Question

Question 2 ) Begin with the economy at full employment. Now assume that there is a decrease in Government purchases of goods and services. Analyze verbally the differing effects of this decrease in G in a i) Classical model and in a ii) fixed nominal wage Keynesian Model. Analyze what will be the effects on labor supply, labor demand, the level of unemployment, the level of prices, and the level of output? Show the effect in the labor market, the IS-LM model and the AS-AD model. In your answer explain fully why AD shifts or does not shift in each case. Explain both the short-run effect and the long-run effects in the Keynesian model.

Question 3) - Look at the variables you were asked to examine in question 2. What would happen to these variables in the Classical and Keynesian model had there been an increase in the money supply rather than a decrease in government spending as in question 2? Be sure to discuss the neutrality of money in your answer.

solve only question 3

Answer 1

i) Under Classical Model

In this situation when LM Curve is is vertical, Money Supply is perfectly inelastic. Any increase in money supply shifts the LM Curve rightward to LM₁. Interest rate falls from r to r₁. It attracts private investment leading to a partial multiplier effect on output in short-run and to full multiplier effect in long-run. IS-Curve also shifts rightward to meet the new new LM-Curve. Increase in demand for money pushes the interest rate upward. Consequently, there will be positive effect on output, employment, produvtion, cost, and the price level.

ii) Under Keynesian Model

In this situation, when LM-Curve is horizontal, Money Supply is perfectly elastic. Any increase in money supply is followed by increase in money demand from all the sectors of economy but the interest rate remains unchanged.It causes a rightward shift of IS-Curve resulting in full multiplier effect on output.This is possible through increase in factor employment, cost of production, and price level.

The net neutrality of money says that although there is an increase in output in the short-run due to the expansionary monetary policy, output will come back to its natural level in the long-run. Thus, the expansionary monetary policy has no effect on the output in the long-run.