Question

Using the Keynesian Framework, answer the following question. Assume that there are rigidities in the price/wage so that we have an upward sloping AS curve.

A. Using the IS-LM and AS-AD models, show the effects of a decline in business investment. What are the effects on Income/Output, interest rates, and prices?

B. Using the IS-LM and AS-AD models, show the effects of an increase in the price of raw material inputs. What are the effects on Income/Output, interest rates, and prices?

C. Using the Labor Market, Production, IS-LM, and AS-AD models, show the effects of an increase in factory productivity. What are the effects on Income/Output, interest rates, and prices?

Answer 1

Keynesiam model describes a downward rigidity of price and wages
a. Decline in business investment reduces the aggregate demand on good and services in the economy. Because business investment is one of the component of aggregate demand. It shifts AD curve into AD 1.Fall in investment reduces the production of good and services. Thereby it reduces the aggregate supply of good and services. As a result it shift the AS curve leftward AS1. The simultaneoud shift in AD and AS curve keep general price level remain same and reduces the output level from Y to Y1. Fall in aggregate demand and aggregate supply shifts IS curve into backward as IS1.It reduces the interest rate from r to r1 due to fall in investment demand
b. Increase in price of raw materials rises the cost of production of firms. So they try to reduce the output level by raising prices. It shifts the AS curve to leftward as AS1. Higher prices reduces the purchasing power of consumers. They reduces the consumption of good and services. It shifts AD curve backward as AD1. It makes price level remain same and fall in output level from Y to Y1. Rise in cost of production due to higher price of raw materials, reduces the investment level in the economu. It shifts the IS curve into leftward as IS 1 and reduces the rate of interest from r to r 1 and income level from Y to Y1.
C. Increase in factot productivity reduces the cost of production and increases the labour demand. It will rise the real wage of labours. It rises the production level and there by increases the aggregate supply of good and services. It shifts AS curve right ward as AS1. It reduces the price level in the economy. It increases the purchasing power of consumers which resulta higher consumption demand. It increases aggregate demand of good and services and shifts AD cure rightward as AD1. So it keep price level remain same at Y1 output level. It increases the investment and that shift the IS curve rightward IS1. It increases the interest rate from r to r1 at new income level Y1