Question

True/False. Explain.

a. In the aggregate expenditure model, the reason an economic can enter a recession is that spending falls.

b. The classical assumption that labor markets clear makes it difficult for that model to explain recessions.

Answer 1

a. In the aggregate expenditure model, the reason an economic can enter a recession is that spending falls.- true

Explanation: In Keynes aggregate expenditure model, recession accrues to two factors: decrease in aggregate demand and sticky wages as well as prices. Aggregate demand is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment. Recessions occur when the level of household and business sector demand for goods and services is less than what is produced when labor is fully employed. Thus if spending of the economy falls, an economy can enter a recession.

b.The classical assumption that labor markets clear makes it difficult for that model to explain recessions.-true

Explanation: The Classical equilibrium model is based on the assumption that wages and prices are flexible. The labor market always clears in this sense as any imbalance is automatically corrected by an immediate movement in prices and wages. For instance, if excess labor force exists the wages will fall absoring more labor and new equilibrium will be reached. Thus the markets clear because demand and supply adjust quickly. This assumption is criticised since it is argued that market-clearing models cannot explain short-run economic fluctuations. On the contrary, the Keynesian model proposes that prices and wages are flexible in upward direction but sticky (rigid) in the downward direction.