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## The complete Keynesian model## Introduction## Wage inflationIn this chapter, we will continue to develop the Keynesian model removing the assumption of fixed nominal wages. We define 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.exogenous, 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. ## Price InflationThe 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.
## Adjustments to the Keynesian models when wages are no longer constant## Real interest rates, nominal interest rate and expected inflationWhen 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 + ne. In this chapter, expected inflation ne is r (although not necessarily constant. In more advanced Keynesian models you will find various assumptions on how expectations are formed.exogenous ## Aggregate demand with inflationIn 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 = R when r = 0, we could make it a function of R.ifWhen = r - R we should write if,or I(r) - I(R We should also write if).or YD(Y, r) - YD(Y, R Since inflation expectations are exogenous (given), it is still the case that if).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.YD ## The IS curve with inflationWe can draw the IS curve for a given value of increases.7f
If must increase by the same amount to keep R and r unaltered.YD ## The money market with inflationLet us begin with the money market diagram in 12.3.6 and introduce inflation. Since the curve to "glide" out towards the right when inflation is positive and toward the left when we have deflation.MD
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 The nominal interest rate will then be constant.
If we let will increase if Y, R > n (prices increase faster than the money supply) and nM will fall if R > nM is unchanged if n. R = n nM.For example, when curve which is why MS increases.R ## The LM curve with inflationIn the previous chapter we found that the LM curve will shift upwards when is constant). This is still true but we can also add that the LM curve MS upwards if glides > n (as nM increases) and the LM curve glides downwards if R > nM n.The previous result is a special case of this result. If > 0 and if n is constant then MS = 0 and the LM curve glides upwards. Earlier, we only considered cases when nM 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.P |

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