Question

Consider an economy that is currently at full employment (at potential GDP). illustrate this economy in an AD-AS model. suppose that there is increased security about jobs and future income.

a. use your graph to show and explain what will happen to the price level GDP and unemployment according to the keynesian model.

b. use your graph to show and explain what will happen to the price level GDP and unemployment according to the neo classical model.

Answer 1

Increased demand of jobs and future income will induce people to consume more goods because there will be more confidence in the economy. They will spend more money on consumption which will raise aggregate demand in the economy and shift demand curve to its right from AD to AD1.

a) In Keynesian model, supply curve is upward sloping. Rightward shift in demand curve will raise price level from P to P1 as well as raise output level from Y to Y1. Rise in output will induce producers to hire more labor which will raise employment level in the economy.

b) In neo classical economy, supply curve is vertical which says that economy is operating at full employment level. Rightward shift in demand curve will only raise price level while keep output level same. It will only result in inflation while cause no change in employment level.