Meeting 8 - Keynesian model of unemployment (Macroeconomics)

Macroeconomics subject
For undergraduate students (semester 2)

1. Keynesian model of Unemployment Meeting 8

2. Warming up quiz 1 GDP Equation C+I+G+Xn Consumption (C), Investment (I), Government Spending (G) and Net Exports ( Xn ) same as AD curve factors Unemployment rate formula (Unemployed/Total labour force) x 100% Natural rate of unemployment Around 5% AS shock example Oil shock OPEC stagflation 1970-1980s Hyperinflation example Zimbabwe, Venezuela Indonesian inflation rate 3-4% Indonesian unemployment rate 5-6%

3. Warming up quiz 2 What is Phillips curve Model of inverse relationship between inflation and unemployment What is menu costs costly price adjustment What is frictional unemployment When you change location or transiting from one job to another Who created macroeconomics? Keynes Years of Great Depression 1929-1939 Which theory thought money and wages are flexible? Classic theory Says law Supply created Demand

4. Menjelaskan model keynesian : pasar tenaga kerja dengan money wage rigidity Explains the Keynesian model: the labour market with money wage rigidity

5. Key facts Keynes rejected the classic idea of full employment Because of Great Depression 1930-s → massive unemployment Involuntary unemployment (underemployment) (if, at the going wage rate, people do not find employment a situation of unemployment emerges) Keynes rejected also the classic wage flexibility → wage rigidity ( upah kaku ) There are two reasons for wage inflexibility: 1. money illusion 2. institutional reason ( trade unions prevent wage rate from falling → wage rate cannot fall below a certain level) Labour supply function , unlike the classical system, is a function of the money wages ( nominal ), rather than real wages

6. What is Money Illusion Tendency of people to think of currency in nominal, rather than real, terms Many people have an illusory picture of their wealth and income based on nominal money terms, rather than real terms. Real prices and income take into account the level of inflation in an economy. Money illusion is a psychological matter that is debated among economists. Some feel that people automatically think of their money in real terms, based on the prices of things they see around them. However, there are several reasons why the money illusion likely exists for many people, including a general lack of financial education, and the price stickiness seen in many goods and services. This term is attributed to noted economist John Maynard Keynes. Money illusion is often cited as a reason why small levels of inflation (1-2% per year) are actually desirable for an economy. Having small levels of inflation allows employers, for example, to modestly raise wages in nominal terms without actually paying more in real terms. As a result, many people who get pay raises believe that their wealth is increasing, regardless of the actual rate of inflation.

7. Cyclical (Keynesian) unemployment Is the deviation of unemployment from its natural rate . The natural rate of unemployment (5.5%) is the normal rate of unemployment around which the unemployment rate fluctuates. Cyclical (Keynesian) unemployment is caused by downturns in the economy that are part of the business cycle . The business cycle is the natural fluctuations in the economy.

8. John Maynard Keynes (1883-1946) British economist who popularized the idea that the government should play an active role in managing the economy. This is a different from Classical economic theory, which suggests there is no role for government because the economy corrects itself. Keynes agreed that the economy might correct itself in the long run . However, he thought a natural correction might take an extremely long time.

9. The remedy for Keynesian unemployment 1 Is an increase in overall spending on newly produced goods and services, which economists refer to as aggregate demand . In the U.S. economy, increased demand for American products encourages U.S. businesses to produce more output . Businesses may hire additional workers to help produce the additional output needed to satisfy the increased demand . Thus, increased aggregate demand tends to reduce unemployment. ↑D → ↑Q → ↑N

10. The remedy for Keynesian unemployment 2 Classicalists believed that the way to maintain full employment was to cut wages and reduce taxes. Keynes spoke out against this, stating that “The best way to destroy the capitalist system was to debauch the currency.”( Skidelsky 40). Because the economy was determined by demand, the cut in wages would reduce employee income, decreasing consumer spending. This reduces demand for products, leading to a reduction in production, forcing companies to not only cut wages, but lay off employees. Now the employees (and former employees) are now even more unable to spend, decreasing both consumer spending and demand. If it goes on like this, the recovery will be unforeseeable. Reducing taxes wasn't an option for the government when their budget was out of control due to the reduction of tax revenues. The way to recovery is to encourage spending. By encouraging consumers and firms alike to increase spending, demand will increase. This will increase quantity produced, leaving companies to need to hire more employees, increasing employee income, making them able to spend more. Put this all together and you get an increase in aggregate demand. This encourages production and helps the economy out of recession/depression.

11. The remedy for Keynesian unemployment 3 Although a believer in free trade (John Maynard Keynes), Keynes believed that Government interference is beneficial to an economy. Through Fiscal and Monetary policies, the government use spending of goods or services to reduce the business cycle. Government spending reduces the price for goods and services, making it more affordable. This increase demand and consumer spending. With the increase in demand, companies need to produce more. So, they will have to hire more employees. The newly hired employees will have more income, leaving them more able to spend. This increases demand and consumer spending. The perfect example is Franklin D. Roosevelt's New Deal, which created agricultural jobs for unemployed farmers. It gave farmers the opportunities taken away from them by the dust bowl. This gave them a wage, which they could use for consumer spending. This of course increased aggregate demand.

12. Keynesian model: Labour supply function Labour supply curve SL has two parts: Because of the rigid wage rate, SL is perfectly elastic. Assume that there is a fixed wage, W. The associated SL curve is horizontal in this region. Above this wage rate, money wages are free to rise. Thus, the labour supply curve SL in this region must be positive sloping.

13. Keynesian model: Labour demand function Labour demand curve DL, however, in the Keynesian system, is assumed to be negatively related to the real wage rate . DL curve shows this relationship.

14. Keynesian model: equilibrium Equilibrium in the labour mar­ket is established when DL curve intersects the DS curve at its hori­zontal portion. Thus, point E describes under­employment equilibrium.

15. Keynesian model: equilibrium (Involuntary Unemployment) Point E Equilibrium: when DL curve intersects the DS curve at its hori­zontal portion. Corresponding equilibrium real wage rate is (W/P)E. At this wage rate, LF people are willing to work while LE people are employed. The difference be­tween the two (LE – LF or EF) measures invol­untary unemployment.

16. Keynesian model: wage rigidity According to Keynes, wage rigidity is the cause of involuntary unemployment. This means that a free enterprise capitalist economy always fails to reach full employment because of wage rigidity. He also gave two other rea­sons: 1. liquidity trap , and 2. interest inelas­ticity of investment—for the failure of a capi­talist economy to reach the state of full em­ployment.

17. Great Depression Unemployment rate: 25%

18. New Keynesian approach 1 1970-1980s Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations. New Keynesians assume that there is imperfect competition in price and wage setting to help explain why prices and wages can become "sticky", which means they do not adjust instantaneously to changes in economic conditions.

19. New Keynesian approach 2 Wage and price stickiness, and the other market failures present in New Keynesian models, imply that the economy may fail to attain full employment. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy would.

20. Neo-Keynesian model Mix of New Classical and Keynesian models Efficiency wage models: They are used to explain long-term effects of previous unemployment , where short-term increases in unemployment become permanent and lead to higher levels of unemployment in the long-run. Workers are paid at levels that maximize productivity instead of clearing the market. For example, in developing countries, firms might pay more than a market rate to ensure their workers can afford enough nutrition to be productive. Firms might also pay higher wages to increase loyalty and morale, possibly leading to better productivity. Firms can also pay higher than market wages to forestall shirking (tukang bolos). Carl Shapiro and Joseph Stiglitz's in 1984 created a model where employees tend to avoid work unless firms can monitor worker effort and threaten slacking employees with unemployment. If the economy is at full employment, a fired shirker (tukang bolos) simply moves to a new job . Individual firms pay their workers a premium over the market rate to ensure their workers would rather work and keep their current job instead of shirking and risk having to move to a new job.

21. The new neoclassical synthesis 1990-s In the early 1990s, economists began to combine the elements of new Keynesian economics developed in the 1980s and earlier with Real Business Cycle Theory. RBC models were dynamic but assumed perfect competition; new Keynesian models were primarily static but based on imperfect competition. The New neoclassical synthesis essentially combined the dynamic aspects of RBC with imperfect competition and nominal rigidities of new Keynesian models.