1 Static Classical and Keynesian Models: A Comparison

Suppose that M goes up. What happens?1. Nothing happens to the equilibrium real wage rate, (W=P) ? .2. Nothing happens the aggregate output y ? .3. Aggregate demand goes up. Therefore, P ? goes up.4. IS-curve stays put. On the other hand, when M goes upLM-curve shifts right and when P ? goes up LM-curve shiftsleft. Recall that y ? doesn't change. Therefore, these shiftsmust cancel each other. LM-curve stays put and nothinghappens to r ? .5. Finally, nothing happens to c ? and i ? .Money Is Neutral!

1.2 The Keynesian Aggregate Supply Function In Keynesian model we assume that wages are sticky|due to,for example, long-term nominal wage contracts. Therefore, in astatic Keynesian model we treat W as if it was exogenous to themodel: W = W: Therefore, the supply of labor n D and the demand for labor n Sneed not be equal. The dierence between the two (n S ; n D ) iscalled (involuntary) unemployment. Hence, the labor market equilibrium consists of four equations:f 0 (n D ) = W Pn S = hW = Wn = n D : WPThat is, the labor market wage rate is above its (exible-price)equilibrium wage rate and hence there is excess supply of labor.

1.3 The Keynesian Model To summarize, we just derived the following relations determiningthe Keynesian system:y = C(y ; ) + I(y r)+g (9)M= L(y r)P(10)y = Given these variables, equationsdetermine c and i, respectively. MP g (11)y = (P W ) (12)y = f(n) (13)f 0 (n) = W P : (14)c = C(y ; ) (15)i = I(y r) (16) We regard the variables W , M, g, and to be exogenous|therst one predetermined and the rest are set by the government.Hence, we have a system of six equations in four unknown endogenousvariables: y, r, n, and P . [Note: the aggregate demandfunction (11) is redundant as it was derived from the IS (9)and LM (10) curves, and (12) is redundant as it was derived fromthe production function (13) and labor market (14) equations.]

The order of determination is as follows.1. Given the exogenous variables, intersection of the AS (12)and AD (11) curves determines the equilibrium output y ?and price level P ? .2. Intersection of IS (9) and LM (10) curves determines theequilibrium interest rate r ? .3. Demand for labor (14) determines the equilibrium employmentn ? . Suppose that goes up. What happens?1. Aggregate demand goes down and hence equilibrium pricelevel P ? and output y ? go down.2. IS-curve shifts left and LM-curve shifts right. Therefore, theequilibrium interest rate r ? goes down.3. Since y ? and P ? go down, n ? goes down.4. Finally, c ? goes down. The eect on i ? is ambigious.

Suppose that M goes up. What happens?1. Aggregate demand goes up. Therefore, P ? and y ? go up.2. IS-curve stays put. On the other hand, when M goes upLM-curve shifts right and when P ? goes up LM-curve shiftsleft. However, since y ? goes up the former eect dominates.r ? goes down.3. Since y ? and P ? go up, n ? goes up.4. Finally, c ? and i ? go up.Money Is NOT Neutral!

1.4 Conclusions1. The classical and Keynesian model have dierent predictionsconcerning the eectiveness of the scal and (especially) monetarypolicy. Which one is more realistic is subject to ongoingdebate.2. The results depend crucially on the assumption that the capitalstock is xed. One could argue that this is not such big issuewhen dealing with the monetary policy.3. The results depend crucially on the assumption that the pricelevel changes (ination/deation) doesn't aect the interest rate.This is not an innocuous assumption when dealing with the monetarypolicy. Hence, next week we will move to the dynamicmodels and relationship between ination and interest rates.