Question

Question- 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.

Answer 1

i) changes in the spending by government for the taxes do not have much independent effects on the aggregate demand. Changes in the tax rate of marginal income have an additional effect on the supply.a decrease in the marginal income tax rate stimulates the supply of labour and ultimately leads to rise in employment and output.
ii)with the increase in the level of price there is decline in the real wage whereas the nominal wage remains fixed.as the real wage decreases forms hire more labourers and hence the output increases.
the intersection of the highest curve and the LM curve states that the labour market and the goods market as well as the other markets are in equilibrium. At a certain point the firmstend to increase their prices and hence the price level increases.as the level of price increases the real money supply decreases and the LM curve shifts upward.balam continues to shift until it comes to the initial position where aggregate quantity of goods which is demanded becomes equal to full employment output.cyclical unemployment is dramatic in the Ada is model when the equilibrium is substantially lower than the potential GDP and also relative the small when the equilibrium is almost near to the potential GDP.