Wage inflation

In this chapter, we will continue to develop the Keynesian model removing the assumption of fixed nominal wages. We define wage inflation πw as the percentage average increase in wages. Wages and wage inflation are still exogenous, i.e. they are not determined within the model. One justification for this assumption is that wages often are determined by agreements which often last for several years.

The problem with the IS-LM model

The starting point of the Aggregate Demand-Aggregate Supply or AD-AS model is an assumption in the IS-LM model (and in the cross model) that limits its usefulness. This is the assumption that if firms where to choose the profit maximizing quantity of L (LOPT), they would produce more than the aggregate demand. In the IS-LM, YOPT > YD must hold as discussed in section Aggregate supply.

To realize why this is a problem in the IS-LM model, we gradually increase the aggregate demand byincreasing G. We can illustrate the process using figure 12.6 in Section The Labor Market

The main difference between the cross model and the Investment Saving, Liquidity preference Money supply (IS-LM)  model is that the nominal interest rate is exogenous in the cross model but endogenous in the IS-LM model. In this chapter we will explain how the nominal interest rate is determined in the IS-LM. P remains exogenous and constant in the IS-LM model.

The Keynesian model

In this chapter we will look at the Keynesian cross model. This model is a simple version of what we call the ”complete Keynesian model” or simply the Keynesian model. The Keynesian model has as its origin the writings of John Maynard Keynes in the 1930s, particularly the book ”The general theory of Employment, Interest, and Money”. Although this book was written as a criticism of the classical model, the similarities between the Keynesian model and the classical model are definitely greater than the differences.

Lets point out the three most important differences directly:

The classical model” was a term coined by Keynes in the 1930s to represent basically all the ideas of economics as they apply to the macro economy starting with Adam Smith in the 1700s all the way up to the writings of Arthur Pigou in the 1930s. In this chapter I will describe the main characteristics of what we now call the classical model and how the macroeconomic variables are determined in this model. As discussed in the previous section, we focus on the cycles and all the components included in the GDP (consumption, investment, importsand exports) are variables where the trend has been removed.

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