y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

O
W

h a n g e Vi
e

PD

XC

er

O
W

F-

h a n g e Vi
e

PD

XC

er

F-

c u -tr a c k

.c

004: Macroeconomic Theory

Lecture 1
Mausumi Das
Lecture Notes, DSE

July 24, 2014

Das (Lecture Notes, DSE)

Macro

July 24, 2014

1 / 18

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
e

N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

h a n g e Vi
e

Keynes & the Classics: Reference

c u -tr a c k

.c

W. Scarth: Macroeconomics; Chapter 1; Pages 1-21.

(Photocopy of the chapter available at the Photocopy Shop and in
the course folder of the CDE server (C:/Courses/004)

Das (Lecture Notes, DSE)

Macro

July 24, 2014

2 / 18

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
e

N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

h a n g e Vi
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Keynes & the Classics: Some Preliminaries

c u -tr a c k

.c

Both the system summarise the aggregate economy in terms of three

institutions:
The Goods Market
The Labour Market
The Money Market

The major dierence between the two system arises from the
description of the labour market.

Das (Lecture Notes, DSE)

Macro

July 24, 2014

3 / 18

h a n g e Vi
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PD

XC

N
y
to
k
lic

.c

.d o

c u -tr a c k

Supply Equation:

.d o

lic

to

The Goods Market:

w

bu

bu

O
W

F-

er

XC

er

PD

F-

O
W

h a n g e Vi
e

The Classical System (in equations)

c u -tr a c k

Y = F (N, K ); FN , FK > 0; FNN , FKK < 0

.c

(1)

Demand Equation:
Y = C (Y ) + I (r ) + G ; 0 < C 0 (Y ) < 1; I 0 (r ) < 0

(2)

The Labour Market:

Supply Equation:
W = Pg (N ); g 0 (N ) > 0

(3)

W = PFN (N, K )

(4)

M=M

(5)

Demand Equation:

The Money Market:

Supply Equation:
Demand Equation:
M = PL(Y , r ); LY > 0; Lr < 0
Das (Lecture Notes, DSE)

Macro

(6)
July 24, 2014

4 / 18

!
y

c u -tr a c k

.d o

.c
Solution
consists of

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
e

N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

h a n g e Vi
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The Classical System: Solution

c u -tr a c k

.c

Equilibrium values of the Price & Quantity in the Goods Market:

P ,Y
Equilibrium values of the Price & Quantity in the Labour Market:
W ,N
Equilibrium values of the Price & Quantity in the Money Market:
r ,M
(A Clarication: We have assumed i = r ; i.e., the nominal and the real
interest rates are the same. This happens only under specic
assumption about the expected rate of ination. We shall get back to
this point later)

The equations being interdependent, we cannot solve for the

equilibrium values of quantities & prices in each market separately. So
we follow a more round-about method.

Das (Lecture Notes, DSE)

Macro

July 24, 2014

5 / 18

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
e

N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

h a n g e Vi
e

The Classical System: Solution (contd.)

c u -tr a c k

.c

We club the SS & DD equations in the Labour Market and the SS

equation in the Goods Market together:
Y = F (N, K ); FN , FK > 0; FNN , FKK < 0

(1)

W = Pg (N ); g 0 (N ) > 0

(3)

W = PFN (N, K )

(4)

This sub-system involves four endogenous variables: Y , N, W and P.

We eliminate two of these variables to get a relationship between P
and Y - which we call the aggregate supply curve (AS).

Das (Lecture Notes, DSE)

Macro

July 24, 2014

6 / 18

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
e

N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

h a n g e Vi
e

The Classical System: Solution (contd.)

c u -tr a c k

.c

We then club the SS & DD equations in the Money Market and the
DD equation in the Goods Market together:
Y = C (Y ) + I (r ) + G ; 0 < C 0 (Y ) < 1; I 0 (r ) < 0

(2)

M=M

(5)

M = PL(Y , r ); LY > 0; Lr < 0

(6)

This sub-system involves four endogenous variables: Y , r , M and P.

We eliminate two of these variables to get another relationship
between P and Y - which we call the aggregate demand curve (AD).

Das (Lecture Notes, DSE)

Macro

July 24, 2014

7 / 18

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
e

N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

h a n g e Vi
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The Classical System: Solution (contd.)

c u -tr a c k

.c

We then simultaneously plot the the AS and AD schedule in the Y -P

plane to determine the equlibrium price level P and equlibrium
output Y in the Goods Market.
Once these two values are determined, other equilibrium values can
be found by substituting these back in the other equations.

Das (Lecture Notes, DSE)

Macro

July 24, 2014

8 / 18

h a n g e Vi
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h a n g e Vi
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Derivation of the AS Schedule under the Classical System:

Graphical Method
!

XC

w
c
.d o
k.
Plot . c(3) and (4) in the N-W plane (assuming some arbitrarily
cgiven
u -tr a c
value of P):

.d o

lic

to

bu

bu

to

k
lic
C

O
W

PD

F-

O
W

er

XC

er

PD

F-

c u -tr a c k

Das (Lecture Notes, DSE)

Macro

July 24, 2014

9 / 18

h a n g e Vi
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h a n g e Vi
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Derivation of the AS Schedule under the Classical System:

Graphical Method (Contd.)
!

O
W

c u -tr a c k

.d o

.c

lic

to

bu

PD

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

c u -tr a c k

.c

Now increase P to a higher level, say P 0 :

The N S curve shifts out proportionally - diverging away from the
earlier curve for higher values of N (Why?)
The N D curve also shifts out proportionally - but it converges closer to
the earlier curve for higher values of N (Why?)
However the new point of intersection still remains N (Why?)

Das (Lecture Notes, DSE)

Macro

July 24, 2014

10 / 18

h a n g e Vi
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h a n g e Vi
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Derivation of the AS Schedule under the Classical System:

Graphical Method (Contd.)
!

O
W

Das (Lecture Notes, DSE)

Macro

.d o

.c
Correspondingly,
the output supplied remains xed at Y :

c u -tr a c k

lic

to

bu

PD

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

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F-

c u -tr a c k

July 24, 2014

.c

11 / 18

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h a n g e Vi
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Derivation of the AS Schedule under the Classical System:

Graphical Method (Contd.)
!

O
W

c u -tr a c k

.d o

.c

lic

to

bu

PD

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

c u -tr a c k

.c

In other words, the AS Schedule under the Classical System is

Vertical:

Das (Lecture Notes, DSE)

Macro

July 24, 2014

12 / 18

h a n g e Vi
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h a n g e Vi
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Derivation of the AD Schedule under the Classical System:

Graphical Method
!

O
W

c u -tr a c k

.d o

.c

lic

to

bu

PD

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

c u -tr a c k

.c

In deriving the AD Schedule, rst notice that the Money Supply

Function is constant. This allows us to write the Money Market
Equlibrium condition as:
= PL(Y , r ); LY > 0; Lr < 0
M

(7)

This is the so-called LM curve, which represents a relationship

between Y , r and P.
On the other hand the Demand Equation for the Goods market
represents another relationship between Y and r :
Y = C (Y ) + I (r ) + G ; 0 < C 0 (Y ) < 1; I 0 (r ) < 0

(2)

This is the so-called IS curve.

Das (Lecture Notes, DSE)

Macro

July 24, 2014

13 / 18

h a n g e Vi
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h a n g e Vi
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Derivation of the AD Schedule under the Classical System:

Graphical Method (Contd.)
!

O
W

lic

to

bu

PD

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

.c
.d o
c u -tr a c k
Plot . cthe IS and the LM curve in the Y -r plane (assuming some
arbitrarily given value of P):

c u -tr a c k

Das (Lecture Notes, DSE)

Macro

July 24, 2014

14 / 18

h a n g e Vi
e

h a n g e Vi
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Derivation of the AD Schedule under the Classical System:

Graphical Method (Contd.)
!

O
W

lic

to

bu

PD

.c
.d o
c u -tr a c k
Now. c increase P to a higher level, say P 0 :
The LM curve shifts out proportionally - diverging away from the
earlier curve for higher values of Y (Why?)

c u -tr a c k

Das (Lecture Notes, DSE)

Macro

July 24, 2014

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

15 / 18

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h a n g e Vi
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Derivation of the AD Schedule under the Classical System:

Graphical Method (Contd.)
!

O
W

c u -tr a c k

.d o

.c

The IS Curve remains unchanged.

lic

to

bu

PD

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

c u -tr a c k

.c

Thus the new point of intersection shifts to the left:

Das (Lecture Notes, DSE)

Macro

July 24, 2014

16 / 18

h a n g e Vi
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h a n g e Vi
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Derivation of the AD Schedule under the Classical System:

Graphical Method (Contd.)
!

XC

w
.c
.c
.d o
In other
words, the AD Schedule under the Classical System
c u - t r is
ack
Downward Sloping:

.d o

lic

to

bu

bu

to

k
lic
C

O
W

PD

F-

O
W

er

XC

er

PD

F-

c u -tr a c k

Das (Lecture Notes, DSE)

Macro

July 24, 2014

17 / 18

bu

to

o
c

lic
C
w

.d o

O
W

PD

bu

to

k
lic
C

h a n g e Vi
e

XC

er

O
W

F-

PD

XC

er

F-

h a n g e Vi
e

Characterization of the Equilibrium under the Classical

System:

.
k.
Equilibrium
price and quantity in the Goods Market - P and . dYo c u - t r-a c are
determined simultaneously by the intersection of the AS and the AD
schedule:

c u -tr a c k

Das (Lecture Notes, DSE)

Macro

July 24, 2014

18 / 18

y
o

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

O
W

h a n g e Vi
e

PD

XC

er

O
W

F-

h a n g e Vi
e

PD

XC

er

F-

c u -tr a c k

.c

004: Macroeconomic Theory

Lecture 2
Mausumi Das
Lecture Notes, DSE

July 25, 2014

Das (Lecture Notes, DSE)

Macro

July 25, 2014

1 / 15

bu

to

lic
C
w

.d o

O
W

PD

bu

to

k
lic
C

h a n g e Vi
e

XC

er

O
W

F-

PD

XC

er

F-

h a n g e Vi
e

Characterization of the Equilibrium under the Classical

System:

c
.c
k.
Equilibrium
price and quantity in the Goods Market - P and . dYo c u - t r-a c are
determined simultaneously by the intersection of the AS and the AD
schedule:

c u -tr a c k

Das (Lecture Notes, DSE)

Macro

July 25, 2014

2 / 15

h a n g e Vi
e

O
W

c u -tr a c k

.d o

.c

lic

to

bu

PD

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

h a n g e Vi
e

Eectiveness of Government Policies under the Classical

System:

c u -tr a c k

.c

We shall talk about two kinds of government policies:

Fiscal Policy - which usually changes the amount of government
expenditure (G )
Monetary Policy - which usually changes the amount of money supply

(M)

There could be other forms of government policies (scal, monetary,

or directly interventionist policies) - e.g. taxes; government
borrowing; governement directly inuencing the wage rate or price
level in the goods/labour market or the interest rate in the money
market - which we shall talk about later.

Das (Lecture Notes, DSE)

Macro

July 25, 2014

3 / 15

XC

h a n g e Vi
e

.c
The . cstandard Fiscal and Monetary Policies (which aect onlyw . d othe
c u -tr a c k
demand side of the economy) are completely ineective in raising
the equilibrium output and employment under the classical system:

.d o

lic

to

bu

bu

to

k
lic
C

O
W

PD

F-

O
W

er

XC

er

PD

F-

h a n g e Vi
e

Eectiveness of Government Policies under the Classical

System (contd.):
c u -tr a c k

Das (Lecture Notes, DSE)

Macro

July 25, 2014

4 / 15

XC

h a n g e Vi
e

y
lic

to

bu

y
bu
to
k

lic
C
.d o

So far
we had not introduced taxes in our model. Let us noww .
.c
.c
do
c u -tr a c k
introduce a proportional income tax (t).
w

O
W

F-

O
W

er

XC

er

PD

F-

PD

h a n g e Vi
e

Proportional Income Tax - A Possible Exception?

c u -tr a c k

This changes the disposable income -available to the household for

consumption:
C d = C (Y

tY ) = C (Y d ); 0 < C 0 (Y d ) < 1

Thus the demand equation in the Goods Market now becomes:

Y = C (Y d ) + I (r ) + G ; 0 < C 0 (Y d ) < 1; I 0 (r ) < 0
The correspoding IS curve (representing the demand condition in the
Goods Market in the Y -r plane) still looks the similar.
But a change in a tax rate will now shift the IS curve, but not the LM
curve. Thus the AD schedule gets aected too.
Das (Lecture Notes, DSE)

Macro

July 25, 2014

5 / 15

h a n g e Vi
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h a n g e Vi
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Proportional Income Tax - A Possible Exception? (Contd.)

y
bu

y
bu

.c

Das (Lecture Notes, DSE)

Macro

to
k
.d o

c u -tr a c k

lic
w

.d o

lic

to

Suppose tax rate decreases from t to t 0 :

w

O
W

PD

XC

O
W

F-

er

XC

er

PD

F-

c u -tr a c k

July 25, 2014

.c

6 / 15

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h a n g e Vi
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Proportional Income Tax - A Possible Exception? (Contd.)

!

O
W

.d o

But . cthis is not the end of the story!!

c u -tr a c k

lic

to

bu

PD

.d o

lic

to

bu

N
m

XC

er

O
W

F-

PD

XC

er

F-

c u -tr a c k

.c

If incomes are taxed then so would be wage income!So the eective

wage rate - relevent for the households (and only for the households)
is now (1 t )W - not W !
In other words, the supply equation in the labour market now
becomes:
P
W =
g (N ); g 0 (N ) > 0
(1 t )
But the demand equation in the labour market remains unchanged
(Why?).
Thus a change in a tax rate will now shift the labour supply schedule
(in the W -N plane), but not the labour demand schedule. Hence the
AS schedule gets aected too!

Das (Lecture Notes, DSE)

Macro

July 25, 2014

7 / 15

h a n g e Vi
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h a n g e Vi
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Proportional Income Tax - A Possible Exception? (Contd.)

y

Macro

.d o

Das (Lecture Notes, DSE)

lic

to

bu

y
bu
to
k
lic
C

Suppose
tax rate decreases from t to t 0 :
.c

c u -tr a c k

.d o

O
W

PD

XC

O
W

F-

er

XC

er

PD

F-

c u -tr a c k

July 25, 2014

.c

8 / 15

h a n g e Vi
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h a n g e Vi
e

Proportional Income Tax - A Possible Exception? (Contd.)

!

XC

y
to

bu

y
bu
to

Macro

July 25, 2014

lic

Das (Lecture Notes, DSE)

k
lic
C
.d o

Thus a proportinal income tax - in particular a tax cut - is eective in

w
.c
.c
.d o
raising
the equilibrium output and employment under the classical
c u -tr a c k
c u -tr a c k
system: (Why proportional? Why not lump sum?)
w

O
W

PD

F-

O
W

er

XC

er

PD

F-

9 / 15

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
e

N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

h a n g e Vi
e

The Classical System - A Comparative Statics

c u -tr a c k

.c

What happens if the stock of capital changes (increases) from K to

K 0 ?

Das (Lecture Notes, DSE)

Macro

July 25, 2014

10 / 15

h a n g e Vi
e

PD

XC

N
y
to
k
lic

.c

.d o

c u -tr a c k

Supply Equation:

.d o

lic

to

The Goods Market:

w

bu

bu

O
W

F-

er

XC

er

PD

F-

O
W

h a n g e Vi
e

The Keynesian System (in equations)

c u -tr a c k

Y = F (N, K ); FN , FK > 0; FNN , FKK < 0

.c

(1)

Demand Equation:
Y = C (Y ) + I (r ) + G ; 0 < C 0 (Y ) < 1; I 0 (r ) < 0

(2)

The Labour Market:

Supply Equation:

W =W

(3)

W = PFN (N, K )

(4)

M=M

(5)

Demand Equation:

The Money Market:

Supply Equation:
Demand Equation:
M = PL(Y , r ); LY > 0; Lr < 0
Das (Lecture Notes, DSE)

Macro

(6)
July 25, 2014

11 / 15

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
e

N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

h a n g e Vi
e

The Keynesian Labour Market

c u -tr a c k

.c

The only equation that diers between the two systems is the labour
supply equation.
The Keyenesian Sytem assumes that labour supply is perfectly elastic
.
at a given wage rate W
The Labour Market:
Supply Equation:

W =W

(7)

W = PFN (N, K )

(8)

Demand Equation:

Das (Lecture Notes, DSE)

Macro

July 25, 2014

12 / 15

!
O
W

PD

h a n g e Vi
e

y
bu
to
k

Macro

.d o

.c

Das (Lecture Notes, DSE)

lic
c u -tr a c k

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

h a n g e Vi
e

Equilibrium in Keynesian Labour Market & the

corresponding AS Schedule:

c u -tr a c k

July 25, 2014

.c

13 / 15

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

bu

to

k
lic
C

O
W

PD

h a n g e Vi
e

XC

er

O
W

F-

PD

XC

er

F-

h a n g e Vi
e

Equilibrium in Keynesian Labour Market & the

corresponding AS Schedule:

ack

.c

u -tr
So the AS schedule is upward sloping under the Keynesian system.

Question: What does this tell you about the eectiveness of the
standard monetary and scal policies?
Das (Lecture Notes, DSE)

Macro

July 25, 2014

14 / 15

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
e

N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

h a n g e Vi
e

Keynesian System: A Comparative Statics

c u -tr a c k

.c

goes up?
What happens when W

Das (Lecture Notes, DSE)

Macro

July 25, 2014

15 / 15

y
o

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

O
W

h a n g e Vi
e

PD

XC

er

O
W

F-

h a n g e Vi
e

PD

XC

er

F-

c u -tr a c k

.c

004: Macroeconomic Theory

Lecture 3
Mausumi Das
Lecture Notes, DSE

July 31, 2014

Das (Lecture Notes, DSE)

Macro

July 31, 2014

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y
bu

y
bu

.c

Das (Lecture Notes, DSE)

Macro

to
k
.d o

c u -tr a c k

lic
w

.d o

lic

to

goes up?
What happens when W
w

O
W

XC

O
W

F-

er

XC

er

PD

F-

PD

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e

Keynesian System: A Comparative Statics

c u -tr a c k

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Keynesian System: Eect of a Rise in Nominal Wage Rate

!

XC

y
bu

y
bu

to

lic

lic

to

The AS schedule shifts to the left - reducing the equilibrium level of

w
and increasing the equilibrium price level.
.c
.c
. d o output
.d o
c u -tr a c k
c u -tr a c k
w

O
W

PD

F-

O
W

er

XC

er

PD

F-

Question: What about the real wage rate? Would the real wage
rate be higher/lower or remain the same in the new equilibrium?
Das (Lecture Notes, DSE)

Macro

July 31, 2014

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Keynesian System: Eect of a Rise in Nominal Wage Rate

(Contd.)
!

O
W

c u -tr a c k

.d o

.c

lic

to

bu

PD

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

c u -tr a c k

.c

The real wage rate in this model behaves in a contra-cyclical fashion

- it is low in periods of boom (high output/high employment) and
high in periods of bust (low output/low employment).
This feature of the model is not supported by the empirical facts.
It has been observed that real wage rate typically moves in
pro-cyclical manner. In periods of boom, employment, output and
real wage rate - all move in the upward direction; opposite happens
during recessions.

Das (Lecture Notes, DSE)

Macro

July 31, 2014

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Extension of the Keynesian System: The Neo-Keynesians

& Sticky Prices
!

O
W

.c

lic

to

bu

PD

.d o

lic

to

bu

XC

er

O
W

F-

PD

XC

er

F-

.c

do
c u -tr a c k
An extension of the general Keynesian structure was later proposed,
which was able to address this issue, while retaining the other basic
Keynesian features. This is the Neo-Keynesian extension, proposed by
Barro-Grossman and Malinvaud in the 1970s.
This extension assumes that not only that nominal wage is rigid, but
so is the nominal price level. (This school is also known as the
Disequilibrium Macroeconomicsor the Macroeconomics of Quantity
Rationing)
Sticky prices mean that the aggregate supply curve is horizontal at

some P = P.
Notice that a horizontal supply AS schedule means that this system is
completely demand-determined. At P whatever output demanded is
always supplied. (Thus this set up is diametrically opposite to the
supply-determined Classical System discussed earlier).

c u -tr a c k

Das (Lecture Notes, DSE)

Macro

July 31, 2014

5 / 11

XC

h a n g e Vi
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y
lic

to

bu

y
bu
to
k

lic
C
.d o

Notice
that if output is demand-determined then the producers
may. c
w
.c
.d o
ck
not have the choice of picking the level of employment that c u - t r a
maximises their prot:
w

O
W

F-

O
W

er

XC

er

PD

F-

PD

h a n g e Vi
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The Neo-Keynesians & Sticky Prices (Contd.)

c u -tr a c k

the level of aggregate demand (from the AD curve)

Suppose at P = P,

is Y (P ).
, the prot maximizing
On the other, suppose at P = P and W = W
rms would like to employ N amount of labour such that output
W
) = F (N , K ), where PF
N (N , K ) = W
.
supplied is Y (P,

). In
If the demand constarint is binding then Y (P ) < Y (P, W
other words, at the prot maximising level of employment, there is
excess supply in the Goods Market.
Since prices are sticky, adjustments have to be made in terms of
quantities. This implies that the quantity produced cannot be
W
); it can at max. be Y .
Y (P,
This quantity adjustment will have implications for the labour demand
function as well.
Das (Lecture Notes, DSE)

Macro

July 31, 2014

6 / 11

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
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N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

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Labour Market under Sticky Prices:

c u -tr a c k

.c

When prices are sticky and the economy is demand-constrained, the

labour demand function is given by:
K ) = Y .
N D = N : F (N,
Question: Do the rms still make positive prot employing N instead
of N ?

Das (Lecture Notes, DSE)

Macro

July 31, 2014

7 / 11

XC

h a n g e Vi
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y
bu

y
bu

to

lic

lic

to

Now lets see what happens when the nominal wage rate when W
w
. c up:
.c
. d o goes
.d o
c u -tr a c k
c u -tr a c k
w

O
W

F-

O
W

er

XC

er

PD

F-

PD

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Labour Market under Sticky Prices (Contd.):

Nothing changes in the Goods Market, except that now there is a

re-distribution of income from prot-eraners to wage-earners.
Das (Lecture Notes, DSE)

Macro

July 31, 2014

8 / 11

!
y

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

h a n g e Vi
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N
m

XC

er

O
W

F-

PD

XC

er

F-

O
W

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Labour Market under Sticky Prices (Contd.):

c u -tr a c k

.c

If workers have dierent propensity to consume than prot-earners,

this might have implications for the consumption function and
therefore for aggregate demand. In fact if workerspropoensity to
consume is higher, the aggreagte demand may get augmented due to
a rise in the nominal wage rate.
This will relax the demand constraint and aggreagte output will
increase in that case.
Thus real wage and output (as well as employment) would move in
the same direction. In other words, the real wage rate now moves
pro-cyclically- consistent with the empirical evidence.

Das (Lecture Notes, DSE)

Macro

July 31, 2014

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N
y
bu

y
bu

to

lic

u -tr

lic

to

Quantity Theory of Money (A Special Case of the Classical

w
System):
.c
.d o
.d o
c
c
ack
w

PD

F-

O
W

er

XC

er

PD

F-

O
W

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Other Extensions of Keynes & the Classics:

u -tr a c

k.

Money Demand Equation now becomes:

M = PkY ; k a positive constant (velocity of circulation money)
The aggregate demand schedule in the Y -P plane is still downward
sloping.
Nothing much changes either in the Classical or in the Keynesian
System.

Liquidity Trap (A Special Case of the Keynesian System)

Equation of the LM curve now becomes:
r = r
(Implicit assumption: money supply is endogenous.)
The aggregate demand schedule in the Y -P plane is now vertical.
In the Keynesian System output is completely demand-determined.
Question: What happens if we import this assumption to the Classical
System?
Das (Lecture Notes, DSE)

Macro

July 31, 2014

10 / 11

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O
W

h a n g e Vi
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y
o

c u -tr a c k

.c

.d o

.d o

lic

to

bu

y
bu
to
k
lic
C

PD

XC

O
W

F-

PD

XC

er

F-

er

Other Extensions of Keynes & the Classics (Contd.):

c u -tr a c k

.c

Autonomous Investment (A Special Case of the Keynesian System):

Equation of the IS curve now becomes:
Y = C (Y ) + I + G
The aggregate demand schedule in the Y -P plane is once again
vertical.
In the Keynesian System output is completely demand-determined.
Question: What happens if we import this assumption to the Classical
System?

Das (Lecture Notes, DSE)

Macro

July 31, 2014

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