The document discusses key concepts of the Keynesian model of unemployment including: - Keynes rejected the idea of full employment and wage flexibility, instead arguing wages are rigid which can cause involuntary unemployment. - Equilibrium in the labor market occurs at less than full employment when the demand for labor intersects the horizontal portion of the rigid wage supply curve. - Keynes argued that government intervention through fiscal and monetary policies can help remedy unemployment by increasing aggregate demand. - New Keynesian and neo-Keynesian models build on Keynes' ideas incorporating rational expectations and imperfect competition to explain why prices and wages adjust slowly.

1. Keynesian model of
Unemployment
Meeting 8

2. Warming up quiz 1
• GDP Equation
• C+I+G+Xn Consumption (C), Investment (I), Government Spending (G) and Net
Exports (Xn) same as AD curve factors
• Unemployment rate formula
• (Unemployed/Total labour force) x 100%
• Natural rate of unemployment
• Around 5%
• AS shock example
• Oil shock OPEC stagflation 1970-1980s
• Hyperinflation example
• Zimbabwe, Venezuela
• Indonesian inflation rate
• 3-4%
• Indonesian unemployment rate
• 5-6%

3. Warming up quiz 2
• What is Phillips curve
• Model of inverse relationship between inflation and unemployment
• What is menu costs
• costly price adjustment
• What is frictional unemployment
• When you change location or transiting from one job to another
• Who created macroeconomics?
• Keynes
• Years of Great Depression
• 1929-1939
• Which theory thought money and wages are flexible?
• Classic theory
• Says law
• Supply created Demand

4. • Menjelaskan model keynesian : pasar tenaga kerja dengan money
wage rigidity
• Explains the Keynesian model: the labour market with money wage
rigidity

5. Key facts
• Keynes rejected the classic idea of full employment
• Because of Great Depression 1930-s → massive unemployment
• Involuntary unemployment (underemployment) (if, at the going wage
rate, people do not find employment a situation of unemployment
emerges)
• Keynes rejected also the classic wage flexibility →
• wage rigidity (upah kaku)
• There are two reasons for wage inflexibility:
• 1. money illusion
• 2. institutional reason (trade unions prevent wage rate from falling → wage
rate cannot fall below a certain level)
• Labour supply function, unlike the classical system, is a function of the
money wages (nominal), rather than real wages

6. What is Money Illusion
• Tendency of people to think of currency in nominal, rather than real, terms
• Many people have an illusory picture of their wealth and income based on nominal
money terms, rather than real terms. Real prices and income take into account the level
of inflation in an economy.
• Money illusion is a psychological matter that is debated among economists. Some feel
that people automatically think of their money in real terms, based on the prices of
things they see around them. However, there are several reasons why the money illusion
likely exists for many people, including a general lack of financial education, and the price
stickiness seen in many goods and services.
• This term is attributed to noted economist John Maynard Keynes. Money illusion is often
cited as a reason why small levels of inflation (1-2% per year) are actually desirable for
an economy. Having small levels of inflation allows employers, for example, to modestly
raise wages in nominal terms without actually paying more in real terms. As a result,
many people who get pay raises believe that their wealth is increasing, regardless of the
actual rate of inflation.

7. Cyclical (Keynesian) unemployment
• Is the deviation of unemployment from its natural rate.
• The natural rate of unemployment (5.5%) is the normal rate of
unemployment around which the unemployment rate fluctuates.
• Cyclical (Keynesian) unemployment is caused by downturns in the
economy that are part of the business cycle.
• The business cycle is the natural fluctuations in the economy.

8. John Maynard Keynes (1883-1946)
• British economist who popularized the idea that the government
should play an active role in managing the economy.
• This is a different from Classical economic theory, which suggests
there is no role for government because the economy corrects itself.
• Keynes agreed that the economy might correct itself in the long run.
However, he thought a natural correction might take an extremely
long time.

9. The remedy for Keynesian unemployment 1
• Is an increase in overall spending on newly produced goods and
services, which economists refer to as aggregate demand.
• In the U.S. economy, increased demand for American products
encourages U.S. businesses to produce more output. Businesses
may hire additional workers to help produce the additional output
needed to satisfy the increased demand. Thus, increased aggregate
demand tends to reduce unemployment.
• ↑D → ↑Q → ↑N

10. The remedy for Keynesian unemployment 2
• Classicalists believed that the way to maintain full employment was to cut wages
and reduce taxes. Keynes spoke out against this, stating that “The best way to
destroy the capitalist system was to debauch the currency.”(Skidelsky 40).
Because the economy was determined by demand, the cut in wages would
reduce employee income, decreasing consumer spending. This reduces demand
for products, leading to a reduction in production, forcing companies to not only
cut wages, but lay off employees. Now the employees (and former employees)
are now even more unable to spend, decreasing both consumer spending and
demand. If it goes on like this, the recovery will be unforeseeable. Reducing taxes
wasn't an option for the government when their budget was out of control due to
the reduction of tax revenues. The way to recovery is to encourage spending. By
encouraging consumers and firms alike to increase spending, demand will
increase. This will increase quantity produced, leaving companies to need to hire
more employees, increasing employee income, making them able to spend more.
Put this all together and you get an increase in aggregate demand. This
encourages production and helps the economy out of recession/depression.

11. The remedy for Keynesian unemployment 3
• Although a believer in free trade (John Maynard Keynes), Keynes believed
that Government interference is beneficial to an economy. Through Fiscal
and Monetary policies, the government use spending of goods or services
to reduce the business cycle. Government spending reduces the price for
goods and services, making it more affordable. This increase demand and
consumer spending. With the increase in demand, companies need to
produce more. So, they will have to hire more employees. The newly hired
employees will have more income, leaving them more able to spend. This
increases demand and consumer spending. The perfect example is Franklin
D. Roosevelt's New Deal, which created agricultural jobs for unemployed
farmers. It gave farmers the opportunities taken away from them by the
dust bowl. This gave them a wage, which they could use for consumer
spending. This of course increased aggregate demand.

12. Keynesian model: Labour supply function
• Labour supply curve SL has
two parts:
• Because of the rigid wage
rate, SL is perfectly elastic.
• Assume that there is a fixed
wage, W. The associated SL
curve is horizontal in this
region.
• Above this wage rate, money
wages are free to rise. Thus,
the labour supply curve SL in
this region must be positive
sloping.

13. Keynesian model: Labour demand function
• Labour demand curve DL,
however, in the Keynesian
system, is assumed to be
negatively related to the
real wage rate.
• DL curve shows this
relationship.

14. Keynesian model: equilibrium
• Equilibrium in the labour
market is established
when DL curve intersects
the DS curve at its hori-
zontal portion.
• Thus, point E describes
underemployment
equilibrium.

15. Keynesian model: equilibrium (Involuntary Unemployment)
• Point E Equilibrium: when DL
curve intersects the DS curve
at its horizontal portion.
• Corresponding equilibrium
real wage rate is (W/P)E.
• At this wage rate, LF people
are willing to work while LE
people are employed.
• The difference between the
two (LE – LF or EF) measures
involuntary unemployment.

16. Keynesian model: wage rigidity
• According to Keynes, wage
rigidity is the cause of
involuntary unemployment.
• This means that a free
enterprise capitalist economy
always fails to reach full
employment because of wage
rigidity.
• He also gave two other rea-
sons:
• 1. liquidity trap, and
• 2. interest inelasticity of
investment—for the failure of a
capitalist economy to reach the
state of full employment.

17. Great Depression
• Unemployment rate: 25%

18. New Keynesian approach 1
• 1970-1980s
• Like the New Classical approach, New Keynesian macroeconomic
analysis usually assumes that households and firms have rational
expectations.
• New Keynesians assume that there is imperfect competition in price
and wage setting to help explain why prices and wages can become
"sticky", which means they do not adjust instantaneously to changes
in economic conditions.

19. New Keynesian approach 2
• Wage and price stickiness, and the other market failures present in
New Keynesian models, imply that the economy may fail to attain
full employment.
• Therefore, New Keynesians argue that macroeconomic stabilization
by the government (using fiscal policy) or by the central bank (using
monetary policy) can lead to a more efficient macroeconomic
outcome than a laissez faire policy would.

20. Neo-Keynesian model
• Mix of New Classical and Keynesian models
• Efficiency wage models:
• They are used to explain long-term effects of previous unemployment, where short-term
increases in unemployment become permanent and lead to higher levels of unemployment in
the long-run.
• Workers are paid at levels that maximize productivity instead of clearing the market.
• For example, in developing countries, firms might pay more than a market rate to ensure their
workers can afford enough nutrition to be productive.
• Firms might also pay higher wages to increase loyalty and morale, possibly leading to better
productivity.
• Firms can also pay higher than market wages to forestall shirking (tukang bolos).
• Carl Shapiro and Joseph Stiglitz's in 1984 created a model where employees tend to avoid work
unless firms can monitor worker effort and threaten slacking employees with unemployment.
• If the economy is at full employment, a fired shirker (tukang bolos) simply moves to a new job.
Individual firms pay their workers a premium over the market rate to ensure their workers would
rather work and keep their current job instead of shirking and risk having to move to a new job.

21. The new neoclassical synthesis 1990-s
• In the early 1990s, economists began to combine the elements of
new Keynesian economics developed in the 1980s and earlier with
Real Business Cycle Theory.
• RBC models were dynamic but assumed perfect competition; new
Keynesian models were primarily static but based on imperfect
competition. The New neoclassical synthesis essentially combined the
dynamic aspects of RBC with imperfect competition and nominal
rigidities of new Keynesian models.