Question

1. What is the purpose of the AD/AS model, and how are the Keynesian and neoclassical perspectives different?

2. Explain how it is possible for one economist to accept both the Keynesian and neoclassical perspectives.

3. Explain how we can model the collapse of the housing market in the AD/AS model. Hints: When the bubble burst and wealth fell so rapidly, what curve will shift? When that curve shifts, what does that predict will happen to unemployment, inflation, and GDP?

Answer 1

1) Purpose of the AD/AS model:

The AD-AS model can be used to illustrate both Say’s law that supply creates its own demand and Keynes’ law that demand creates its own supply.

Aggregate demand and aggregate supply are viewed differently by the Keynesian and neoclassical. According to the neoclassical, government intervention is not required, and the self-adjustment process would lead to the full employment condition where the aggregate supply would be vertical.

Thus, AS is an important factor in determining the full employment in the economy.

Conversely, the Keynesian does not presume the vertical supply curve.

The supply curve is horizontal and increase in the aggregate demand would reflect in the rise in the output only.

2) Possible for one economist to accept both the Keynesian and neoclassical perspectives:

An economist would choose either neo classical or Keynesian perspective but not both because both the schools are conflicting and takes different assumptions and comes to different conclusions.

On the other hand Keynesian believes that economy is not always at full employment level.

Some economist accepts the both Keynesians and neo-classical perspectives.

Over the short run, the Keynesian explanation of economic fluctuation is correct while in the long run, the economy is at full employment level, thus here the neoclassical views hold true about the economy.

Hence, economists accept the both theories depending on the time periods.

3) Can model the collapse of the housing market in the AD/AS model:

· Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP and relatively small when the equilibrium is near potential GDP.

· The natural rate of unemployment—as determined by the labor market institutions of the economy—is built into potential GDP, but does not otherwise appear in an AD/AS diagram.

· The collapse of the housing market led to a fall in the aggregate demand in the economy, thus only the aggregate demand was main cause behind the crisis, the AD shift to left by establishing the lower level equilibrium that corresponds to the under employments.