27-11-2023

Errol D’Souza

The Labour Market AD – AS in the Keynesian Case

Errol D’Souza Keynes argued that money wages are sticky

• Minimum-wage laws that result in an artificial floor

to the wages that firms can pay

• Organized groups of workers seek to keep their

nominal wage at levels they think to be
appropriate relative to other occupations -
workers seek to maintain their position in
the job ladder hierarchy
• Workers and firms adopt implicit contracts. This is
a tacit agreement that firms will not reduce
workers’ wages during an economic downturn
and neither will workers demand a raise in
Email: errol@iima.ac.in wages when business conditions improve

1 2

Errol D’Souza Errol D’Souza

Panel A Panel D
w p1 (MRSY ,l ) p
F p0 (MRSY ,l ) AS
w
Keynesian AS curve
p1 E
D
p0

w
Labour Supply: = MRSC ,l p1MPN
P p0 MPN
N Y
Labour Demand: w N 0D N1D ND = NS N 0S Y0 Y1 YF
= MPN
P Y Y = F (K , N ) Y
AS Curve

Output Supply: Y = F ( K , N ), N = min N D , N S  YF
Y1
Nominal Wage Ridigity: w=w Y0

Panel B Panel C

450 Y
N
N0 N1 NF
Keynesian Aggregate Supply - (see “The Labour Market”)

3 4

1
 27-11-2023

Errol D’Souza Errol D’Souza

Keynesian Aggregate Supply Curve Complete Keynesian System

P AS
IS Curve: Y = C (Y − T , i −  e ) + I (i −  e ) + G
(+) ( −) ( −)

s
AD Curve
LM Curve: M = L( Y , i )
P (+) (−)
Aggregate Price Level

Labour Supply: w
= MRSC ,l
P

Labour Demand: w
= MPN
P
AS Curve
Output Supply: Y = F ( K , N ), N = min N D , N S  
Nominal Wage Ridigity: w=w
Y
YF Aggregate Income
Six unknowns: w, N D , N S , i, P,Y
AS curve is upward sloping as long as N D  N S . At full
employment the AS curve becomes vertical.

5 6

Errol D’Souza Errol D’Souza

Panel A Panel D
w p
p0 (MRSC ,l ) AS
The following diagram depicts a Keynesian situation
Aggregate Price Level

w
where (N 0S − N 0D ) individuals are willing to work
Nominal wage

p0
but no job offers are forthcoming – called a
situation of involuntary unemployment
AD
p0 MPN
N Y
N 0D N 0S Employment Y0 YF Aggregate Output
Y Y = F (K , N ) Y

Y0
Aggregate Output

Y0

Panel B Panel C

Y 450
N
N 0D Employment Aggregate Output
Figure 9.5: Aggregate Demand and Supply in the Keynesian System

7 8

2
 27-11-2023

Errol D’Souza Errol D’Souza

P AS Keynesians are of the view that the low aggregate

demand is due to low confidence of investors
regarding the future prospects of the economy

Investment demand is thought by the Keynesians

Aggregate Price Level

to be unresponsive to the rate of interest and

P0 E the IS curve is considered to be steep

I = a − b(i −  e ) with b a small value

AD

Y Crowding out of private expenditures would be low

Y0 YF Aggregate Income
and so Keynesians advocate fiscal policy
Figure 9.4: The Market for Real Output (Keynesian)
According to Keynes how should we
expand aggregate demand?

9 10

Errol D’Souza Errol D’Souza

b small, or, b → 0 : IS curve is vertical

Keynesian reading of the Great Depression -
i Demand for money interest elastic, e large
IS a + c0 − (1 − c1 )(Y − T ) − (T − G )
i IS = + e Stock markets declined by 85% between Sept.
b + c2
1929 and June 1932

Between 1929 and 1933 GNP in the US fell

E by nearly 30%
LM
M
h + nY −
P
During this period unemployment rose from
i LM =
e 3 to 25 per cent

Net investment was negative from 1931 to

Y 1935
Keynes attributed this to a leftward shift of the IS
Keynesian Fiscalist Case
curve due to low confidence of investors
regarding the future prospects of the economy

11 12

3
 27-11-2023

Errol D’Souza Errol D’Souza

Monetarists such as Friedman attribute the Great

Depression to a leftward shift of the LM curve

As interest rates declined and depositor confidence
in the economy declined they rushed to with-
draw their deposits from banks
Banks were unable to meet depositor demand for
cash and many banks failed
Increase in the desired currency-deposit ratio
resulted in a reduction in the money multiplier
Money stock declined by 26.5 percent between
1929 and 1933
Friedman and Schwartz fault the Federal Reserve
Board in the US for failing to increase the
money and offsetting the decline in aggregate
demand
Monetarists argue that the LM curve is steep and
that an increase in money supply is the
effective policy in shifting the aggregate
demand schedule to the right

13 14

Errol D’Souza Errol D’Souza

Friedman Lucas AS curve

Besides the disagreement regarding demand
management - whether to use fiscal or
monetary policy – Friedman and Lucas
also disagree about the appropriate
construction of the aggregate supply curve Labour Supply: w
= MRSC ,l
Pe
Friedman argued that with workers imperfectly Labour Demand: w
= MPN
P
informed about the price level expectational AS Curve
errors occur and the aggregate supply curve Output Supply: Y = F ( K , N ), N D = N S
for a given expected price AS ( p  pe ) is
upward sloping Price Expectations: (
Pt e+1 = Pt e +  Pt − Pt e )
When expectations are realized we have a vertical
aggregate supply curve, AS ( p = p e )

15 16

4
 27-11-2023

Aggregate Price Level Errol D’Souza Errol D’Souza

Panel A p0e (MRSC ,l )
w p (
AS p = p e ) w Panel A p (
AS p = p e )
Panel D p0e (MRSY ,l ) Panel D
AS ( p1e  p1 )
w1 A
(
AS p0e  p0 ) (
AS p0e  p0 )
Nominal wage

AS ( p2e  p2 )

w0 E w0 E p1MPN p1 A/
p0e = p0
w2 B p0
p2 E/
p0 MPN p0 MPN B/
AD p2 MPN
N Y N Y
Employment Y* Aggregate Output ND = NS Y2 Y1
Y Y Y Y = F (K , N ) Y
Y = F (K , N ) Y1
Y* Y* Y* Y*
Aggregate Output

Y2

Panel B Panel C Panel B Panel C

450 Y 450 Y
N N
N* Employment Aggregate Output N2 N * N1
Diagram XII: Mistaken Expectations Aggregate Supply
Mistaken Expectations AS

17 18

Errol D’Souza Errol D’Souza

Friedman Lucas Complete System Friedman Lucas Complete System

IS Curve: Y = C (Y (−+ )T , i −  ) + I (i −  ) + G IS Curve: Y = C (Y (−+ )T , i −  ) + I (i −  ) + G

e e e e
( −) ( −) ( −) ( −)
AD Curve AD Curve
LM Curve: Ms LM Curve: Ms
= L( Y , i ) = L( Y , i )
P (+) (−) P (+) (−)

Labour Supply: w Labour Supply: w

= MRSC ,l = MRSC ,l
Pe Pe
Labour Demand: w Labour Demand: w
= MPN = MPN
P P
AS Curve AS Curve
D S
Output Supply: Y = F ( K , N ), N = N Output Supply: Y = F ( K , N ), N D = N S

Price Expectations: (
Pt e+1 = Pt e +  Pt − Pt e
) Price Expectations: (
Pt e+1 = Pt e +  Pt − Pt e )
Suppose the AD curve intersects the AS curve when
price expectations are p0e at point M to the left of
the natural rate of output, Y *

19 20

5
 27-11-2023

Aggregate Price Level Errol D’Souza Errol D’Souza

Panel A p0e (MRSC ,l )
w p (
AS p = p e )
Panel D

(
AS p0e  p0 ) Workers have expected a price higher than the realized
Nominal wage

price, p0e  p1
w0 E
p0e = p0
p1e = p1 M They realized a nominal wage w1 that is lower than
p0 MPN what they expected to realize (w0 )
AD
N
Employment Y1 Y* Aggregate Output
Y Employment and output are lower than the natural
Y Y rate of output, Y1  Y *
Y = F (K , N )
Y* Y*
Aggregate Output

Y1
Y1

Panel B Panel C

450 Y
N
N* Employment Aggregate Output
Figure 9.6 : Mistaken Expectations and AD - AS

21 22

Aggregate Price Level Errol D’Souza Errol D’Souza

Panel A
p0e (MRSC ,l )
w p (
AS p = p e )
Panel D

(
AS p0e  p0 ) Workers have expected a price higher than the realized
Nominal wage

price, p0e  p1
w0 E
p0e = p0
w1 p1e = p1
M They realized a nominal wage w1 that is lower than
p0 MPN what they expected to realize (w0 )
AD
p1MPN
N
Employment Y1 Y* Aggregate Output
Y Employment and output are lower than the natural
Y Y rate of output, Y1  Y *
Y = F (K , N )
Y*
As workers adapt to this outcome they will revise
Y*
Aggregate Output

Y1 their expectation of prices downwards and

Y1
the supply of labour will shift down pushing
the money wage down as well
Panel B Panel C
Initially the downward revision of price expectations
N
450 Y to say, pie , will result in the mistaken expect-
N* Employment
Figure 9.6 : Mistaken Expectations and AD - AS
Aggregate Output
ation aggregate supply function AS ( pie  pi )

23 24

6
 27-11-2023

Aggregate Price Level Errol D’Souza Errol D’Souza

Panel A p0e (MRSC ,l )
w p (
AS p = p e )
Panel D

(
AS p0e  p0 ) Workers are still expecting a price level above the one
Nominal wage

(
AS pie  pi ) that actually obtains at the intersection of the
w0 E
p0e = p0 AS ( pie  pi ) and the AD curve.
w1 p1e = p1 M
p e = pi
p0 MPN i
They will then continue to revise their expectation
p1MPN
AD of the price downwards until price expectat-
N
Employment Y1 Y* Aggregate Output
Y ions are consonant with experienced prices,
Y Y pne = pn
Y = F (K , N )
Y*
Operative mistaken expectations AS curve then
Y*
Aggregate Output

Y1 is AS ( pne  pn )
Y1

Panel B Panel C

450 Y
N
N* Employment Aggregate Output
Figure 9.6 : Mistaken Expectations and AD - AS

25 26

Aggregate Price Level Errol D’Souza Errol D’Souza

Panel A
p0e (MRSC ,l )
w p (
AS p = p e )
Panel D

pne (MRSC ,l ) (
AS p0e  p0 ) Adaptive expectations mechanism has restored
Nominal wage

(
AS pie  pi ) employment to its natural rate and there
w0 E (
AS pne  pn ) is no need for government intervention in
p0e = p0
w1 p1e = p1 M the form of AD management.
pie = pi
wn p0 MPN pn
AD
pn MPN p1MPN
N
If in this Monetarist set up government
Y* Y
Employment Y1 Aggregate Output manipulated aggregate demand and
Y Y shifted the AD curve to the right it would
Y = F (K , N )
push up the price level exactly at a time
Y* Y*
Aggregate Output

Y1
when workers are revising their expectation
Y1 of prices in the reverse direction

Panel B Panel C

450 Y
N
N* Employment Aggregate Output
Figure 9.6 : Mistaken Expectations and AD - AS

27 28

7
 27-11-2023

Errol D’Souza Errol D’Souza

Essence of the Keynesian Monetarist debate is is about If markets self correct with reasonable accuracy
whether governments should intervene by and speed, it is expedient to allow markets
manipulating aggregate demand judiciously so to solve economic problems such as
as to achieve full employment or should market employment
forces be relied on to eventually bring about the
necessary adjustment of the real and nominal
wage

Macroeconomists prefer state intervention if their

prior belief is that money wage are sticky and
respond only sluggishly or with large inertia to
excess supply in the labour market

29 30