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3rd Lecture: macroeconomic fluctuations, traditional Keynesian theory

Nikolina Kosteletou

Keynesian theories

National and Kapodistrian University of AthensDepartment of EconomicsMaster Program in Applied EconomicsUADPhilEcon

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Basic assumptions and characteristics

• Prices and wages are not perfectly flexible.

• Nominal stickiness

• Nominal rigidities

• Slow-moving nominal adjustments →real effects on output and employment.

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Keynesian models:

• basic relationships among aggregates

• Static models

• Demand side is important (goods market, money market – effective demand)

• Supply side (labor market, employment, output)

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Keynesian models

• From the Keynesian cross to the IS-LM model

• From the IS-LM to the AD-AS model.

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ADASP

Y

Aggregate Demand and Supply

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From the Keynesian cross to the IS-LM

• Keynesian cross: demand side (no money)• Real values matter• Prices are constant• Planned and actual expenditure • Expenditure - output• Equilibrium• E: planned real expenditure

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equilibrium

• E: planned real expenditure.• In equilibrium planned expenditure is equal to actual

expenditure.• Actual expenditure is equal to output, Y.• In equilibrium planned expenditure is equal to the

economy’s output.• E=Y• If actual expenditure is greater than planned → inventories.

• Firms cut their production.• → Keynesian cross

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Keynesian crossE

Y45o

A

E=Y

E

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Planned expenditure E

• Components:• C, I, G (closed economy)• C=C(Y-T)• I=I(i-πe)• G, T exogenous• Standard specification of E:• E=C(Y-T) + I(i-πe) + G

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General specification of planned expenditure

• E = E(Y, (i-πe), G, T)• Assumptions about the effect of changes of

determinants of components, on expenditure:• 0<EY<1,• Ei-πe <0,• EG>0,• ET<0.

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IS

• Relates Y and i for which planned expenditure is equal to actual expenditure.

• The slope of the IS is negative:• Y=E(Y, (i-πe), G, T)• dY/di=(∂E/ ∂ Y) (dY/di) +(∙ ∂ E/ ∂(i-πe)) (d(i-∙

πe) /di) ⇒• dY/di=(∂ E/ ∂ Y) (dY/di) + E∙ i-πe

• dY/di= Ei-πe /1-EY <0

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dY/di= Ei-πe /1-EY

• Slope of IS:• di/dY= (1-EY)/ Ei-πe <0• the is flatter• The larger is EY and the larger is Ei

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45o

E

Y

A

E=Y

E

i

Y

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LM

• Combinations of Y and i that lead to equilibrium the money market for a given price level.

• Money: high powered money (currency and reserves issued by authorities)

• (money base, reserve money)

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Demand for real money balances

• (M/P)d=L(i,Y)• Li<0, Ly>0• (M/P) d=(M/P) s=M/P• Slope of the LM• di/dy

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(M/P)=L(i,Y)

• Slope of the LM:• d (M/P)/di = (∂L/ ∂i)(di/di) + (∂L/ ∂Y)(dY/di) • ⇒• 0= (∂L/ ∂i) +(∂L/ ∂Y)(dY/di) • 0 = Li + Ly(dY/di) )(dY/di) ⇒• dY/di = -Li/Ly >0

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i

Y

LM

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dY/di = -Li/Ly >0

• LM steeper: the larger is Ly (classical case)• the smaller is Li

• LM flatter: the smaller is Ly• the larger is Li (Keynesian case)

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Elasticity of the demand for money

• With respect to income:• (d(M/P)/M/P)/(dY/Y)• %(M/P)/%Y• dln(M/P)/dlnY• =0 (flat LM)

i

Y

LM

dY/di = -Li/Ly >0

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Elasticity of the demand for money

• With respect to the interest rate:• (d(M/P)/M/P)/(di/i)• %(M/P)/%i• dln(M/P)/dlni• =0 (vertical LM)

i

Y

LM

dY/di = -Li/Ly >0