Question

Consider a permanent adverse productivity shock (for example, a permanent increase in the price of oil) which lowers the current and future productivity of capital and the current and expected future real incomes of households. Assuming a closed economy, first analyze the general equilibrium effects of this shock on output, employment, the real wage, the price level, and the real interest rate in both the classical and the Keynesian versions of macroeconomic adjustment. Second, explain how the adjustment effects would differ in the case of a temporary adverse productive shock.

Answer 1

SOLUTION:-

* Suppose economy is in long run equilibrium at point F where Long run aggregate supply curve and aggregate demand curve intersects at Y level of potential output and P level of price.

* A permanent adverse productivity due to increase in price of oil lowers the current and future productivity of capital and expected future real income of households Classicals Increase in oil prices rises the cost of production of firms. It will reduce the aggregate supply of production in income.

* Because increase in cost of production reduce the productivity and output of the economy. Fall in production level reduce the profit of firms. As a result it will reduce the labor demand and employment. Then as result of rise in unemployment real wage of individuals declines. Thereby it reduces the general price level in the economy. It will reduce the cost of production of firms.

* Fall in price level increase the real wage of consumers. Firm will increase the labor demand and it rises employment in the economy. Rise in employment increase the production level in economy. It boosts the aggregate supply of good and services.

* It will shift the LRAS curve to previous full employment equilibrium Keynesians Fall in productivity and consumer real income leads to fall in aggregate supply and aggregate demand for good and services in the economy and it shifts both AD and LRAS curve backward.

* According to Keynesian economists, government should increase its spending to boost aggregate demand in the economy. Increase in government spending will increase the consumption and investment in the economy It will boost aggregate demand in th economy. It will increase the production and output in the economy. Thereby it rises aggregate supply .

* It will shift both AD and LRAS curve rightward to full employment equilibrium b. If there is a temporary adverse productivity shock , it would reduce the aggregate production and supply of good and services in the economy.

* In order to correct economy, increase in consumer spending will boost the aggregate supply. Because higher demand for good and services induce firms to increase their production.

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