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1、Chapter 7:The Analysis of Price DeterminationGang GongCopyright Notes:This electronic file is only used as a lecture notes for the student in this class.It is not allowed to be used for presentation anywhere else without the permission from the author.IntroductionThe objective of this chapter is to
2、discuss how price is determined in Keynesian analysis.Some textbooks would like to refer the analysis in this chapter as the medium analysis in contrast to short run analysis.This is because in the short run the price is assumed to be fixed,and therefore nothing we can say about the price determinat
3、ion.IntroductionGenerally speaking,Keynesian economics does not exclude the market condition(excess demand or supply)as a factor to determine price.Yet in addition to the market condition,the cost of production is also important in price determination.This seems to be contrast to the Neo and New cla
4、ssical analysis according to which only the first is emphasized.Wage Determination In reality,wage may set by many ways.Collective bargaining between firms and union may be one way.The government may set up a minimum wage rate.Firms may simply decide a wage rate according to the market condition.Or
5、a firm may even pay an efficiency wage(the wage level beyond the condition)to keep the worker work efficiently.Wage DeterminationGenerally,one could have the following equation regarding the wage determination:where is the expected price,u is the unemployment rate and z represent other factors.In pa
6、rticular,one could assume Wage DeterminationNote that the above way of wage determination capture our two basic forces(market condition and cost)in determination of price.Price DeterminationIn macroeconomics,the cost of a product in general is reflected by the wage.Therefore one could write the pric
7、e equation asP=(W+q)(1+)where q could be regarded as the production cost other than wage;the markup over the cost W+q.Price DeterminationIt should be noted that there is no reason to believe and q are always fixed.One could think of as being a reflection of the market condition in general industry w
8、hile q as being determined by import price,change in productivity among others.All these can be regarded as supply shock.Price DeterminationThere is no reason to believe is fixed.Indeed,one could think of as being a reflection of the market condition in general industry.Thus,given the unemployment r
9、ate,one could determine the price and wage simultaneously by the wage and price equations.Putting All Markets TogetherWe are now ready to put all markets together and construct a hypothetical“general”equilibrium model with one industry:Putting All Markets TogetherThe model should includes the follow
10、ing equations:IS curve:LM curve:the production function:Y=F(N)the wage equation:the price equation:P=(W+q)(1+)the definition of u:u=1-N/LPutting All Markets TogetherThe solution of this system can often be represented by the so-called aggregate demand and aggregate supply analysis.In particular,the
11、IS and LM curves represents an aggregate demand curve since from them one can find a negative relation between P and Y.Putting All Markets TogetherThe other four equations form an aggregate supply since from them one can find a positive relation between Y and P.(question:how can it be understood as an aggregate supply curve?)The solution of P and Y is thus be determined by the intersection of demand and supply curve.