GRIPS Macroeconomics II

Fall II Semester, 2016

Lecture 2b: Determination of National Income  Keynesian Theory
Junichi Fujimoto
December 5, 2016

Keynesian AD and AS Curves (overview)

Let us review the gure from the last lecture.

Demand Side
Equilibrium in the
goods market

Equilibrium in the
money market

IS curve

LM curve

Supply Side
The LRAS is vertical, just like
in the classical theory Y =
Y*
The SRAS is either horizontal (= P constant)
or upward sloping, due to insufficient price
adjustment

downward sloping AD curve

Determination of national income (Keynesian)

Figure 1: Derivation of AD and AS curves (Keynesian theory)

Keynesian AS Curve: A Model of Sticky Wages

2.1 Timing

According to the Keynesian theory, the LRAS curve is vertical as in the classical model, but the SRAS curve is
generally upward sloping. An extreme case is where the SRAS curve is horizontal, which implies that there is no
price adjustment at all in the short run. There are several dierent models that explain why the SRAS curve is
upward sloping: here we will look at one of them, a model of sticky wages due to labor contracts. The timing
assumption of the model is as follows.
1. Ex ante optimization problem of the household (or worker) and the rm: the household and the rm have
the same expectation P E of the price level, and optimize taking P E as given. This yields the expected labor
demand and supply curves.
2. Signing the contract: The rm and the worker agree upon nominal wage w , before the realization of the actual
price level P . Nominal wage w is such that it equates the expected labor demand and supply obtained in step
1. According to the contract, the worker has an obligation to supply, at this contract wage w , as much labor
as the rm demands ex post.
1

3. Firm's ex post optimization problem: After P has realized, the rm chooses the optimal level of employment
(and accordingly, that of output).
Let us examine this through an example.
2.2 Ex Ante Optimization Problem and the Contract Wage

Suppose the household's ex ante utility maximization is given by

max U

1
C E (LES )2
2

C E ,LES

wLES

P ECE

s.t.

Solving this problem, we obtain the expected labor supply curve

LES =

w
.
PE

(1)

Suppose, on the other hand, that the rm's ex ante prot maximization problem is given by
max

P E Y E wLED

Y E ,LED

1
Y E = LED (LED )2
2

s.t.

Solving this problem, we obtain the expected labor demand curve

LED = 1

w
.
PE

(2)

From (1) and (2), the contract wage w that equates LES and LED is
w
=

1 E
P .
2

(3)

2.3 Firm's Ex Post Optimization Problem

Let P denote the realized price level. The ex post prot maximization problem of the rm is
max
L

s.t.

The rm chooses L such that the real wage

P Y wL

Y =

1
L L2
2

equals the M P L, hence

1L=

1 PE
=
.
P
2 P

Therefore, the equilibrium level of employment is

LSR = 1

1 PE
,
2 P

(4)

whereas the equilibrium level of output is

YSR
=

1
1 PE 2
(1 (
) ).
2
4 P

(5)

LRAS

SRAS

PE

Y*

Figure 2: Keynesian AS curves

2.4 The SRAS Curve

The SRAS curve is given by

1 PE 2
1
(1 (
) ).
2
4 P

Y = YSR
=

(6)

Note that Y is an increasing function of P , or equivalently, that the SRAS curve is upward sloping. The reason is as
follows. Since the nominal wage is xed at w , a rise in P leads to a fall in the ex post real wage Pw , and thus the rm
can increase prots by increasing the labor input. More formally, since the production function exhibits decreasing
returns to scale (conrm that M P L is a decreasing function of L), under the prot maximization condition which
equates the real wage and the M P L, a fall in the real wage increases employment. A rise in employment in turn
increases output.
2.5 The LRAS Curve

In the long run, it is likely that the contract wage is updated according to the realized price levelP . Thus, as in the
analysis in the classical model, the household and the rm take P as given and solve, respectively, the problems

s.t.

PC

1
C (L)2
2
wL

max

P Y wL

Y =

1
L L2
2

max U
C,L

and

s.t.

The solutions to these problems yield the labor demand and supply: the equilibrium wage is such that they are
equal. Actually solving the problem yields
LLR

YLR

1
,
2
3
.
8

These values are identical to what are obtained by substituting P E = P into (4) and (5). This means that the gap
between P E and P has no impact on the aggregate supply in the long run, but in the short run, the larger the gap
between P E and P , the larger the deviation of the aggregate supply from its long run level.
3