Question

Using the natural rate model, explain and diagrammatically represent the changes in P, Y, W, and N (in both long and short run) as a result of a rise in the money supply. Also draw the short-run and long-run phillips curves that are consistent with the results.

Answer 1

In the simple Keynesian model of an economy, the aggregate supply curve (with variable price level) is of inverse L-shape, that is, it is a horizontal straight line up to the full-employment level of output and beyond that it becomes horizontal.

This means that during recession or depression when the economy is having a good deal of excess capacity and large-scale unemployment of labour and idle capital stock, the aggregate supply curve is perfectly elastic. When full employment level of output is reached, aggregate supply curve becomes perfectly inelastic.

With this shape of aggregate supply curve assumed in the simple Keynesian model, increase in aggregate demand before the level of full employment, causes increase in the level of real national output and employment with price level remaining unchanged.

That is, no cost has to be incurred in the form of rise in the price level (i.e., inflation rate) for raising the level of output and reducing unemployment. In the Keynesian model, once the full-employment level of output is reached and aggregate supply curve becomes vertical, further increase in aggregate demand caused by the expansionary fiscal and monetary policies will only raise the price level in the economy.

That is, in this simple Keynesian model, inflation occurs in the economy only after full-employment level of output has been attained. Thus, in the simple Keynesian model with inverse L-shaped aggregate supply curve there is no trade off or clash between inflation and unemployment.n the basis of a stable Phillips curve for a country, they emphasised the trade off that confronts the economic policy makers. This trade off presents a dilemma for the policy makers; should they choose a higher rate of inflation with lower unemployment or a higher rate of unemployment with a low inflation rate.