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In: Economics

Suppose a war causes a sudden, large increase in government spending. (a) What happens to both...

Suppose a war causes a sudden, large increase in government spending. (a) What happens to both prices and GDP in the short-run Classical Model? Do they increase decrease or stay the same? Explain. (b) What happens to both prices and GDP in the short-run Keynesian model? Do they increase decrease or stay the same? Explain in 200 words or more.

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Expert Solution

Classical model: A classical model runs on money neutrality i.e. in a classical model an increase in the money supply or government purchase will only increase the price of the good leaving the actual GDP unchanged. The economy runs at a potential level all the time and any increase or decrease in the demand will only affect the nominal price of the things. Employment level will remain the same and the output will be unchanged at a potential level only the nominal value of things will change.

A Keynesian model: In a Keynesian model, the wages are sticky i.e. they don't change in the short run. With increased government expenditure the prices of the good in the economy will change this will decrease the real wage of the labor and firms will hire more and increase the production in the short run. This will increase the output of the economy and increase the GDP. More people will get employment and prices will be high.

Rahul Sunny answered 2 years ago
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