The complete Keynesian model
In this chapter, we will continue to develop the Keynesian model removing the assumption of fixed nominal wages. We define wage inflation nw 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.
We do not need a new model to deal with inflation. Non-constant wages can be handled within all three Keynesian models as long as they are exogenous. The reason we chose to let wages be constant in the previous Keynesian models were entirely pedagogical - these models are easier to understand when wages are constant.
The main reason for allowing for non-constant wages in the model is that we then can allow for persistent inflation/deflation. With constant wages, we cannot have persistent inflation as real wages would go to zero.
Neutral inflation is defined as a situation where wage inflation is equal to inflation (in prices). With neutral inflation, the real wages are constant. The Keynesian model does not require neutral inflation and real wages may vary over time. However, we cannot have an inflation which is always greater than or always smaller than wage inflation as real wages again would go to zero or infinity (again, remember that growth has been removed so we expect no upward trend in real wages). However, a few adjustments must be made in the models when we have inflation.
Adjustments to the Keynesian models when wages are no longer constant
Real interest rates, nominal interest rate and expected inflation
When we have inflation, we cannot, of course, assume that expected inflation is zero. Therefore, real interest rate will no longer be equal to the nominal interest rate and we must use R = r + ne. In this chapter, expected inflation ne is exogenous (although not necessarily constant. In more advanced Keynesian models you will find various assumptions on how expectations are formed.
Aggregate demand with inflation
In previous versions of the Keynesian model, none of the components of aggregate demand depended on P. In the IS-LM and in the AS-AD models, investments depended on the nominal interest rate R. We argued that investment actually depends on the real interest rate r, but since R = r when if = 0, we could make it a function of R.
When if no longer is zero and the real interest rate r = R - if, we should write I(r) or I(R - if). We should also write YD(Y, r) or YD(Y, R - if). Since inflation expectations are exogenous (given), it is still the case that YD depends negatively on R. Note that if there is an equal increase in expected inflation and in nominal interest rate, real interest rate is unaffected and so is investments and aggregate demand.
The IS curve with inflation
We can draw the IS curve for a given value of if. As previously explained, the IS curve is not affected by changes in P. However, it will shift upwards when 7f increases.
Fig. 14.1: The IS curve and expected inflation.
If if increases, R must increase by the same amount to keep r and YD unaltered.
The money market with inflation
Let us begin with the money market diagram in 12.3.6 and introduce inflation. Since the MD depends positively on P, the MD curve to "glide" out towards the right when inflation is positive and toward the left when we have deflation.
Fig. 14.2: The money market with inflation and constant money supply.
If money supply is constant, nominal interest rate will continuously increase when we have inflation and continuously decrease when we have deflation.
An interesting special case is when money supply increases by the same rate as P. In this case, the money supply curve will also glide outwards or inwards (depending on whether we have inflation or deflation) at exactly the same rate as the money demand. The nominal interest rate will then be constant.
Fig. 14.3: The money market with inflation and rising money supply.
If we let %M denote the growth rate in money supply, we can conclude the following. For a given Y, R will increase if n > nM (prices increase faster than the money supply) and R will fall if nM > n. R is unchanged if n = nM.
For example, when n > nM, the MD curve glides out to the right faster than MS curve which is why R increases.
The LM curve with inflation
In the previous chapter we found that the LM curve will shift upwards when P increases (assuming MS is constant). This is still true but we can also add that the LM curve glides upwards if n > nM (as R increases) and the LM curve glides downwards if nM > n.
The previous result is a special case of this result. If P increases, then n > 0 and if MS is constant then nM = 0 and the LM curve glides upwards. Earlier, we only considered cases when P jumped (from say 100 to 120). This translates into having inflation for a short period, an LM curve that glides upwards and when P reaches 120, inflation cease and the LM curve will stop moving.