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77

iSince iJ.(L) cannot be less than 1, it cannot be everywhere decreasing in L. Thus eventually the AS curve must turn up.

jjL is constant, the real wage is countercyclical because of the diminishing marginal product of labor, just as in Case 1. Since the nominal wage is fixed, the price level must rise when output rises; thus the AS curve slopes up. Again as in Case 1, there is unemployment as long as labor supply is less than the level of employment determined by the intersection of AS and AD.

If ijl(L) is sufficiently countercyclical-that is, if the markup is sufficiently lower in booms than in recoveries-the real wage can be acyclical or pro-cyclical even though the nominal rigidity is entirely in the labor market. A particularly simple case occurs when ix{L) is precisely as countercyclical as F(L). In this situation, the real wage must be constant. Since the nominal wage is constant by assumption, the price level is constant as well. Thus the AS curve is horizontal.If ix(L) is more countercychcal than F(L), P must faU when L rises, and so the aggregate supply curve is actually downward-sloping. In ah of these cases, employment continues to be determined by the level of output at the intersection of the AS and AD curves.

Figure 5.15 shows this cases implications for the labor market. The real wage equals F(L)lix{L), which can be decreasing in L (Panel [a]), constant (Panel fb]), or increasing (Panel [c]). The intersection of the AS and AD curves determines Y (and hence L) and P, and thus where on the F(L)/ix(L) locus the economy is. Unemployment again equals the difference between labor supply and employment at the prevailing real wage.

In short, different views about the sources of incomplete nominal adjustment and the characteristics of labor and goods markets have different implications for unemployment, the real wage, and the markup. As a result, Keynesian theories do not make strong predictions about the behavior of these variables. For example, the fact that the real wage does not appear to be countercyclical is perfectly consistent with the view that the aggregate supply curve is nonvertical. The behavior of these variables can be used, however, to test specific Keynesian models. The absence of a countercyclical real wage, for example, appears to be strong evidence against the view that fluctuations are driven by changes in aggregate demand and that Keyness original model provides a good description of aggregate supply.

5.5 Output-Inflation Tradeoffs

A Permanent Output-Inflation Tradeoff?

The models of the previous section are based on simple forms of nominal stickiness. In all of them, nominal wages or nominal prices are completely fixed in the short run. In addition, if the level at which wages or prices are fixed is determined by the previous periods wages and prices, the models imply a permanent tradeoff between output and inflation.



w p

FmML)

w p

F\L)ML)

W P

FmML)

FIGURE 5.15 The labor market with sticky wages, flexible prices, and an imperfectly competitive goods market



Wt = APt„i, A > 0, Yt=F(Lt). FC)>0, F"C)<0,

(5.31) (5.32)

(5.33)

Assume that initially the AD and AS curves are steady, and that the price level and output are therefore constant. This situation is shown by the curves ADq and ASo in Figure 5.16. Now suppose that in some period-period 1, for convenience-policymakers use fiscal or monetary policy to shift the AD curve out to ADi; the price level therefore rises from Pq to Pi and output rises from to ]. Because Pi is higher than Po, the wage set for period 2 is higher than the one that was set for penod 1. Specifically, the wage is adjusted for the previous periods inflation, and so the period-2

P2 Pi

ASo,A5i

FIGURE 5.16 Using aggregate demand policy to permanently raise output under a simple model of aggregate supply

To see this, consider, for example, our first model of aggregate supply, with fixed wages, flexible prices, and a competitive goods market. Suppose that W is proportional to the previous periods price level; that is, suppose that wages are adjusted to make up for the previous periods inflation Thus the aggregate supply side of the economy is described by



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