X neoclassical synthesis
1 / 44

X. Neoclassical synthesis - PowerPoint PPT Presentation

  • Uploaded on

X. Neoclassical synthesis. X.1 Keynes vs. real world. Keynes: theory. Macroeconomics Equilibrium with unemployment Incompatibility with standard microeconomics It is NOT “General Theory”, but theory for economies in depression

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
Download Presentation

PowerPoint Slideshow about ' X. Neoclassical synthesis' - ferrol

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

Keynes theory
Keynes: theory

  • Macroeconomics

  • Equilibrium with unemployment

  • Incompatibility with standard microeconomics

  • It is NOT “General Theory”, but theory for economies in depression

    • The existence of equilibrium – in a strict sense - depends on assumption of rigid nominal wage

Keynes ad and as
Keynes: AD and AS

  • AD (for simplicity, still assume πe=0, i.e. i=r):

    • in LVII, slide 39, substitute (5) and (6) into (1),

    • Solve (4) for dr:

      and substitute into (1) as well; we obtain:

  • AS: in the same slide, substitute (3) into (2) (and dK=0):

  • In AD schedule, increase of P implies decrease of Y, in AS schedule, increase of P implies increase of Y

Keynes equilibrium and policies
Keynes: equilibrium and policies

  • In the more general Keynesian model, we can construct standard AD and AS schedules

  • Equilibrium: AD x AS intersection

    • However, equilibrium determined by position of AD and does not have to correspond to full employment one

  • Keynesian policies: shifting AD to the position where it determines equilibrium at full employment








Keynes true legacy for policies
Keynes: true legacy for policies

General acceptance of policy recommendations:

  • Capitalism does not have internal forces to produce at full employment (potential product) continuously

  • The Governments can and should stimulate the aggregate demand to bring economies closer to full employment

  • The General Theory (and its ISLM simplification) provides the tools: fiscal and monetary policies

First applications
First applications

  • During WWII, both in UK and in the USA

    • White Paper on Employment Policy

    • William Beveridge: Full Employment in a Free Society

    • Oxford Institute of Statistics: The Economics of Full Employment

    • Policy: British budget of 1941, US budgets since 1942

Keynes vs real world 1
Keynes vs. real world (1)

  • AD and AS above – general version of Keynesian model, AS not very useful for practical for several reasons

    • Nominal wage given, inflationary expectation also constant

  • In the short-run: prices and wages rigid for many reasons

    • Informational problem, slow reaction of firms (do not change prices and wages instantaneously, etc. – see next chapters)

    • This is true for any point of business cycle, not only for depression

  • Consequently, in the (very) short-run, wages and prices constant: aggregate supply horizontal - SRAS

Keynes vs real world 2
Keynes vs. real world (2)

  • In the real world the prices adjust and clear markets, even if in very short run sticky

  • When capital fixed, then product given by employment, and when after full adjustment of prices and wages labor market is in equilibrium as well, then this (equilibrium) employment determines full employment and potential product

  • Neoclassical synthesis: in the long-run: aggregate supply vertical (classical) - LRAS

X 2 the first attempt downward nominal wage rigidity
X.2 The first attempt – downward nominal wage rigidity

  • Originally: F.Modigliani (1944) – downward wage rigidity

  • Reasons for rigid wages in general:

    • Long-term wage contracts, implicit wage agreements, power of trade unions

    • Some flexibility upward

  • Intuitively: if nominal wage rigid, then price increase lowers real wage  firms increase employment  product increases, i.e. demand increasing function of price

Franco modigliani
Franco Modigliani

  • 1918-2003, born in Rome, when young, immigrated to the USA

  • MIT

  • 1944: elements of neoclassical synthesis (PhD)

  • 1953: new theory of consumption function (life cycle hypothesis)

  • 1958: contribution to the theory of money, Modigliani-Miller theorem

  • 1985: Nobel price in economics


  • Only for situation when product smaller or equal to potential (full employment) product

  • Labor market

    • Either in equilibrium – full employment and potential product

    • Or product lower than potential, involuntary unemployment  labor supply higher than demand and level of employment determined by demand (when , quantity realized on the market always equal to min (D,S))










Wage rigidity weakness of the model
Wage rigidity – weakness of the model

  • Model explains the relation between the fall or increase of price and aggregate supply, when product lower or equal to potential one

  • Does not consider the situation, when product temporarily increases above potential level

  • Real wages move against business cycle

Dynamic adjustment
Dynamic adjustment

  • Nominal wages aren’t downward rigid forever, but there is a slow adjustment (“beyond the short-run”) → there is an adjustment of labor supply over particular moment of time

  • 1958: A.W.Phillips: The Relation between Unemployment and the Role of Change of Money Wages. British data.

    • First investigation before Phillips: Irving Fisher already in 1926

    • Inverse relationship between unemployment and nominal wage change

    • Phillips: statistical fit for 1861-1913:

    • 1948-1957 data fitted to this curve very well, too


  • High unemployment: bargaining power of workers during wage negotiations is weak, firms are able to hire additional workers without offering much increase in nominal wage

  • Low unemployment: bargaining power of firms weak, as to hire more workers they must offer more substantial nominal wage increase

  • Wage main component of prices

  • Consequently: high unemployment implies low inflation and vice versa


  • Data seemed to suggest that there is a negative relation between change of nominal wages and unemployment

  • Two crucial questions:

    • Is this a stable, long-term relationship, valid for other countries as well (see US data on the next slide, for original Phillips data see Dornbush, Fischer,Startz in Literature to this Lecture)?

      • Many empirical studies followed

    • Theoretical explanation of this relationship

  • Policy consequences:

    • As in the short run, change in wages determine inflation, is there a trade-off between inflation and unemployment that can be effectively used by policy makers to simultaneously achieve both low inflation and low unemployment?

Phillips curve concept
Phillips curve - concept

  • Note: here, in LX, we present original approach, as emerged after Philips‘ article in 1958

  • Define unemployment as u≡(NS-N)/NS

    • Remember: in K. model, we do not include labor supply function, but it exists, as NS(W/P)

    • However, in a particular moment of time, real wage W/P real wage is known, so value of labor supply NS is known as well (but in general,

      N≠ NS)

Phillips curve formalization 1
Phillips curve – formalization (1)

  • From above:

  • To simplify, suppose discrete time:

    and after rearrangement

  • Nominal wage in the next period is a function of current wage and a ratio current employment N and current labor supply NS

Phillips curve formalization 2
Phillips curve – formalization (2)

  • In words: wage in next period is equal wage in the current period, adjusted for the actual level of employment

    • At full employment (N=NS), next period wage equals current one

    • If employment is above full employment, (N>NS), wage in next period increases (and vice-versa)

  • Speed of adjustment – parameter ε

  • Formally: at present, W, NS constant  linear relation (WN line), with positive slope, between W+1 and N

    • ε large, WN steep. Ε small, WN approaches horizontal

Wage adjustment
Wage adjustment









WN always passes through (NS,W)

If NNS, WNshifts in time

From wages to prices
From wages to prices

  • Short-term: labor costs - the only variable costs

  • Price determined by current labor costs plus a mark-up z > 0 (e.g. profit, embedded in price)

  • Simplification (for this chapter only) - production function with fixed coefficients:

    a ... labor productivity

    • labor costs per unit of output: (1/a).W

  • Price (with incorporation of mark-up)

Dynamic as 1
Dynamic AS (1)

Building blocks

  • Phillips curve:

  • Link from wages to prices:

  • Additional assumption: output and unemployment closely linked (in next Lectures Okun’s law):

    , ω>0

  • Combining three equations above, see next slide

Dynamic as 2
Dynamic AS (2)


then combining the three equation and


Simplifying as

Dynamic as 21
Dynamic AS (2)

  • In words: price in the next period is equal price in the current period, adjusted for the difference between actual output and full employment one

    • Difference between actual output and Yf: concept of output gap – see future Lectures

  • AS is very steep for λ>>0, very flat for λ→0

  • Dynamics: AS shifts in time (always runs through point [Yf,P]) – see next slide

Dynamic aggregate supply
Dynamic aggregate supply









AS always passes through (Yf,P)

If YYf, ASshifts in time

Adjustment 1
Adjustment (1)

Assume starting point Yf at P+1 = P, different time periods and increase in nominal money.

  • Very short run: wages (and prices) don’t have any time to adjust → horizontal AS. An increase in nominal money leads to decrease in interest rate i and, because of the larger investment demand, leads to the increase of overall aggregate demand → excess demand

Adjustment 2
Adjustment (2)

  • Short to medium run: Excess demand → firms intend to increase the production, hiring more people → wages (and prices) slowly start to adjust (both nominal wage and price increase). An initial shift of AD (in the very short run) is partially offset, as in medium run, AS is positively sloped

  • New (static) equilibrium, as intersection of AD and AS. Not a dynamic one, adjustment not finished yet

    • W+1 ≠ W and P+1 ≠ P

  • Medium and long run: AS continues to shift to the left till the output doesn’t fall back to Yf, but with higher price P

    • Both static and dynamic equilibrium restored

Medium to long term adjustment
Medium- to long-term adjustment










P (=P-1)





Adjustment summary
Adjustment - summary

  • Aggregate demand: both in short- and long-run decreasing function of price

  • Aggregate supply

    • In the long-run: vertical at potential product, long-run aggregate supply (LRAS)

    • In very short-run (ISLM): horizontal at fixed price, short-run aggregate supply (SRAS)

    • In medium term: positively sloped AS

  • Shifts in AD

    • In the long-run, do not change product, but over-all price level – consistent with classical model

    • In very short-run, do change the level of product (and employment), but price is fixed – consistent with original version of Keynesian model

Short run shift of ad external shock that contracts ad
Short-run shift of AD(external shock that contracts AD)




Long run shifts of ad external shock that contracts ad
Long-run shifts of ADexternal shock that contracts AD




From short to long run 1
From short- to long-run (1)

  • Short-run equilibrium:

    • AD equals AS, adjustment through quantities  AS adjusts to AD

    • Price fixed, equilibrium as state of rest, there can be excess supply on labor market (involuntary unemployment)

    • Actual product can be lower than potential one

  • Long-run equilibrium:

    • AD equals AS

    • Simultaneous adjustment of all prices generates equilibrium on all markets

    • Actual product equal to potential one

Long run equilibrium
Long-run equilibrium







From short to long run 2
From short- to long-run (2)

Intuitive interpretation:

  • Fixed price corresponds either to the depression (Keynes) or to very short-run, when prices (and wages) are fixed in all economies and at (almost) all situations (exceptions – e.g. hyperinflations)

  • Long-run equilibrium – prices and wages had to react to changes in demand/supplies on all markets (including labor) and their adjustment cleared all markets simultaneously

Neoclassical synthesis summary
Neoclassical synthesis - summary

  • Neoclassical synthesis: in the short and medium run, a change of policy variables (e.g. G, M, T(.), etc.) can change (in the Keynesian tradition) the level of output. However, in the long run, there is always a built-in mechanism, which (in the classical tradition) brings the economy back to the full employment level of output, albeit with a different price level.

Phillips curve implication
Phillips curve implication

  • There is a trade-off between inflation and unemployment

    • Higher unemployment → lower inflation and vice versa

  • Trade off, combined Keynesian demand management of either fiscal or monetary nature, was perceived as a basis for Keynesian economic policy after first period of post-war reconstruction

  • This initial belief to potential trade-off between unemployment and inflation, based on original Phillips curve, proved to be one of the biggest mistakes of modern macroeconomics

  • Later lectures: incorporation of inflationary expectations into Phillips curve

Literature to ch x
Literature to Ch. X

  • The Phillips curve, derivation of AS and dynamic adjustment explained here according Dornbusch, Fischer, Startz, Ch. 6

    • Including the simplification when production function has fixed coefficients and depends on labor only

  • Snowdon, B., Vane, H., Modern Macroeconomics, Edward Elgar Publishing, 2005., pp. 135 – 144

    • More detailed, but simple and comprehensive explanation

  • Downward wage rigidity: Modigliani, F., Liquidity- Preference and the Theory of Interest and Money, Econometrica XII (1944), pp. 45-88, reprinted in many Macroeconomic Readings

    • It is always worth to read this original attempt to deal with Keynes

  • General discussion of AD and AS in Keynesian model: Sargent, Macroeconomics, Ch. 2