Question

1. With the aid of graphs explain the effect of contractionary monetary policy on the level of output, prices, and interest rates for (i) the Keynesian AS-curve case, (ii) the classical AS-curve case, and (iii) the intermediate case.

2. Use the AD/AS graphical framework to show the effect of expansionary fiscal policy on the level of output, prices and the interest rate in the short run and the long run

Answer 1

1. A contractionary policy is one which decreases the aggregate demand of the economy by using various mechanisms like open market operations of selling bonds to decrease money supply and increase the interest rate. The rise in interest rate crowds out some Investments and Consumptions. This results in a fall in Aggregate Demand. The AD0 curve moves left to AD1.

The three Aggregate Supply curves are such that - Keynes has a horizontal (short run) Aggregate Supply, Classical AS curve is vertical (long run) and Intermediate AS curve is upward sloping (medium run).

i. The Keynasian AS is horizontal because perfectly rigid price and wages. So when AD decreases then output falls from Y0 to Y1 while prices remain unchanged. This is like a perfectly competitive case if you see this from a micro point of view.

ii. The Classical AS curve is vertical because of perfectly flexible price and wages. So due to AD's leftward shift there is no change in output only price falls from P0 to P1.

iii. The intermediate AS curve is upward because of a few reasons like partial price rigidity and relative price misperceptions. So when AD decreases then both price and output fall as demonstrated in the graph.

Observe that output falls most in Keynasian case while price falls most in Classical case.