farro EconomicCs:

AD-AS: 11

42.
COMPLETE
OF KEYNESIAN
EQUILIBRIUM THEORYPRICE,
OUTPUT,
Y (mid of the 1930s)
KATE
omplete Keynesian QOF YMENT,
INTEREST, ETC DETERMINATTON EMPLOYV
determination consists of heory
three
theory of
of equilibrium employment,
equilibrium empu output, price, elc.
markcts:
i. Labour market:
i.
ii.
Money market;
Letus first concentrate on Product market:
S I iniroduce the
the (i) labour market:
demand side of the labour market. Keynesian theoTy posu
geregate production function relating employment (N) to the
ven that the stock
of capital stock is fixed in the short period output
at K
Y
employ labour with in the
economic zone of production and thus
K.
Enreprc urs
ageregate demand for labour ys0, yNN
(with firm level profit maximization goal) is given .
W/P =yN (N) by
IW, P denote the money wage and the product
ce respectively]
or, W (N)
real wage N- P.M PN
. )
a)
N

TabdaieN here N'a(W/P)<0]

The same fnctional
(1.b)
onslestabinsh niegativey slope demand for labour function
with respect to realage sine y INCE m
Let us now once.rae on the stPp side o abour nurket.
Keynes argid that nom tyage is ally given at some level. This happens
due to: O033 Mornb
A. Theong-teniuractual agreements ween employees and employers
union
inthe pres nce ofowerfulrde 2D29
structure
B Expenses and ne involved Tevising highly complex wage a

and the consequen uctane to revise the wage structure often,

C. Fear of the loss of good reputation through money wage cut, etc.
An individual worker's effort supply can be obtained from the goal of his utility
maximization derived from income and leisure subject to spendable time constraint
the total
that can be into work hour (Ns) and leisure hour.
split Aggregating al the individual effort
Supply functions we get the supply of labour function as
w= W/P=g(N) N denotes the aggregate supply of labour]
.....(2)
or. W= P. g(N) .(2a)
or, N=g"(W/P)
or, Ns =ns (W/P) TWhere n's>0 by the assumption of below
standard of living of the
average national
workers to ignore backward bending supply of

labour. . . . . . . . .

now concentrate on the labour market equilibrium:

Let us lunction from equation-i: wy(N)
We have the labour demand
funetion Irom equation-(2):
W- g(N)
We have the laboursupply
Fqlng w we gel:
vN N)...
 Wacro 1conomics:

AD-AS: 12
This determines the
separately. KeynesianCquilibrium
wge is N of the labour market when the market is consiaercu
figure-1 depict then d theory assumes
rigid downwardCory assu
complete inflexibility of money wage.
and it is 1.C..
situation. institutionally fixed at
at some level.
S Quadrant-1l ana
The relation between P and W/P is a
rectangular hyperbola for any given money
wage. This relation is
represented for three
money wages Wo, Wi and W2 in
The full quadrant-l|.
the
employment levcl of employment and
AD corresponding real
Yo yy wage are Nf and (W/P)¥F
respectivcly. Money wage is rigid downward
and is
JN4 - institutionally given at the level Wo.
n Quadrant-IV represents the short-run aggregate
Ns n, (W/P) Np= na(w/p NF Fig 1 production function.
n' >0
n'd0 y =y (N, K) Aggregate supply (AS) curve shows the
1O
YN0, yNN0 quantity of real output that producers are willing
supply at each'price level. We
have derived the AS curve in
quadrants-ll, III and IV of
figure-1. quadrant-I in accordance with
We start with the price level Po. next we find
wage rate for this
price level against the institutionally given money wage Wo in the rea
hat
produces the real wage wo. At this real quadrant-i
wage, the employment of labour (as
employers concern) is at the level No in quadrant-111. Then we find real output yoperin
quadrant-IV corresponding to No. We then plot the
n e same point (yo, Po) in quadrant-l. We can repeat
procedure with any other price level. Following the same sequence we arrive at the
ageregate supply (AS) curve quadrant-1. In the
Keynesian model, the AS curve is directuy
Sensilive to changes in price. The positively sloped AS curve is really the result of the
Keynesian argument that money wage is given institutionally.
Kevnes derived the ageregate demand (AD) curve from the IS-LM frame work
IS-LM ramework determines the demand side equilibrium output. The IS-LM
framework does not bother whether the equilibrium output, determined by the interaction
between the IS and LM curves, can be produced or not with any given factor endowments
(specifically. labour). Variation in price level (P) implies variation in the demand side
and
cquilibrium output (y). Aggregate demand function for the currently produced goods
services can be obtained by relating the variation of y to that P.
Equation to the IS curve may be written as:
r=A/b-(1/ba)y [Where.
A FC. autonomous consumption.+
c.TR, MPC(¢) times exogenousl
fixed transfer payment( TR) + .
autonomous investment. + g: The
autonomous part of the aggregate
demand function of the economy.

-b=ollôr: Sensitivity of investment to a

change in the rate of interest (r).-
a

negative constant.
investment
4: Simple Keynestan
multiplieri
proportional tax rale
T

Outpul
 AD-AS: 13

Alacro lconomics:
has a positivC
curve
the IS
Clearly. situation.

hiercept with the vertical axis and it is shoped depicts the

negatively. Figurc-I
as.
'quatio
quation to the LM curve may be wrillen
h/)y M/.P
Where: fixcd ominal
supply
M: Exogenously
central
moncy supply by the
of the
monctary authority
cconomy.
- OSp.dd/Or: Sensitivity ofT
demand for moncy
speeulative
rate of
(Sp.dd) to a change in the
constant.
interest (r),- a negative
k 0Tr.dd/ðy: Sensitivity of
transactions demand for money
in income
(Tr.dd) to a change
constant.
(y).- a positive
level.
P: Exogenously fixcd price
curve has a negative
early, the LM curves
a set ol LM
ntercept with the vertical as and it is slopcd positivoly. We have drawn
infigure-1 for different locls of pe Mavda
22f 202
NS
Ma (M.Po)M, (M Klall in pric raises intecept of the LM curve with

A/MM.PP Ahe r i s t lavesth slopenchanged. In figure-2 the

Po) to LM, (M,toPi<Pa) to
2M SYYehili_frojn Mo (Mleclines from Po Pi to P2
LM: M P) as prlevel from ey to ej moves

Fig-2 ectively, Ae pont of eqylibrium

A agghte demand for the currently produced
to to y2 respectively.
gOodmdserviccsriges from yo yi combinations from
(y. P)
O We plo the equjbrium and ez in figure-3
and obtain
re-2 for thë points co, ei We can generate
the points like e. e and ez respectively. all these
Joining
different values of P.
SO many points for in
obtain the aggregate demand (AD) curve
points we

Por Fig-3 figure-3.

We superpose the AD curve from figure-3 in the
P quadrant-I of figure-1. The
first
AD curve cuts the
AD curve within the zone AS.
at point E
Yo Yi Y2 y aggregate supply curve
the classical zone. With total
portion assumes total flexibility of money wage,
-

The SS' it
the product market equilibrium is attained at point E since if it comes about
price lexibility
the equilibrium level of employment, output, price,
has no tendency to change. Consequently,
At point E, AD equals
are Na. yo. Po, Wo and un respectively.
real wage and unemployment market is also
holds and along the AD curve and money
AS. i.e.. saving-investment equality in equilibrium. But
both the goods and money markets are
in equilibrium. So, at this point
of unemployment of un'. W'ith the equilibrium price leve
unfortunately there is an existence rate of interest is
is .Ma and the crresponding eyuilibrium
P'the position of he LM curve demand
cquilihrium level investment, the specilative
FWe c i ohetermine the correspomling

OTRVStRRIL
 AD-AS: 14 MacroEconom
Macro Economics:

Jor level of consumplion and

output level is yo and the equilibrium
VUngs
Vings be
be Orum
can
c an
determined from the respective funcor From equation-(1.a) nave. e

Lake mathematical note

a in this context.
f I
function. with institutionally gIven
P. yn(N). The labour supply
money wage io Wo P. y»lN). From this
=

W o . Thus. in labour market equilibrium. N in terms of P: N= P ) .

labour market equilibrium value of
Pulting
g this valuis ne
value of N in the we get: y y{D(P). K;. T his =

aggregate production function

aggregate production u
relation
ISOn expresses
expresses the he
the
aggregate supply luncuol, s a1ating r from tne
ations
curve and 1M
curve we can P land
express y in terms o for any gv
solving for p ers. Ihis expresses the aggregate demand, yo d{P). Equating
function the the equilibrium price level. Putting this value ofP in the ys S{
production functi uilibrium output. Substituting this value of y in the aggrega

employment
mployment cancan ate
also we get the cquilibrium level of employment. This caui
be determined (institutionally
given moneyage,
wage, Wi/equilihri
by substituting
y equilibrium real wage
substituting the equilibriu tian.
equilibri Wi/equilibrium price) in the demand 10r a Substituting u
of
labour. The va nelabour supply function we can
e
determine the equilibrium suppiy
the¢
equilibrium demand for labouronary unemployment be calculated by subtracting
can
from the
employmcnt
Duc equilihri equilibrium supply
to the co-existence of unemployment of
with equilibrium,
labour. it is called the under

PROBLEM:
Consider the
following macro economic model building functions:
S =
0 5YD
T 10
G= 8
Y = N/2

M 100
k 2
I = 20 02r

N 400
1. Using these functions set up the classical model and derive the
equilibrium values of all the endogenous variables.
Incorporate money wage rigidity (W = 2) and rewrite the model. Do you

have underemployment equilibrium? What should the maximum value of

price be to have full employment? What are the different ways in which
you can have that price?

73. THE IS-LM VERSION OF CLASSICAL AND KEYNESIAN THEORY:

the LM maintains the
IS curve maintains the goods market equilibrium and
curve

functions are as follows:

moncy (and the wealth) market equilibrium. The relevant
l:quation to the IS curve:
y= A tc.(1 -1) y-b.r.
Where.
A FC. autonomous consumptuon.+
c.TR. MPC(e) times exogenously
TR) I.
ixed transter paymen
uloo Us nCstnent. he

OTR
INSRRI
 AD-AS: 15

autonomous part of the aggregate

demand function of the econonmy.
-b =Ol/Or: Sensitivity of investment to a
change in the rate of interest (r).- a
negative constant.
a: Simple Keynesian investment
multiplier ett-0i.0t=
proportional tax rate<1
ary.the
negatively. IS curve
has a
y: Output
positive intercept with the vertical axis and it is slopcd
Equation to the LM curve:
r
(k/¬)y M/P
-

[Where:
M: Exogenously fixed nominal supply
money supply by the central
monetary authority of the
economy.
OSp.dd/ôr: Sensitivity of
eculative demand for money
Sp.dd to a change in the rate of
terest a negative constant.
0ldd/oensitivity of
R A

NSFE transae ons demand for money

dd 6achange income in
D.B a positiveconstant.
SINCEP: yogenously ked price level.
Putting the vatue of r
uation tp M cury the IS curve we get
A
or C(D
-b.(k/
33R MPTp
DD MoydMdd
P) 20 2024,
or. y c 6+MP1-c(1-1)+ b.k/A}
1is represents the Dunction only y and P are variable).
Now. bM/(P
Thus, OPra0an-fhe AD function is sloped negatively.
We can represent the AD curve in a general form as follows:
y=A +B.(M/P)
[Where,
A: A/{I-c(1 -1) + b.k/l}. a positive constant:
B: (b/)/1 - c(1 -t) + b.k/}. a positive constant)
We see that changes in the fiscal policy or the real supply of money affect the level of
AD in the intermediate zone of the economy.
thus the fiscal policy changes
Keynes assumed inlinite in deep recession and
makes the inclusion of the wealth market pale. In
onsistent with zero crowding etleet, which
extra than the simple Keynesian model. Actually
this sense the same AD has nothing to do identical. Basically.
curve makes the two situations
=
and the consequent horizontal LM have some clcct
the same situation and liscal policy changes
the AD curve is vertical under
with the complcte Keynesian positively
on both the level
of cquilibrium oulput and prICe in
we hae shown
the cllect of an expansionary fiscal change
sloped S curve. In ligure-i
 : Macro Economies:

AD-AS: 16

ADa AD, the AD-AS frame work and that in the IS-LM
AS Irame work in figurc-2. The subscripts 7ero and
one initial and the changed
P represent the
P Siluations respectively. We see that the inclusion
o1 the labour market (development of the
FixI
complete Keynesian model over the IS-LM
model) is irrelevant for the expansionary effect
on output. This is parallcl to thinking that the AS
is horizontal.

LM (M. P)
in

Fig. 2
PA
AD AD
The horizontal AS curve in figure-3
epresents the price rigidity thought. However,
-AS
the rigidity of the equilibrium price as a result of
he exclusion of the labour market remains
Fig.3
Yo Y
inconclusive.
On the other
hand, the classical belief of
fiscal policy change is completely ineffective in zero makes the LM curve vertical. Here a

PA influencing the equilibrium outpul. F1owe

AS the AD curve is sloped negatively and it
shifts upward following an expansionary
fiscal change. In figure-5 we have depicted
P the fiscal change through the parallel
Fig.4
P oulward shift of the IS curve. In figure-4
-AD we have represented the situation in the
AD AD-AS framework. Figure-4 and 5
concludes the complete ineffectiveness of
LM(M, P the fiscal policy.

IS
ISo
Fig. 5
OL
P
AS
The dircct implication of the
ineffectiveness of liscal policies
is the

vertical AS curve. ligure-6 depicts the

Fig. situation.
 AACen sUudenis may cheek how well thefacts fu in with the Keynesianclassicalviews]
THE cONCEPTS OF SHORT-RUN AND LONG-RUN:
Most macrocconomists believe that the
key difference between the short-run and the
long-run is the behaviour of prices. In the long-run.
prices are flexible and can respond to
changes supply demand. In the short-run, many prices are sticky at some
in or
level. Because prices behave differently in the short-run than in predetermined
the long-run. economic
policies have different effects over different time horizons.
To see how the short-run and the
long-run differ. let us consider the effects of a
change in the monetary policy. Let us suppose that the central
reduced the supply of money. According to the classical model. monetary authority suddenly
which almost all economists
agree describes the economy in the long-run. the
money supply affects nominal variables but
not real variables. In the
long-run, all prices (including nominal
wages) are reduced
equiproportionately with the nominal
money supply whereas all real variables emain
same. Thus, in the long-run, changes in the the
or employment.
money supply do not cause fluctuations in output
In the short-run, however, many prices do not respond to
supply does not immediately cause all changes
A reduction in the in monetary
money policy.
all firms to cut the
pay. stores to change the
price tags on their goods, all mail-order firms towages they
catalogs. and all restaurants to print new menus. Instead, there is issue new
many prices; that is, many prices are little immediate change in
short-run impact of a sticky. This short-run price stickiness
change in the money
supply is not the
implies that the
A model of economic fluctuation same as the long-run
must impact.
take into account this short-run
stickiness. Modern economic price
price
theories explain that the failure of
completely means that, in the short-run, prices to adjust quickly and
adjusting instead. In other words. output and employment must do some
of the
classical dichotomy no during the time horizon over which
longer holds: nominal variables can prices are sticky. the
cconomy can deviate from the intluence real variables. and the
equilibrium predicted by the classical model

8308.3.35t06 () 539.5349ti OT TR SRAR!E: DE

 AD S
In
&eyesian
and the M curves. analysis the
aggregate demand side of the
economy consists of
aro

Fquation to the IS curve the Is

that maintains the
goods market equilibrum 1s
A+C.(1 -)y - b.r Where.
A: The autonomous
part of
aggregate demand function the of
the economy.
-b ollor Sensitivity of
investment to a
change in the
rate of interest (r). a
constant.
negative
0<c-MPC. proportional tax
rate<
y: Output
r: rate of interest|
or.
{1-c(-)},y tb.r =A
or.
c(1-0)}.dy +b.dr =dA [Taking total differential
or.
-c(-)}.dy/dA +b.dr/dA+ 0.dP/dA =
1
Dividing throughout by dA
..
..()
The cquation to the LM curve may be written as
k.y-r+ L.P=M
[Where:
M: Exogenously fixed nominal supply
money supply by the central
monetary authority of the
economy.
-=Sp.ddcr: Sensitivity of
speculative demand for money
(Sp.dd) to a change in the rale of
interest (r).- a negative constant.
k Cir.dd ôy: Sensitivity of
transactions demand for money
(Tr.dd) to a change in incomee
(y).- a positive constant.
L: Sensitivity of nominal money
demand to a change in the price
level
P: Theprice level.
total difierential|
or. k.dy tdr
L.dP=
+
dN [Taking throughout by
d Ldr d\+L dP dA- 0 [Dividing
or. h.dv dA and putting dN1 0.1

tconomy
arLate
supply side otthe
the
conccniral
on luncton is
Us no aggrgale
producton
u.ilion tothe
h
 LicC
Macro Economics:
AD-AN: 2 com

YN
Where: Suppl
YN 0. Ys <0 and N'denotes cha
the level of employment] argur
deri
************** .-{} M
Optimum (prolit maximizing) employment ot labour requires:
W= P. YN) dees
[W is the institutionally
S
given money wage] la
or. W P.YNY'(y)} Putting N trom (i)
out
or. W P Qy)
or. P. P.dy
jConsideringY"'(y)}-O(yi
+D(y).dP = dW [Taking total differential}
or. P.O.dy dA +0.dr dA +O).dP d =0
Putting dW = 0 and dividing throughout by dA]

(I)
We can solve the set of equations (). (11) and (li) for dy dA. dr/d and dp dA by
applying Cramer s rule: b
-t L

dy/dA { c ( 1 - t ) } - b{k®y) - PO,L}

1-e(1-1)1
k
P.O

Thus. the complete Keynesian auonomous ndi tipT

SINCE
B696
The above set of equationsvith I olyd for dA and dP dA:

k
P. -ky)+ PO.L
dr/dA =
t D(y){1-c1-)} - b{k®y) - P.0,LI
->0
1-c(1-1)} b
k -
L
P.D 0 (y)
The above set of equations with I, II and IlI can also be solved for dr/dA and dP/dA:

1-C(1-1)b
k -
0
P.O tP.P
dP/dA -tD(Y) {1ct1-4)} - b{kOIY) -POL
1-c(1-1)} b
L
k -

P O inerease
interest and the price level both inerease with an
i.C.. the equilibrium rate of
Irame work.
In the autonomouS expenditure in the complete Keynesan

N 36IN3546M2559 ()
 AD AN

Wacro Economics:

detemnne
te ceet on the
tunction lo
production
donsider the aggregate
"Can
cquilibrium level of cmployment
Y(N)
or. N Y(y)
0
Y"().dy dA)
()
or.UN dA
an inereaNe
in auto s
level of emploment rises with
n e cquilibruum
Capenditure.
increase in the autonomous expenditure shitts the
IS curve tga *
Basically. an

and. consequently. the aggregate demand curve (figure-1.b) parllel upwar

LM(M.P*
M,(M. P** p*)

Fig.Ia

AD We have superposed the shift of the AD

AD Fig.Ib curve in quadrant-I of figure-2.

With institutionally given money wage.

i.c.. positively sloped aggregate supply (AS) curve.
the point of equilibrium moves from Eo to E and.
E consequently. the equilibrium output. price.
employment inerease from yo to y1. Po to Pi and No
to N respectively. The parallel upward shilt of the
WP AWf
IS eurve (figure-1.a) means increase in the
1No
---NY-- - -
equilibrium rale of interest at any given price
**********************************T situation.
NF
Ns n, (w/P)
n 0 ND n(W/P)| y (N.K)
n0 yN0,yNN 0
N

Fi 2

Interesting points to be noted:

The complete Keynesian autonomous expenditure multiplier.

AConplete- Kev es l c(1-) b.ht+b.P.oLEDY)

The IS-LM autonomous expenditure muliplier.

ct1-0; b.h

The simple Kevnesian

autonomous expenditure muluplier.

IRSRI
 Macro Economics
AD-AS: 23

When the economy is the

autonomous expenditure liquidity irap then = w,
Putting this valuc of in the
multipliers lor the complete Keynesian
see that: and the IS-LM
setup we
(A» Complete-
The three Keynes A IS-t.M
A Simplc- Keymes
multipliers are cqual when investment is
This is
equivalent to saying that the deep recessionary perfectly
interest inelastic and b 0. =

constant and thus the interest induced situation keeps the rate of interest
I n the liquidity trap the part of the investment
function
aggregate demand curve is vertical and this is abscnt.
solution with the classical vertical
aggregate supply curve. For this yields no determinate
against the classical theory, the
classicists Keynesian attack
Pigou, a wage-price deflation (under the advanced
below
with the Pigou effect.
According to
automatic full employment via an increasC in
the
full-employment operation)
level of consumption. Ile generates
when money wages are
of
cut, prices fall and the value of argued that
money means a rise in the real value of money rises. The rise in the value
assets will make their owners assets. The increase in the real value of fixed
feel richer than before.
their current income and They will, therefore, save less out of
demand for the currently spend
more on
produced
consumption. This will increase aggregate
goods and services, and will
employment in the economy. Keynesians believe that the same generate automatic full
this makes delay in price adjustes, mechanism takes time and
adjustment power of the classical this arseards the belief of very fast or speedy
Keen students may invisiblehand.
compe compicd Kenesia IS-M and the simple
multipliers with an invesnentthefinctic
We have analyzed the which is depe ident both income and Keynesian
interest.
workings of the favourbie iníence of dity rap in the very speedy
classical inyisibl hahd. Pigoufesfect pro ded a
classicists as a
favoyrable influe noe on solution on behalf of the

influence on price austments s the pncejustments Howevr, another unfavourable

the Pigou effect
and seq
anicipated/umantici ate flation. The working of
is ent speeior idjustment dpends on whether the deflation
anticipated or unaricipated
3 3 5 0

4. NEUTRALITY VERSUSNON
Inthe cla_sical theory the NEUTRALITY
aggregate
OF MONEY
suppl
neutral in the sense that it has schedule s vertical and there money is
noeffec cal outp empBoyment, eal ralc of interest, real
wage. On the other hand. in the
Keynesia
positively and the monetary policy has sometheon he aggregate supply schedule is sloped
money is non-neutral in the Keynesian
effect on the real variables.
Thus, in general,
setup.
Neutrality of money means that money is neutral in its effect on the
change in the money stock can have no long-run influences on the level economy. A
employment, rate of interest, or the composition of final output. The only of real output,
change in the money stock is to alter the general price level. Patinkin lastingtheimpact of a
of money as a situation when *a explains neutrality
uniformly introduced increase in the quantity of
money
causes a
proportionate increase in the equilibrium price of commodities and levels the
equilibrium rate of inierest unaffected." Provided there is absence of money illusion and
distribution effect. According to Gurley and Shaw.
money is neutral if money is either
entirels f the "outside variety. or entirely of the "inside" variety. They define
money as the nab1it
neutrality of
hanges in ihe nominal stock ot moncy to alfect the rate of interest.
ilpi an h . ini, ibies."
 24
Macro Economics: Macre

lime lag.
there Is long-run
instantaneous. If
there is a economic units are
is
neutrality of money
individual
but
absolute (money) prices.
dgthe

There are changes in absolute prices

and their level
eulrality. determines only It is
them. The quantity of
to
money
formation and employment.in
unresponsive
of income, interest, rate capital
of
not aflect the level the econOmy.
does neutral in its effects on
the working of It plays no role
this sense that money is on the economy.
neutral in its cffect
in the classical system, money
is are delermined by
Rather, they
income and output. habits of
the determination of employment, resources. saving
n of natural
stock. of technology. availability
state money 1s to
act as a
abour. capital classical system, the main function of
the
people. and so
on. In the which gods and services
level of prices at
ot exchange. It is to determine the general level is a function of the
Hedium of money states that price
wlbe exchanged. The quantity theoryMV=PT, where M. V. P and T are
the supply of money.
supply of money. Algebraically.and the volume of transaction (or total output) respectively.
velocity ot money. price level., equals the total
value of ouiput, P1, in
cquation tells that the total money supply, MV,
he V T to be constant, a change in M
causes a proporiionate change
ne ecoomy. Assuming and determine the general price
level at
Thus money is neutral whose main function is to
in P.
which goods and services exchange. is neutral.
in which money
Keynesian system, there are two situations
ln the entire
ot money
Ihe first is the situation of full employment when any
increase in the quantity
at that
but output renmains unchanged
Drings about a proportionate increase in the price level is n the iiquidity
level. The second is the special of liquidity trap. When the economy
case
is increased
of interest even if the money supply
trap. there cannot be a further fall in the rate varrables as
be no effect on such real
by monetary authorities. This implies that there will balances. In
are added to idle
Investment and income. and all changes in the money supply
intermediale situation
this situation, money is neutrai. However, money is
non-neutral in the
between these two exireme cases in the Keynesian system.
non-neutraiity can not be ignored since the Keynesian
The question of neutrality or
controller of the interesi rate (for
prescnption of accommodat ing monetary policy
as a

reducing the erowding out etlect) requires non-neulrality of money. Economists. after 1970s,
are not detined.
discovered that the debate remains inconclusive till peopies anticipations
view, Completeiy depends cm
hciher the
The neutraltty or non-neulrafiiy of money, in their
monctary policy is anticipaiti or unanticipaicd.

5. MONETARISTS VERSUS FISCALISTS:

the task of refining his theories and
After Keynes died in 1946, his successors took up
Western nations as they converted to the
applying them to the policy questions facing
World War II. One aspect of the Keynesian
peacetime economies in the aftermath of
revolution was an attack on the classical quantity theory
of money. In fact, early Keynesian
Monetar1sm began as an
economists attached very littie importance to the money supply.
and therefore of monetary poicy.
attempt to reasscrt the importance of money
We can ist four propositions that characterize the monctarist proposilion
on nomIl iticanit
T h e supply of moncy is the dominant iniBucnce
on the priee ievel and
2 fn the ong-run, the infiuence of noney primarily
is
othcr oiili:l m4gnitudes. u the long run, rcal vattatbtes suh as outpu

emplynenl.arc dciemid by rual

t moneiary i. s
 AD AS

The private sector s IIhCrentIy stable. Instability in thc c c o n y

primarily the result of yovernnent policies.
Wo policy conclusions follow from these proposilions
Stability in the growih ol O e y supply is crucial for a stable cconony

Monctarists believe thit stucih stability is best achieved by nloptinp a nule

lor the owlh rale m he momey supply. Milton Ficdnn us om

proposcd a constant nO1ey rowlh rate rule. Other monetrists fiavonur les
inllexible rules, but monctarists generally favour rules rather than diseretion
in policy imaking.
Fiscal policy, by itseli. has little systematic cflect on either real or nominal
income. Fiseal policy is not an effcctive stabilization rule

6 . TUE EMERGING; TIHOUGUITS:

The post-Keynesians started to believe that business eycles can arise lrom aggregate
supply shocks too. A change in the aggregate supply schedule, like changes in aggregate
demand schedule, has some immediate eflects on the cquilibrium price and output. The
same changes in price and output and the consequcnt changes in the job market,
government actions are eitlher antiopttec or wicipated. Anticipations or expeclations
are foresight bascd... pectatfonmay adaptive or rational ***

Expcctations may be foryard Jooling o Naloog . he micro units

may delay to adjust....

aA NSF
Honerthis elapiiledigmed t I sund hallseuss the same
developn s in d e n r ofluh,ik7 l e d u s tah a short view on
ectatloris fo conolgiNEIrrloent of anisís......
19
7. ADAPTIVE EXPECTLLO
TATONS:
Adaptive expectation expp t h utur vae ofa variahle formed on the
husis of n adjustment whichsonepoporior1hy error in expectations maule last
period. The error is the difference bCNeen whet epected last period and whul ctuall
happened
Let us now imagine any worker who has arrived at the end of some
that worker look back over the economic
period t-1, and
history of that period and of previous periods. That
worker has noticed that in the past the
price level has moved jerkily up and down without,
say, any overall trend or drift. Then that worker might adopt correction
making adaptive expectations. That worker's guess about the future price levelmethod
an error
would for
be
composed of two parts. One is the actual price level when that worker makes his forecast, and
the other is a term that
adjusts for your error in the previous forecast. Formally. we can write
The lirst term is actual
P P 1A (2Pl Pr).. )
price level at 1-1. and the second is an adjustment factor
times the error that ogker made in
forecasting the price level in 1-1. We imagine that a lies
hetween 0 and 1) Hhe 7ero extreme that Worker
ignores past erroneous anticipations.
placing all the weight on the last period's actual price level: with .
changes his expeelations at all. unity. that person never
Weno Want to see that il enpectattons arc djustcd by an cror corTecton
meehanism stuch as the one gnen in cquation (l). the unplicaiion is that this perds
 Nnee nould e n m ant e r n
nithout iumit
d Aneiations arr a
p r o p a k in a statle worid ahere the mce
Nimple adantre es
d a i t o n . the nartmal adustmeE
Inel is not sudIei
to nerorahle
intitOn
O d .n
piaus1dle in a wOrid win
S Oi random mon emenmts in tnc
mochanism is mone
on-unme shitis
eiel, rather than
Let us suppose that a T-1. P. goes
P hach down again. Ihen adaptive expataions
would he helow the actual price ievei duri
T but above the atuai level during T-1. T-2
With the risk of being in error in either
direction. we ouid no uan o oom

ourseles to beliet in the permanence of any

Fig.l Indcerd. a smalkr adjusmat
ehanges.
comesponds to a smaer change
parameter
is peTmaneaib
that a givenchange
TABLE-
P

D.
SRNNOE
n m e n i in whvh the

So adaptive eNeetatns
ca ssibilin of s m e u h a
the
and dovn in (on about the
unNmK

price level m o v e s up
pemanen
shitis in the backgroen analvze the a n s U U n s

more
static equilibaum modo t i i t o d enngenous d i s t u r t a n s
environment in anv
e neral Adartive
in output and the pric the ctuti Tur

for changes randomlh

interwetvd as
that can be environnnent. )A
anpropriate in this wrkr a d icun
expectations seenm
understarnd how tie comn
ihat people s»xemi
1he t h e o r be made.
Rational
expectation:
while ranniom
errors mn
mistakes. s o thai.
their
quickhy from exnrtations ar

a r e not
made.
-P,
=

PP,). Rational
persistent
errors
function as
expectations
write an
We can
around as
the other wav
usually presented P P +E
mY
stortastk
nlus a
with prdictad nriee levet. ranáNn.
cauals the pir lenei
s
realizcd price level t o r undiasd. It the ean
That is. the i ) is sald a l s hut
prediction in acnssnib
with mean
7ero. Our with a gven
distnbuton

term nossibilitv.
is a
that is. a nonzer E,

irt!hemm r
i
pulatin mear

in: tn
 REC1I ING the words of Milton Fricdman.
s aiways a e m p o r a r y iraue01l Deiween n u a u o n a n a unempioyment; t n e r e is no p e r m a n e n

hetemnorarv tradeoff comes not from infation ner se. hit from nanticinated intlafint whic

generaluly means, Irom a ris1ng rate ot intlation.

.
THE MISPERUEPUONS THEOKY:
dorting to the classical model, prices do mot remain fixed for ann' substmtil periond of time, so the
short-run ggregate supphr curve is irrelevant. The only relevant aggregate SuPyly curve is the
u R R g a t e supply curve, which is vertical Changes in the none" spply cuuse snply lo change
e l changing the level of ouput. Ths momey is meutral in the classical model
o r money to be non-neutral, the relevant aggregate supPply curve must not be
e t us, extend the cassical model to incorporale the assumption that producers
C imperfect information about the general price level and thus sometimes misinterpret
nrad h e general price level as changes in the relative prices of the goods that they
Ptoauce. We demonstrate that the assumption that producers may misperceive the aggregate
price level the misperceptions theory implies a short-run aggregate supply curve that
Veucal. However, the short-run aggregate supply curve based on the misperceptions
ncory does not require the
assumption that prices are slow to adjust. Even though prices
y adjust instantaneously, the short-run aggregate supply curve slopes upward. so money
iS non neutra! in
the short run.
C
misperceptions theory was originally proposed by Nohel laureate Milton
Ficaman and tnen was
of the
rigorousiy íformuiatei by anoiner Nobei iaureate, KODert E. Lucas, J
University of Chicago According to the misperceptions
theory. the aggregate quanuty
OLOULpuL Suppiied rises above the juii-empioyment ievei, yr, When_une aggregaie price. leve
PIS higher than expected.) Thus for
any expected price level. the aggregate supply Curve
relaung ne price level and the aggregate quantity of
o
ouuput suppiiea siopes upward.
understand the misperceptions
theory and why it implies an upward sloping
aggregate supply curve, iet us think aboui an individuai producer o1 a parucuiar good. ror
Simplicity. we may consider a firm owned and operated by one person. The producer devotes
all his iabour to
making product and earns aii nis income dy seiing them. inus tne price of
his product is effectively the producer's nominal wage and the product price relative to the
general price ievei is the producer s reai wage. when the reiative product price increases. ine
producer responds to this increase in his current real wage hy working more and producing
more. Simiiariy, wnen the product price iaiis reiauive to ne ouner prices in tne economy, ine
producer's current real wage falls and he decreases the amount of the product he produces.
To caicuiate tne reiaive product price, the producer needs to know botn the nominai
product price and the general price level.The producer knows the nominal price of his
product because he seiis that item every day and observes tne price directiy. iowever, the
producer probably is not as well informed about the general price level. because he ohserves
the prices of the many goods and services he might want to buy iess irequentiy than he
observes the price of his product. Thus. in calculating the relative product price. the producer
can not use the acIuai curreni price ievel. i ne dest ne can ao is to use nis previousiy Iormea

expectation of the current price level to estimate the actual price level
initalion yOw. oI X0. tne actual rate oi
Say, tne producer expecled an over all
exceed. equal. falls short of that exnected o . rate When the actual rate of
ntlation mav or
tnal tne reauve price O1
iniauon lais snorn oi nal xpecieu rale tnen ne producer perCCivcy
his product has deereased.) Conseauentlv he reduces his outnut.When the actual rate of
anu
(xo) lNen ne pereeivCs
an mcTease in C a u v e price
Iniauon exCCeus nal eNp¢Ciea rale

/)TI RRI
 A t c f i

a c r o lconomK$: AD-AS: 29

ths raises his production. Ile maintains the same rate of production when the actual rate of

cquals that cxpected rate)

x%.
inílatiop
Thus. acecording to the misperceplions theory. the amount of output that producers
chaose io suppiy depends on the actual gencral price level compared to the expecied general
rice levcl When the price level excecds what was expected. producers are fooled into
iaink ine that the relative prices of their own goods have risen, and they incrcase their outpui.
Silarly. when the price level is lower than cxpected. produçers believe that the relative
i c s af their goods have fallen, and they reduce their output.(This relation between oulput

is captured by the cquation

and prices
yyrtb(P - P")
Where b is a positive number thal deseribes how strongly outpul responds when the
actuai price levcl
cxcccds the Cxpecied price ievel. Fqualion-i summarizes the
misperceptions theory by shOwing that output. y, excecds full-employment output, yr. when
the ievei, P,
price
excecds the expected price level, PE.)
P A LRAS
SRAS
To obtain an
aggregate supply curve
Urom_the misperceplions theory, we graph
in figure-1. Given full employment
eguat
o u p yandhe expectecd price level, P", the
Fig ggreghtesupp. curve slopes upward,
between the amount of
illastrating he relaon
actual price level. P.
ABI Suppi y. nthe
AP increáss the anpuntof the output supplied by
Because an increase in t p r i c e
Thus the aggregate
Ay b.AP. the slope ohe ageregd subplyrvs AP Ay.= Vb.
Supplycurve is steep if'b B relgiElat ib is la ge.
Point E helps us oca aggregaupplycurve At Ehe price level. P. equals
mount output supplied equals
the expected price levei, s o quation
NU3ibdelis igher an expected (P P"), the
>
full-employment output, y he when the
curve shóws thar thean ut greater than y:
aggregate supply
than expected (P P outputisless than
<
price level is lower
The aggregate supply curve gure- called he short-run aggregate supply
time that P" remains unchanged.
(SRAS) curve because it applies onytoihe short perioof level
run. people learn what
is actuallyhappening to prices, and the expected price
(In the long
When the actual price level equals the expected price
adjust to the actual price level (PandP°).
=

level of output. In
level, no misperceptions remain producers supply the full-employment
P equals P, and output, y, equals full-empioyment
terms of equation-1, in the long run
run. then. the supply
of output does not depend on the price level.
output. yF. In the long curve is vertical at the point
where output
aggregate supply (LARS)
Thus, the long-run
equals y.) NONNEUTRALITY OF MONEY:
10. THE MISPERCEPTIONS THEORY AND THE
THEORY:
MONETARY POLICY AND THE MISPERCEPTIONS in the extended version of the classical
n o w reexamine the neutrality
of money
Let us important
theory. This iramework highiights an
modei based on the misperceptions
changes in the money supni
hetween anticipated and unanticipated
distinction hut anticipaled
nominal suppiy have real eitects.
in the money
Unanticipated changes
are neutrai and have no reai cifects.
changes
 AD AN

UNANIIPADD(IANGES IN I M4NEY SUP'TLY ccono1y lor explaning he

cqilhbin sitation of the
N t with n penel
s incicae sAupply. We suppose
in oney
hal
ic CCOnomy
uliciated wlere the i l : a l igErCgale demand
gencral vquilibrium at point : in ligure-2, curve SRASj. IJCre, oulpul cqual
mteiscets the initial stont run aprepale supply
AD
ployment level, yi, and the price level and thhe expectcd price ievel botn cqual P
level to r e i l i h Constant
SP)Ose that cveryone expects the n n e y supplyand the price
Cehtral monetary authority unexpcctedly and withoul publicity increases tne money
y by o . An % inerease in the Oney supply shilts thc AD curve up lo AD,,

e reasing the priee level at cach level of oulput by x%. For the expectled price level Pi, the
RAS curve nemains
unchanged, still passin through poine
l'A
RAS The incrcase in aggrcgale demand bids up
SRAS the price levcl to the new cquilibrium price level,
SRAS P2, where AD, intersects SRAS (point F). In the
ICW short-run cquilibrium al F, the actual price
Fi 2 Ievel excceds the cxpected price level and output
CxCecds y. Because the incrcase in the money
-AD; Supply leads to a rise in output, moncy is not
AD neutral in this analysis.
The reason is that producers are fooled.
y Tach producer mispcrccives the higher nominal
Pe is
output as an inerease in its relative price, rather than as an increase in the
price level. Although general
output increases in the short-run, producers are not better oll. Ihey ena
up producing more than
he
they
would have if they had known the true relative
prices.
cconomy can not
stay long at the equilibrium represented by point ' because at F
the actal price level,
P>, is higher than the expected price level,
inforation about the true level of P. Over time, people obtain
prices and adjust their
expectations accordingly. The only
cquilibrium that can be sustained in the
underestimate or overestimate the long-run is one in which people do not
permanentiy
price level so that the expected price level and the actual
price level are equal.
Giraphically, when people learn the true price level, the relevant
ggregale supply curve is the long-run aggregale
cquals P. In ligure-2 the long-run cquilibrium point supply (L.RAS) curve, along which P always
is I, the intersection
Atll output cquals its of AD, and ILRAS.
full-employment
initial price level, Pi. Because
level. yr, and the price level, P3, is x%
higher than the
everyone now expects the price level to be P3, a new SRAS
curve with P"= Pi, SRAS2,
passes through
1.
Thus, according to the misperceptions thcory,
raises output and is not neutral in the short-run. unanticipated the money supply
an in
However, an unanticipated increase in the
money supply is neutral in the long-run, alter people have learned the true
price level.
In the extended chassieal model bused on
the misperceptions theory. the efeets of an
nliciputed money supply increase are ditferent from Ihe effects ofa
nCreuse
money supply swprise

ANTICIPATED CHANGES IN THE MONEY SUPPLY

Let us start with a general
equilibrium situation of the economy for explaining the
cllects ol anticipaled ncrease
an in money supply. We suppose that the
cconomy is initially
In general cquilibrium at poinl in figure-3, where the initial
aggregate demand
Interseets ihe mital short
curve AD
run
ageregale supply curve SRAS|. AL h1s mital situation output

9AS 25395319
 Macro Economi

AD-AS: 31
Cuuals its
full-employment level, yr,
cqual Pi. Let us and the
actual and the
Increase thhe suppose that the central expected
monetary authority announcesprice
levcls are boln
money supply by x% and that the that it is going o
An x%
increase in the money public believes this
output, from AD to supply shifts the AD curveannouncement
AD2. However, with up by x% at each level ol
up. The reason is that theanticipated change in money supply the SRAS
Curve also shifis
people learn of the increase in public's expected price level rises as soon as
the money
supply. Let us suppose that people
correctly--that the price level will also rise by x%
PA so that expect
expected price, P°, rises by x%, from
LRAS P to P2. Then the new SRAS curve, SRAS2,
through point F in figure-3, where y equals and passes
SRAS
both the actual and yr
.SRAS The new expected price levels equal P2.
equilibrium is also at F, where AD2 and
SRAS; intersect. At the new
cquilibrium, output
P Fig.3 equals its full-employment level, and prices are x%
AD2
higher than they were initially. The anticipated
increase in the money supply has not affected
output
buthas raised prices proportionally. Similarly, an
antcipatedrop in the money supply would lower
ces but noect output or other real variables.
Thusanticipaed changmmoney Supplare neral in the short-run as well as in tho
long-run. The reaso that Producers kinowt t increaes in the nominal prices of their
products are the res an hcreaseNB Ahe moneasup and do not reflect a change in
relative prices, the would not báfooled intò iRereasin prodtueion when prices rise.
POLICY ISsu>RAION ADEXPkd'ioNs AM TmE ROLE 0 MONETARY POLICY:
In the etended cla
sial hudased ren the nisper ptions theory, unanticipated
changes in the nne.stppl affect oDg, but anticip tod chinges in the money supply are
neutral. Thus, ifgovermnaanted to uonetfy poli to affect output, it seemingly
shoulduseonly ungnticinatedcnag3heoney Apply
According he misperceptions theory to achieeany systematic change in the
behaviour of output,e governiment autherity conduçis monetary policy in a way that
systematically fools thepublic B there are rong incentives in the financial markets and
elsewhere for people to try to figre out wha e monetary authority is doing. Thus most
economists believe that attempts by the government authority to surprise the public in a
systematic way cannot be successful.
The idea that the government authority cannot systematically surprise the public is
of rational
part of a larger hypothesis that the public has rational expectations. The hypothesis
the
expectations states that the public's forecasts of various economic variables, including
are based on reasoned and intelligent examination of
money supply, the price level, and GDP,
understand
available economic data. If the public has rational expectations, it will eventually
If expectations are rational, purely random
the government general pattern of behaviour.
and thus non-neutral. However, because
changes in the money supply may be unanticipatedthe it can not use
the government would not be
able to surprise public systematically,
stabilize Thus, even if smoothing business cycles were desirable,
monetary policy to output.
the misperceptions theory and rational expectations, the
according to the combination of
can not systematically use monetary policy to do so.
government -

in search of deeper thoughts the of

-

the windows for post-storm look

The misperceptions theory opened We do not know the voluntary or involuntary character of the
supply schedule.
slope ofthe. gregate classical term full-employment' becomes
obsolete. It is
Consequently, the
observed unemployment. Economiststhoughit it betterto cali the full employmentI
as the natural result.
better to call the potentiality values as the natural rates

L
2539-5349 (1)
9830833506 (1)
 AD-AS: 32

n Tejuired t o tidu ther wori the, bgliene inat therv h e i d he work ul uilasie jur iiem 2 0

igiert7i wage inun the e offered, thus he de 201 actep! ihai rel 2nit loak jr ihe highes m. u
O do nmin of thesc unemployed cali themselves unempioyed br! soctety s ch
O e r v cun he n
1 dfst imortani iniPuti dit "
doubt ihut expeciulions relaiing to fulure prices hae uni5 he
C decistors ihu! afjecf tody s tand tomorrov 3} price and wage levei Erpeciations cteariy cn rt
u n ) iattsjue tor theory uf inflation and hence es a -onseguence from hat of the E 58
demand and
supph as an
rlerpreter oi J!uciuot:O!s

Most economists analyse shot-run fluctuations in aggregate income and ihe price ievct
ung the model of
aggregate demand and aggregate suppBy. They believe tnat agea
upply behaves
differently in the short-run than in the long-run But, ecconomists are not
n l in search of best way to explain the short-run aggregate supply. In neir vie
are
s tlexible in the long-run and the aggregate supply is vertical
1rt-run, prices are sticky, and the aggregate supply curre is not 1erticai. B
AnyConras,
change iii
curve

Ergae demand has no effect on equilibrium output and it remains fixed at the
narura! rae
Ciects the price level; on the other hand, in the shori-run, this causes 1iuctuaions
Ouput. Many economists think that prices are sticky in the short-run and thus tne
Supply curve ol an economy is not vertical in the short-run situation The agercsa
Lneir
analysis can be explained in terms of a simplest versto
horizontai aggregate supply function but a mor
BCneralized version opines in favour
of a rising slope and the analogy can be
temis oi the sticky-price model. On contrary, some economists believe in the interpretcd
stickiness or
nominal wages and argue in favour of a positive slope of the short-run aggregate suppiy
funciion their analysis can be explained in terms of the sticky-wage model. Ihe third
group of economists believes that the short-run supply funciion is rising and il 1s
of impertect information of some agents comprising the economy. Their analysiS tne oucome
can be
taken care of the
imperfect-information model.
in all ihe models, some market imperfection (i.c. some type of friction) causes the
ouipui of the economy to deviate from ihe classical point of reference. As a resalt, the shor
run aggregate supply curve is upward sloping, rather than yertical, and shifts in aggregate
demand curve cause the level of output to deviate temporarily from the natural. +hese
temporary deviations represent the booms and busts of the business cycle
Although cach of the three modeis takes us down a different theoreticaB route. each
route ends up the same place. That finai destination is a shori-un asgregatc suppl
equation of the m
aThe sensitivity oi outpui (y) along
the business cycle per unit of deviation
of the labourers
ofexpected price (P")
from the actual price (P). - a pOsitive
consiant
rate of output.
yR The naturai
function. We
a .Thus, CP:Cy
=i/, the slope of ihe aggregale supply
Now. y P
=

fiunction depends on the responsiv

eness
of output to
see that the sBope of the aggregate supply
irom aciuai price di the ecoon
a change it eapeciei price abcu' u hai ic brhnd this short-ru
Each oi the three modcis telis a ditiereni slory
Driiar r e s e t h
in other ords. vach h.ghighi
a Lale supn!, EuatiOn
Y
t
 AD-AS: 33
.
THE STICKY-WAGE
Many economists stressMODEL:
positive slope of the shori-run the sluggish adjustment of
money wage aggregatc supply function. Thenominal
relies on the foliowing belief
wages as the core of the
of
I. line
(In many industries. nominalof reasoning: sluggish adjustment of
not wages are set by
adjust quickly when economic long-run contracts, so wages can
market relations conditions change These
because each
mecan that one
party will not take long-term labour
gains from continuing advantage of the other.
who stay in the
same joh save
reasonably trouble-free relations. Workers
for new themselves the trouble quitting and
jobs; fims save the costs searching
workers. Each benefits if they get on of locating, screening, and train1ng new
2.Even in industries not covered bytogether. formal contracts,
between workers and firms
may limit implicit agreements
3. Wages may also depend on social wage changes. )
norms and nofions of fairness that that
evolve slowly. Thus, in the
short-run, it is
mportant role of firms for reputation also sticky.
make the money wage sticky in the
short-run.
For thes pns, may econoists believe that nominal wages are
sticky.in hc short-run
The sticky-wage miel estio ion on he sticky money wage for the
aggregate supply function explan ion behind the model states
that a fall in price
levela eal wage level and makes
labour cheaper. Conseaeftitly s, hire morelabáar andeoutut level rises accordingly.
This positive relations
ip pri andolipný mepans tha thea regate supply function is
sloped positively duri n t1NOBal vmg nosaust
The stickywag sd oMESome 2s3 pUons.
Wor an ain gree oihe nominal wage before
hey o ir agreement takes
effect
(The barg an minea target eal wage
The targemy be Age of the labour market. Mor
ikely, the tci geis hi i the equiibrium reai wage. union
power and efiic setralions tend ie keep ieal wages aboi
A ieve! thai biing. suppiy àlid dem2ild inlo baiaitCc,
(The workers and fiims set the nominal the nominal wage based on the
target real wage and on their expectation of the price level.)
(Let us abbreviate nominal wage, target real wage and expected price
level by W, w and P" respectively for an illustration of this point. The
nominal wage they sci is
W w xP
After nominal wage has been set and before abour has been hiredl
firms leam the actuai price level P. The real wage turms oui to be
wP= w x (PP
THis egueiion sioys that the eal wages deviHe: rora its taryet ! th
aua priK c i ditis frona he xpected peice lev) h i e a
 AD-AS: 34

and the fims

ioes noi aeteimine the
t i s iteais ihai the bargain bctvecn the workcrs
as much labor as
workers agree to prOVIde
ee of employment in advance: instea ihe
firms wish to buy at the predetermined wage.
changc in the price fevcl moves
,Dccause((he wage is sticky. an unexpectcd
nominal
real wage iniluences the
in ihe
cawage awajy from the target rea! wage, and ihis change
quantijes of labour hired and outpui produced)
funclon: Mnf WPW:M
e describethe ims' hiring docisions by the labour dernand and the vice-VCIsa.
0Ihisstates that the lower ihe reai wage, the labour firms hire
Y{N) Y0. his
uput is determined by the aggiegaie produciion function: y
states that the nmore iabour is hired, the more ouipui is produced)+TO
We have represented the short-Tur aggregate supply unCIon quadrant- that is wis
obtained from the rest of the
quadranis: xed ot
PA

The relat1on between P

and W/P is a
Wo rectangutar hyperbola
WP W(N/P)NR, yo yNR for any given nioney
wage. This relaiion is
N- represenied for the
NR sticky money wage Wo
N s , (W.P)
n', No ngw/) y (N, K) quadrant-2. The
n'0 yN . yNN0 natural raic
employment and the
cOTesponding real wage are N and (WP respectively. Quadrant-!V reprcsents the short
run aggregale produciion function. Tie full
employmeni ouipui ievei is y2
Aggregate suppiy (AS) curve shows the quantity of reaB ouiput that producers are
wi!ling to suppy at each price ieve. We have derived the AS curve in quadrani-i in
accordance wiih quadrants-ii, til and y we stari wiih ihe price Beve! Po. next we tind the
1eal vage rate for this price level agatasi the nstituionally givsn noney wage w in
qadrani-fi ihai roduces the real wae w A' this reai wage. ihe employmeni of labour (as
per employers concem) 1s ai tie level No in quadrant-ili. then we tind real ouipu' y in
quadrant-IV corresponding io No. We then piot the point (yo. Pu) in quadrani-i. We can repeat
the same procedure with any other price levet. Foliowing the same sequence we arive at the
aggregate supply (AS) curve quadrant-i The AS curve is directly sensitive to changes in
price
ihe aggregate suppiy funciion càn be wTitten as
a a (P-P'). {Where:
The sensitivity of ouiput(y) along
the buwness cycie per unit ot dev 1atton
of expected price (P) oi he abourer
ro hctaprce (P, pusitA
onsa
 AD-A 35

2THE MPERFECT-INFORMATION MODEL:

The
units of
imperleci-inlformalion model is based on asymmeiric inlormalion of dilfercnt
the sysie. It is based ihe
on
following assumptions
All wages and prices are free to adjustto balance supply and demand
femporary mispercepiions about prices cxist in thc cconomy.
a c h supplier in the cconomy produces a single commodity and consumcrs
coisume many commodiics.
ihe prineiple of the imperfect-infomation model relies mainiy on the third
not lake nole oi all prices at all times due to the presencc of
assunpnon The suppliers can
of what ihey produce but less
large anmbei of commoditics. They moniior closcly the prices
commoditics they consune. Because of imperfect information,
closcl the prices of all the in relative prices.
sontctimes coniuse changes in the overall level of prices with changes
they
This cor:fusion inlluences decisions aboul how much to supply, and it leads to a positive

relatiogship between the price level and output in the short-run

an individual producer for an
illustrative analogy of the
We may consider the casc for
changes. The s a n e producer earns income by selling
producers behaviour in respcct of price the amount of produci
income to purchase goods and scrvices,
his o n n preduci and uses this
on the price of his product
reiative to the prices of other goods
he chooses io produce depends is high, the producer is
If the relative price of his product
and ser c e s in ihe economy. relative price
noiivaled to work hard and prod he inçentive is high. ff the
is low. he prefers to enjoy m sureandOducee know
prodclion decision, he does
nol
Qdua

infortunately, wh particular product and thus he

ihe relatve price of his oduct Produceroduce
But he does
nd alwaws th ce of his product.
munitor his produci a ust, therefore,
estimate the
not ano the prices kecon prod iand his expectation
of the
reiaive pce of his roduo Ahe pri
CLCra ICC ieve in the
if all prices
nere are t spGEhea oducer
roduci, mereas
econuny including
he exected this change in prices.
s 5
n ihe price of his produci, hts
does nui Oik
unhanged. tle

any
this much). When
he
SR (or to increse by
ientTcase
price he is not sure
increase in the price of his product,
observes the relative of
which case the
prices have risen (in
whether other the price of his
or whether only
unchanged)
his product is relative price of
his
which case the
risen (in
product has
product is higher) the producer
in other words.
is that some ofeach has happencd. relaiive price has T1sen

rational
inference that its
he
price of his product iasluon
behave in ihe
nominal sam:
increase in produrers
the Many he
observeincreases in
iom
iniers
hardEr and produces
more.
works in ihe c c n n y
O m C v i He rcia
istakeniy.ihat the
unpeciedly,
äll supplieis
eiel i s e s
r e all nfer 1iona!
p2d:ehey
g . ihe

.
 AD-AS: 36

atP- p"), { here

y a he sensitivity of outpui (y) along
of deviation
the businesscycle per unit
of the labourers
of expected price (P")
a pos1tivc
{P). -

iTOm the actual price ( k h a t a )

consiant:

The naturai raie of ouput.J#

yR
expEeicu
rate when the priceteve! deviates from ihe
Ouiput deviaies from the natural
price tcvcl
THE STICKY-PRICE MODEL: ihe prices they charge in response to

not instanily adjust

n i s model emphasizes that firms do are:
changes in demand. The reasons behind the sticky-price between fims and
customers.
Sometimes prices are set by long-run contracts in order noi to
Even without formai agreements, firms may
hold prices steady
price changes.
regular cusiomers with frequenimarkets
annoy their
are struciured (menu
cost).
3. Some prices are sticky because of the way the
fins io derive
decisions of individual
We tnay tirsi of ali consider the pricing
faced by an
curve of an economy. We
consider ihe pricing dccision
supply
ageregate lirm.
individual he firm's desired pricc ip)depentson two matroeconemic variables for
overall level of prices (P). Any im charges higher pYicealso
The are now
rises since the costs
itsproduci as the overall price
higher for the firm in question.
the demand for
y. As income rises,
2. he level of aggregate income. rises and the marginal cost
of p-
the product of the fim also is the
level of production, - higher
production is higher for higher
desired price of the firm in question.

price of the fim's desired price

as
Thus, the desired
pPta (y - y»R) ..(1)
P
ihe overalB levei of prices
price p depends
on
he desired
states ihat
This equation relative to the natural
rate (y-y»s).1he parameter
outpui
and on he icvel of aggregate
i m s desired price responds io the level of aggregaie
measures how much the
Bpositiyc} (1} we gct,
logarithm on both
sides of
output akimg iog p og*
logaíy
P= log a log (y- yNR) i

or, log p-- iog

or, log (p/P)

log a + log (y yNa) the
=
then
firm's price and price level,
of the îrom the
and P as the logarithms the deviation of output
If we interpret p price depends
on
desired relative
ihat the
states They
this equaiion
haye ficxible prices.
natural rate. types of
finns: First ivpes of fiums of firns
have sticky
us n o w
assume
two
relation (1).
The second type conditions
Let according to ihe
they eApect
economic
what
iheir prices based on
aiways sei their prices
in sdvance
announce
to value ot h
prices: they sei prices
acording
er rtes expcctee
i n s
ihese iype of 0srain.
io be.
 .C, trns
with
charge stieky pries set AD-AS: 37
NOW, the
their prices bascd on
by the iwo overal! pricc what they
groups of firns. level in the expeti othet
raction with flexible economy is the
IfE is the fraction
prices. then the overail of firms weighied
with stikyavcrage of ihe prTC
P price level is prices and t ne
or. P E,P(13)P
E,P *a(y- y l rom (1) and (2)}
Basicaily, or, P =
P+
{1-5). a(y -y.)
ihat iix prices fims expeci a {a.(l-5)G} (y - ys)
when
in
advance set their high price level, they .(3)
high prices also. prices high. These expeci high costs.
This expians Hience, a high expecicd price level (P)high prites cause the other hose tums to
intuitively the leads to ahigh achual
output is high, the demand forrelation between P and P of the same relation.price levet t
et
high, which leads to a goods is high. Those firms with flexible Again, when
high price level. The effect prices set the prices
proporiion oi firms wiih llexible prices. This is the output on the price levet depends
of
on
the same relation. intuitive explanation of the second termtheot
Now, from (3),
- P

Or
(P
Where, a ={5/a(1 )1
Thus, thc dey ion NSRe nalya positively associated with the
deviation of the priclevel txDected priee lex
PA D.B
9INCE
1909
3506 ihe
NR
Al the threc mode!s stress o
HORI of the short-run agregate
on of an cconomy. An cconmy
these markct
ain all three of
and ail may contribute to he
ctions,
haviour of sltocl-run aggregalc suppty

SCRI-RUNGGREGATE SUPTLY
FUNCTIO2N

1TIONS OF TIIE THREEMODELS: model, but the money

N.B: RELATIVE CONSIDER with the real wage
in the sticky-wage
for labour varies clear.
Demand
There markets
do not assumes that
unchanged. model
remains imperfect-information
wage model, the to balance stupply and
sticky-wage adjust
Unlike the are free to
and prices
i.e.. all wages
markets clear
-

consider
market, we can
the goods short-
demand. model emphasizes stuck in the
the sticky-price
If a firm's price is able to
Although labour market. is
in the amount
that the lirm
what is happening reduces the its
dematid
brielly demand änd
production
reducng its
aggregate
r e d u c t 0 n in not
run, then a
lls io the drop tn
sales by odel the ims here d
sell. The
fim res lo tie sticks-w ive are asso itd
conirasi nt vurput
f e the thicfuatron
faber det
n lnstead.
labour curve
for hilt
b u r demand B e c a u s e t h s e

m on vur
ourdemand