Question

Consider the following model of aggregate demand and supply. Consumption
depends positively on disposable income with a marginal propensity to consume
between 0 and 1, investment depends negatively on the real interest rate, and labour
supply depends positively on the real wage. The real interest rate is the nominal
interest rate minus the rate of inflation. Prices are flexible, and firms hire labour up
to the point where the marginal product of labour is equal to the real wage.
Monetary policy is conducted by the central bank setting the nominal interest rate.
The nominal interest rate is adjusted in response to changes in inflation, with the
nominal interest rate rising by more than 1% following a 1% increase in inflation.
(a) Explain why aggregate demand is negatively related to the inflation
rate.
Suppose that owing to a loss of confidence, households unexpectedly increase the
amount they would like to save (this is a reduction in the autonomous level of
consumption).
(b) Make the classical assumption that wages are always fully flexible.
What happens to output, inflation, and the real and nominal interest rates?
Explain how the economy adjusts so that investment is equal to saving.
Now make the Keynesian assumption that nominal wages are fixed in the short run
(but prices are flexible).
(c) Explain why aggregate supply is positively related to the inflation
rate.
(d) Consider again the increase in desired saving from part (b). With
sticky wages, what happens to output, inflation, and the real and nominal
interest rates? Explain how the economy adjusts so the investment is equal to
saving. Compare your answers to those from part (b).
(e) What action should the central bank take to stabilize output
following the increase in desired saving? What will be the resulting nominal
and real interest rates if the central bank takes this action? Explain whether or
not your answers would be different if the central bank was aiming to
stabilize inflation.

Answer 1

(a) Explain why aggregate demand is negatively related to the inflation rate.Suppose that owing to a loss of confidence, households unexpectedly increase the amount they would like to save (this is a reduction in the autonomous level of
consumption).

If there is inflation which is increase in the average price levels in an economy then consumers and companies need more money for day to day activities. This situation leads to increase in demand for money . As money demand goes up interest rates also go up. As interest rates go up the cost of borrowing from banks and financial agencies also increases and hence consumer purchase decreases financed by borrowing. Similarly, firms also lower investment spending as they may afford very high interest rates.Hence, aggregate demand is negatively related to the inflation rate. Low consumer confidence shifts aggregate demand curve to left.

(b) Make the classical assumption that wages are always fully flexible. What happens to output, inflation, and the real and nominal interest rates? Explain how the economy adjusts so that investment is equal to saving. Now make the Keynesian assumption that nominal wages are fixed in the short run (but prices are flexible).

Assuming classical economists view point it is clear that decreased consumer confidence will shift aggregate demand to left. This will create deflationary gap as shown in figure below. AD1 shifts to AD2 and average price levels come down from P1 to P2, real GDP goes down from Q1 to Q2. According to monetarists, economy will achieve its full potential Q2 in the long run as wages will fall due to recessionary impact. Firms costs of production will decrease and aggregate supply will shift to the right bringing economy back to potential Q1.

Keynes believes that wages are sticky and hence as wages do not come down, firms do not increase aggregate supply and economy will be stuck at Q2 at price levels P1 and unless govt. intervenes, real GDP will not come to potential.

(c) Explain why aggregate supply is positively related to the inflation rate.

Aggregate supply is positively related to the inflation rate due to profitability. As output prices go up and resources price stay low in short run, firms make more profits. They supply more.

(d) Consider again the increase in desired saving from part (b). With sticky wages, what happens to output, inflation, and the real and nominal interest rates? Explain how the economy adjusts so the investment is equal to saving. Compare your answers to those from part (b).

As explained in answer b as real GDP is stuck, output goes down. Inflation remains at same levels. Govt. needs more money and as govt. spendings in an economy go up, demand for money goes up and interest rates will go up making people to save more. Nominal and real interest rates go down.

(e) What action should the central bank take to stabilize output following the increase in desired saving? What will be the resulting nominal and real interest rates if the central bank takes this action? Explain whether or not your answers would be different if the central bank was aiming to stabilize inflation.

Central bank has monetary policy to make changes in interest rates and money supply. It reduces interest rates to make saving less attractive and spending more attractive. Nominal real interest rates will go up. In this case change in real GDP is targeted.

During inflation stabilization also central bank raises interest rates and decreases money supply but at that time it assumes that prices will fall and real GDP is not targeted.