time t-1. The workers are bound by the contract to work at the set wage rates as much as is required by the entrepreneurs. The level of employment is flexible to be determined according to the labor demand at time t.

Ex-post revisions of expected price levels do happen, and shift the labor supply and demand curves around. However, the labor supply curve is redundant as it is effectively replaced with the wage line, which is set through the contract. The equilibrium takes place where the horizontal nominal wage line intersects the newly shifted labor demand curve.

2) Derivation of New Keynesian AS curve in the Short-run

Graphic Derivation is as follows:

Start with P1.

For the given price level, get the labor supply and labor demand curve in the second panel.

The intersection of the labor supply and demand curves gives the equilibrium level of employment N1.

This feeds into YS1 in the aggregate production function.

YS1 = Y1 in the third panel.

Now in the fourth panel, Y1 matches with P1.

Suppose that the price level goes up to P2.

This sends both the labor supply and demand curves up.

However, the level of nominal wages does not change due to unions or money illusion. It is the effective labor supply curve; note that it replaces the shift labor supply curve, which is meaningless.

The new equilibrium level of employment is given at N2.

This feeds into the aggregate production function to give YS2 = Y2.

Y2 goes down to match P2.

By linking the two points of Y in the fourth panel, we get the New Keynesian Aggregate Supply Curve. It is upward-sloping.

3)Comparison of the New Classical and the New Keynesian AS curves in the Short-run

Note that the slope of New Keynesian AS curve is flatter than the corresponding New Classical AS curve: if we look at the labor market only for a unexpected rise in the price level, the comparison is as follows:

Comparison of New Classical and New Keynesian equilibriums:

Note that the slope of New Keynesian AS curve is flatter than the corresponding New Classical AS curve: if we look at the labor market only for a unexpected rise in the price level, the comparison is as follows:

4) New Keynesian AS curve in the Long-run

The school of New Keynesians is still being made, and thus has diverse versions within the school.

Extending from the above, what will happen to the New Keynesian Aggregate Supply Curve if there is an increase in the price level?

There are two different versions for the long-run:

(1)Some New Keynesians say that in the long-run

the nominal wages or money wages will fully adjusted upward in proportion to the rise of the price level, and thus

the NKAS curve will move up all the way just as in the case of the New Classical Aggregate Supply curve,

and the newly shifted NKAS will be aligned with the vertical ‘Long-Run Aggregate Supply Curve’.

Note that this version is a minority view in the New Keynesian school.

Illustration of the ‘minority’ version of New Keynesian equilibriums in the long-run:

*Can you indicate the exactly corresponding points? If you are not sure, please ask me.

In the left-lower panel, the points that matter are the one where the horizontal money wage line or ‘effective aggregate labor supply curve intersect the labor demand curve. These two points correspond to N1* and N2* as we have seen in the previous graph. Through the corresponding points on the aggregate production curve and the 45 degree line of YS =Y curve, you can get the corresponding points on the P-Y plan on the lower-right panel of the above graph. That is the NKAS. The only difference between this NKAS and the New Classical Aggregate Supply curve is that this NKAS is flatter. That is because in the case of New Keynesian the money wage does not have to go up and thus entrepreneurs can hire more workers. On the other hand, in the case of New Classical labor market, the money wage has to be raised along the aggregate labor supply curve(can you spot this equilibrium point in the labor supply-demand curve). Thus in the case of New Classical labor market, the profits left for the employers or entrepreneurs will be smaller, and compared to the case of New Keynesian, the employers will expand the production less, and hire less workers.

Now back to New Keynesian model. If the money wage goes up fully in proportion to the price level, as is assumed by some New Keynesian economists– which is the same assumption as the New Classical in the long-run, there will be a new set of intersection points between the horizontal wage line or the effective labor supply curve and the aggregate labor demand curve: they correspond to N3* and N1*.

These changes are equivalent to having the vertical LRAS curve.

(2)The majority of New Keynesian economistssay that in the long-run the NKAS curve will NOT fully shift to the alignment with the vertical line of LRAS.

The idea is put forth by some representative New Keynesian scholars such as Gregory Mankiw, and Paul Romer.

There are two reasons why the Money Wage or Nominal Wage will not fully adjusted in line with the changing price level. In other words, there are two grounds of the New Keynesian argument of Rigidity of Nominal Wages. They are:

i)Menu Cost

ii)Monopolistic Competition in Product Market

plus some Monopsonic Labor Demand

If there is a substantial menu cost, changing the price tag is costly. The change in the price level will lag behind and the extent will not be fully in line with the changing price level. Think of the cost involved in changing all the price tags in a super-market. It may be quite high. Mankiw argues that even a small menu cost can lead to a big change in the national income, and that the menu cost might be substantial. As of now, not many economists agree with his arguments.

The more convincing ground for the rigidity of money wage comes from the New Keynesian observation that many of modern industry have Monopolistic Competition rather than the Perfect Competition. In perfect competition, all the producers are price-taker and no one can play a game with the price of their outputs. And thus, where there is a change in cost of any kind, and particularly labor cost, the price will go up fully reflect the change in cost. If the cost goes up, as there is no profit right now due to perfect competition, a company has no choice but to raise the price. Still there will be no profit as the increase in the price is exactly the same as the increase in the cost. When the cost goes down, the price will have to go down in the same proportion. If any company does not fully cut down on the price of its output, in the perfect competition of the industry as assumed, the company will not be able sell any product as all other company will cut down on prices exactly in proportion to the decreased cost.

However, in the case of monopolistic competition, the resulting industry price will be somewhat rigid. When the price level in general goes down in the economy and the production cost goes down, a company with monopolistic power does not have to lower the price of its output fully. It has some monopolistic control of its consumers. And the money wage does not have to go down fully either.

When the price level of the economy goes up and thus the production costs rise, in the setting of monopolistic competition, a company cannot raise the price of its output fully in line with the rising general price level or costs: Due to the competition side of monopolistic competition, the company would not dare to raise the price fully. If it does, it will lose its market share in a big way. So there will be a rigidity of price level at the industry level. Obviously the profits might be squeezed if the money wages are rising fully in line with the price level. However, as many big companies have monopsonic power (buying monopoly) in the labor market, the money wage may not have to go up fully either. Thus the price rigidity is transferred to the money wage rigidity.

Illustration of the majority view of New Keynesian equilibriums in the long-run:

*Can you indicate the exactly corresponding points? If you are not sure, please ask me.

Note that the money wage line does go up fully in line with the rising price level.

The labor market equilibrium points are the one where horizontal wage line or the effective labor supply curve intersect the labor demand curves. Note that for a given price level, upon a change in the money wage, the equilibrium moves along a given labor demand curve (indicated by arrows in the lower-left panel of graph). This movement leads to a shift of the corresponding points in the lower-right panel of graph(indicated by arrows respectively)

*The above movement of the NKAS curve in the long-run leads effectively to a non-vertical but slanted Long-Run Aggregate Supply Curve.

5. Putting them all together in a complete macroeconomic model with the Lucas AS, Long-run AS and AD curves in the New Classical Framework.

In the New Classical world, there is no institutional rigidity of money wage. However, there could be information asymmetry between the workers and the employers in the short-run.

So far we just assume that there is an increase in the price level P. Why or how does it happen, or what causes this rise in the price level?

In reality a rise in the price level or inflation is most likely the result of government’s expansionary fiscal or monetary policies, which shift the AD curve.

Suppose that government increases nominal money supply or MS. It will put a train of economic sectors in motion:

First, the real money supply curve ms will shift to the right.

Second, the LM curve will shift to the right.

Third, the AD curve will shift to the right.

Now, when it comes to the response of the AS side, there are different assumptions for different circumstances:

1)Unexpected Increase in AD

(1)If the increase in Money Supply is unanticipated or unexpected for the workers or the general public, then the SAS curve does not move at all in the short-run.

(2)Even if the expansionary monetary policy is unexpected, eventually in the long-run the general public will figure out the consequent increase in the price level. Suppose that there is no institutional wage rigidity in the labour market. As they demand a higher money wage so as to recover the real wage, the money wage will rise and the SAS will reflect the wage(labour cost) increase and thus decrease(shifting to the left or up visually).

Note that all short-run misalignment of Lucas’s AS and LRAS will be corrected by itself as time goes by in the long-run.

2)Expected increase in AD

If the expansionary monetary policy is announced well in advance and is executed by the monetary authority as announced, and at the same time, if there is no institutional money wage rigidity, then there is the Policy Ineffectiveness Theorem holding once-for-all, i.e., in the short-run as well as in the long-run. There will be no increase in Y even in the short-run.

3)Over-expected Increase in AD

If the workers expect a certain increase in AD, for instance, due to an increase in money supply, then they will have a projection of where the new AD will be. The expected new position of AD will give the expected new long-run equilibrium price level at its intersection with the LRAS. The workers will accordingly demand a higher wage commensurate to the new expected long-run equilibrium price level. Thus Lucas’s AS will move up by that amount.

However, in reality, the actual increase in AD, for instance due to an increase in money supply, may fall short of the expected increase in AD. Thus, the workers may have over-expected the increase in AD.

Then, as the wage level is too high for the full employment, there will be an increase in unemployment rate at least in the short-run.

However, in the long-run, if there is no downward (money) wage rigidity, the labour market will correct the short-run misalignment by itself: In the long-run, the workers will find out their forecast errors and revise their expected new AD and the expected long-run equilibrium price level downward. And Lucas’s AS curve will come down. It is quicker than the adjustment of the conventional adjustment process where the presence of unemployment above the natural rate of unemployment will lead to competition among the (not-hired) workers and thus to a lower money wage rate.

Can you illustrate the above points in one graph of LRAS, Lucas’s AS, and the initial AD and the over-expected new AD curve and the actual new AD curve?

Macroeconomics1Chapter V. AS-AD