Models that Fit the Empirical Evidence

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Last updated: January 29, 2019

Explain for which reasons the real wage is expected to be acyclical in the Classical model, countercyclical in the Keynesian model and procyclical in the New Keynesian model. Which model would better fit the empirical evidence? Real Wage is defined as the payment to labour measured in units of output adjusted for the current level of inflation. This can be written as: Real Wage= Nominal Wage x (Expected Price Level/ Price Level) W/P = ? X /P P Real Wage cyclicality is the relationship between the real wage and the business cycle. I will try to find the direction real wage moves with respect to output in the Classical, Keynesian and New Keynesian models. Classical economics is widely regarded as the first modern school of economic thought. The theory begins with the simple production function: Y=F(K,L) Letting Y denote the amount of output, K denoting capital and L denoting labour.

This equation states that output is a function of capital and labour.The production function can be used to help maximise profit where: Profit = Revenue – Labour Costs – Capital Costs = (Price x Output) – (Wage x Labour) – (Rent of Capital x Capital) = PY – wL – rK = P x F (K,L) – wL – rK The competitive firm takes the product price and the factor prices (wage and rent of capital) as given and chooses the amount of labour and capital to maximise profits. When the competitive, profitmaximising firm decides how much labour to hire it takes into account the effect on profit.It therefore compares extra revenue from an increase in production that results from added labour to the extra cost of wages: ? Profit = ? Revenue – ? Cost = (Price x MPL) – W MPL, the marginal product of labour, is the extra amount of output the firm gets from one extra unit of labour holding capital fixed. MPL is used to show change in revenue because an extra unit of labour produces MPL units of output which sells at P dollars. Extra revenue is P x MPL and the extra cost of hiring another worker is W (nominal wage).

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If MPL x P>W, each extra unit of labour increases profit. If MPL x P


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