The Production Function

Explain for which grounds the existent pay is expected to be a-cyclical in the Classical theoretical account, countercyclical in the Keynesian theoretical account and pro-cyclical in the New Keynesian Model. Which model better fits the empirical grounds?


Classical Model

Y=F ( K* , N ) ; K*= Capital Stock e.g. machinery, N= Employment

This shows how different degrees of end product are affected when changing the factors of production. In the short tally, it assumes capital to be fixed ( K* ) . Labour units are allowed to change but a fixed population is assumed because otherwise labor would increase on its ain. Therefore, any alterations in end product ( Y ) depend on alterations in Labour ( N ) . This displays decreasing returns to scale ; end product additions proportionally less as the figure of labour units is added.

The Labour Market Equilibrium

Perfect competition is assumed and degree of employment is determined by equilibrium in labour supply and demand. With regard to demand, a house would engage workers up to the point at which an extra cost of a unit of labor is equal to its end product produced.


Under net income maximization, P=MC so P=W/MPL or W/P=MPL. Thus, net income maximization can be graphed by plotting the existent pay and fringy productiveness of labor against different degrees of labor. By making this, we would obtain a downward- sloping labour demand curve, where the ‘price ‘ of labor is the existent pay. Now, if you take a horizontal summing up of labour demand for all houses and at each existent pay, we get the aggregative demand curve for labor ; Nd = degree Fahrenheit ( W/P ) .

Classical economic experts assumed agents maximised public-service corporation. Using a micro-level theoretical account ; public-service corporation was increased by devouring leisure and decreased by gaining existent rewards to purchase leisure. Therefore, U =f ( W, L ) and budget restraint is N = 24 – leisure ; we N is the figure of hours for work. If we plot the indifference curve will demo the trade-off between the two goods. The higher the existent pay, the steeper the budget line. This shows that as the existent pay additions, fewer hours are devoted to leisure and therefore more given to working.

If we now do a horizontal summing up of hours that all persons are willing to work at all the rewards, so we would achieve labour supply ; Ns = degree Fahrenheit ( W/P )

AD/AS Framework

The individuality M V = P Y with V fixed implies that, for a fixed M, there is a downward inclining relation between Y and P.

In the Classical Model, merely the money supply can switch the AD curve and the money supply is fixed. With different M ‘s you can acquire displacements in Aggregate demand.

The speed is changeless due to the engineering of exchange. M = k P Y. Give a fixed money supply, the merchandise P Y must be changeless. This determines an aggregative demand curve.

Because Y is determined by existent factors of production, the equation of exchange determines the monetary value degree. In peculiar, alterations in M alteration merely P.

The AS curve is perpendicular because equilibrium is determined in the labour market. Wage rigidness.

Keynesian Model

The Labour market Equilibrium

In the Classical theoretical account, there is equilibrium in the labor market because of the premise that money rewards and monetary values are absolutely flexible. However, Keynes believed nominal rewards were non flexible, but rigid based on two signifiers of pay bargaining. First, dickering takes topographic point non merely for fiscal agencies but besides for the position deductions relative to other groups of workers. Therefore, nominal pay becomes stiff as workers try to keep a pay differential relation to other functions in the industry. Second, brotherhoods can hold formal contracts with houses to keep the money pay for a specific clip period. Furthermore, there can be informal contracts or a inclination by the houses to keep the money pay for some clip.

Therefore, a fixed nominal pay causes disequilibrium and the degree of employment is determined by the demand for labor. Labour is supplies up until the point at which houses wish to purchase at the existent pay rate.

AS/AD Framework

The aggregative demand curve is as before but is derived through the IS/LM model, which allows it to switch through a scope of different constituents. This does non a ground behind the cyclicality of the existent pay here.

In the Keynesian theoretical account, the expected monetary value degrees enter into the maps of nominal and existent rewards. Workers and houses bargain over and transport out an understanding over nominal rewards before they find out the monetary value degree. They form their understanding on the nominal pay by holding in head the mark existent pay. This is normally greater than the equilibrium existent pay due to brotherhood power and efficiency-wage considerations. Corporate bargaining between brotherhood caputs and steadfast direction raises the pay above equilibrium degree and so allows how much staff the house wants to engage. This causes a decreased work force for the house than that a equilibrium degree. Efficiency-wage theories propose that rewards above equilibrium make workers more productive as they will be healthier, less likely to go forth and bring forth better quality work. Last, the minimal pay Torahs mean that for low paid occupations, it keeps the existent pay above equilibrium.

Therefore, the nominal pay ( W ) is based on the mark existent pay ( tungsten ) and the expected monetary value degree ( Pe ) : W= tungsten X Pe. When this is set, the houses really find out the existent monetary value degree ( P ) . The existent pay is so: W/P= tungsten X ( Pe/P ) . This shows that when the existent monetary value degree is higher than that expected, the existent pay is lower than its mark and vice-versa.

( diagram, page 350 mankiw )

When the nominal pay is stuck, an addition in the monetary value degree causes a lessening in the existent pay. Nominal pay does non set to keep the existent pay. Therefore, this causes labour to go cheaper and so houses more labour. Finally, as labor is increased, they produce greater existent end product.

New Keynesian Model

Histories for existent pay rigidnesss

Empirical Evidence

The grounds seems to



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