Question

(a) Derive the AD curve from the IS-LM curves. Label the axes in the two graphs.

(b) What is the difference between the Keynesian and classical views on price adjustment?

(c) Describe the effects, according to both views, of an increase in the money supply. Explain what happens to real output and the price level. Use the AD-AS model diagram to discuss the effects.    

Answer 1

( A ) The aggregate demand curve shows inverse relationship between price level and GDP or total output of a country.

Now, if price level increases while we keep nominal money supply constant, there would be an decrease in real money supply ( M / P ).

As we know decrease in real money supply will push up the interest rate r which will lead to decrease in investment and a decrease in real output Y on the graph.

Increase in interest rate shifts LM curve to the left, and aggregate demand will fall down.

( b ) Keynesian view on price adjustment says that prices are rigid upwards and firms in order to save costs may reduce number of workers, but they generally do not cut the prices. Therefore, there is no flexibility of prices.

Whereas classical economic theory believes that prices and wages are fully flexible. For example, if there is an excess in the labor, the wage or price of these will adjust to bring back to the level of equilibrium.

( c ) According to Keynes increase in money supply increases aggregate output in the economy.

Whereas according to Classical theory increase in money supply results in increase in the price level of the economy with no increase in aggregate output of the economy.