CHAPTER SUMMARY

1. Keynesians are skeptical that a mismatch between workers and jobs can explain all unemployment. They argue that some unemployment is caused by real wages that are rigid and above the level at which the quantities of labor demanded and supplied are equal.

2. One explanation for real-wage rigidity is based on the efficiency wage model, which assumes that work­ers work harder in response to an increase in the real wage. Firms can attain the highest level of profit by paying the real wage, known as the efficiency wage, that elicits the most worker effort per dollar of wages. If the effort curve relating effort provided by workers to the real wage doesn't change, the efficiency wage, and hence the real wage actually paid, is rigid.

3. At the efficiency wage, firms demand the level of employment, N, at which the marginal product of labor equals the efficiency wage. If the efficiency wage is above the market-clearing real wage, employ­ment is determined by labor demand. The difference between the quantity of labor supplied and the quan­tity of labor demanded at the efficiency wage repre­sents unemployment.

4. Full-employment output,, is the output that can be produced when employment is at its full-employment level, N, and worker effort is at the level induced by the efficiency wage. The FE line in the Keynesian IS-LM model is vertical where output equals its full­employment level. In the Keynesian model, full­employment output and the FE line are affected by productivity shocks but not by changes in labor sup­ply because changes in labor supply don't affect employment in the efficiency wage model.

5. Keynesians attribute the nonneutrality of money to price stickiness, which means that some firms may not change their prices in the short run even though the demand for or supply of their product has changed.

6. Price stickiness can arise from the profit-maximizing behavior of monopolistically competitive firms that face menu costs, or costs of changing prices. Such firms are price setters rather than price takers, and once they set their prices they meet customer demand at that fixed price. These firms readjust prices only occasionally, generally when costs or demand have changed significantly.

7. In the Keynesian model with sticky prices, output is determined in the short run at the intersection of the IS and LM curves. The economy can be off the FE line in the short run because firms are willing to meet demand at predetermined prices. The level of employ­ment in the short run is given by the effective labor demand curve, which shows the amount of labor needed to produce any given amount of output. In the long run, after prices and wages have completely adjusted, the LM curve has shifted to restore general equilibrium with full employment.

8. The short-run and long-run equilibria in the Keynesian model can also be analyzed with the AD-AS model. The short-run equilibrium is represented by the inter­section of the downward-sloping aggregate demand (AD) curve and the horizontal short-run aggregate supply (SRAS) curve. In short-run equilibrium, monopolistically competitive firms produce whatever level of output is demanded at the fixed price level. Eventually, however, the price level adjusts and the economy reaches its long-run equilibrium, repre­sented by the intersection of the AD curve and the vertical long-run aggregate supply (LRAS) curve. In long-run equilibrium, output equals its full­employment level,

9. In the Keynesian model, an increase in the money supply shifts the LM curve down and to the right, raising output and lowering the real interest rate in the short run.

10. In the Keynesian model, an increase in government purchases or a cut in taxes shifts the IS curve up and to the right, raising output and the real interest rate in the short run. In the long run, output returns to the full­employment level but the real interest rate increases. Fiscal policy isn't neutral in the long run because it affects the composition of output among consump­tion, investment, and government purchases.

11. Keynesians attribute most business cycles to aggregate demand shocks. These shocks hit the IS curve (changes in government purchases, desired consumption, or desired investment) or the LM curve (changes in money supply or money demand). Keynesian busi­ness cycle theory, which has traditionally emphasized the importance of aggregate demand shocks, can account for the procyclical behavior of employment, money, inflation, and investment. To explain the pro­cyclical behavior of average labor productivity, the Keynesian theory must include the additional assump­tion that firms hoard labor—that is, they employ more workers than necessary during recessions.

12. Macroeconomic stabilization, also called aggregate demand management, is the use of monetary or fiscal policy to try to eliminate recessions and keep the economy at full employment. The Keynesian theory suggests that macroeconomic stabilization is both desirable and possible. However, practical problems include the difficulty of measuring and forecasting the state of the economy and determining how much monetary and fiscal stimulus is needed at any par­ticular time. Keynesian antirecessionary policies also lead to a higher price level than would occur in the absence of policy changes.

13. Following the oil price shocks of the 1970s, the Keynesian theory was modified to allow for supply shocks. Supply shocks lead to stagflation (a combina­tion of inflation and recession) and pose great diffi­culties for stabilization policy.

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