Question

1. Explain and show how the full Keynesian sticky wage model is built. What are the main relationships? Explain briefly what each curve depicts.

2. Imagine that the economy starts off in a situation where the labor market clears. The economy is hit by a shock that reduces consumption demand temporarily. (See e.g. Figure 3.) Show the effects of the shock using graphs. Explain every shift of a curve. What are the effects on the interest rate, consumption, investment, output, the price level, the real wage and employment?

3. Do these effects fit the business cycle facts?

4. What would happen if the nominal wage adjusted in response to the shock? (Assume for this that wage adjustment is faster than the return of consumption demand to its initial level, i.e. maintain consumption demand at its low level induced by the shock here).

5. Using graphs, illustrate how fiscal policy could be used to counteract the effect of the shock. (Assume that the nominal wage remains at its initial level.)

6. Show, using graphs, the effects of the same shock in an economy where the nominal wage is flexible. How do the interest rate, output, the price level, the real wage and employment change?

7. How do these changes compare to those in a) the short run and b) the long run of the Keynesian model?

Answer 1

Answer 2 : The clear labour market means that the supply is equal to the demand . In such a situation the supply is neither surplus nor deficient to the demand. At this point the market is in perfect equilibrium. A shock in an economy is an unpredictable happening which affects drastically. A shock is of two types : positive and negative. In a negative demand shock aggregate demand decreases. It's price decreases because of shift in the demand curve. See the graph below

This is the demand decrease graph. It has curve tilting towards the left . If we look closely we can see the market was all clear at Q1 and P1. The supply demand were in an equilibrium. But when the market faces a negative demand shock the supply remains the same while the demand consumption is decreased. In such a situation the new plot Q2 shows the decrease in quantity. D1 is the slope of the clear market graph while D2 is the slope of the reduced consumption. The demand decrease is affected by many factors like monetary taxes prices and many more. Effects on interest rate , consumption, output ,price , real wages and employment is a negative one . Since the demand of a commodity decreases the consumption decreases so the companies providing employment limit their jobs to maintain the money. Output also decreases and the interest rate decreases because of the inability of the market to earn sufficient funds. People refrain from investing in a market that is falling so the investments decrease too.

Answer 1 : In sticky wage model of upward sloping , the aggregate supply curve in short run is based on the labour market . The short run are kept by the contracts in many industries. That depicts that worker and labourers are paid on the basis their relative permanent scedule which is already decided by the union or the management /authority or maybe both .Also when the change in economy happens , the adjustment cannot be made for the wage of workers.In sticky wage model of keynesian , the wages are sticky and the chain of events is very straightforwad with increase in price level with the output .See, when the price level rises somehow , the basic wages remain fixed the reason is that this is totally dependent on the $ amount of wages .while a higher price level indicates that a provided wage is enough to purchase the basic goods and avail the basic services .Also when the real wage of the worker given by the firm falls , then labour becomes very cheap . since the produced output per unit labour is same , the organization prefer to hire more workers and increase their own revenue and profits.When the firm do this , thier output increase by more labour hire . Therefore because of sticky wages , the output increases as a result of price level rise.Basically the Agrregate Supply curve depicts the interrelationship between the output and the price level .The agrregate supply curve is sloping upward in short run and is vertical in case of long run agrregate supply curve . The very first model of short term aggregate curve sloping upwards is the Sticky wage model of keynesian

Answer 3 : Business cycle or economic cycle or trade cycle is the crest and trough movement of the gross domestic product around a long term growth. The length of the waves of the trade cycle is equivalent to the duration of time it is covering example one year two year or ten year. The fluctuations represent the growth and regression in the gross domestic product. But if we look closely the fluctuations are not constant and completely unpredictable so it is not actually a cycle. The above situation does fit the business cycle because of the sudden economic that was completely unpredictable. The market was going smooth and the supply was meeting the demands and there was no clear indication of the consumption suddenly dropping even though temporarily. This is what happens in the business cycle too the fluctuations are totally unexpected. So the drop of demand consumption from a clear market completely resembles the unpredictable fluctuations of a business cycle.

Answer 4 : Nominal wages are fixed wages that don't vary with the change in market prices or shocks. Which means neither are they increased with the profit nor deducted with the loss. They are not like regular wages which is variable with time and market conditions. If the nominal wage is adjusted at a time when the market is at a decline then the obvious conclusion is that the wages will be decided at a low price. The reason behind this is simple. The product will not be in an increased demand and the supply will be in excess in comparison to the demand and the products will not get consumed so the producers will reduce the consumption. The reduced consumption will demand less labour and even though the labour will be required they will not be paid as well off because the importance of the commodity will have decreased. If we consider the situation of a growing market and the nominal wages were to be adjusted in that case the wages will be higher

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