Question

1. According to the Keynesian model, whenever the economy is out of equilibrium, inventories begin to change. The Keynesian assumption is that management will always respond by changing ________________ (2 pts).

2. The Classical model suggests that given the same situation, management will always respond by changing ________________ (2 pts).

3. Austrian economics rejects equilibrium. Explain their position (2 pts).

4. Why do Keynesian economists believe increasing the money supply is a good idea? Use the equation of exchange in your answer (2 pts).

5. Briefly explain the Austrian Business Cycle. Use diagrams to support your statements (3 pts).

Answer 1

1) According to the Keynesian model, whenever the economy is out of equilibrium, inventories begin to change. The Keynesian assumption is that management will always respond by changing "Production. In case of excess supply, management will see an increase in unplanned inventory and therefore, cut back on production in next cycle while in case of excess demand, management will see a fall in unplanned inventory and hence, increase production in next production cycle."

2. The Classical model suggests that given the same situation, management will always respond by changing "Prices because classical economist believe that prices and wages are flexible. Any disequilibrium will be corrected through market forces of demand and supply and the price will increase in case of excess demand and price will fall in case of excess supply."

3. Austrian school of thought believe in the subjective explanation of the individual preferences. Austrian economics believe that the price of a commodity is also, influenced by the subjective preferences of individual and can not be objectively defined like classical and Keynesian economist. They also emphasize on the heterogeneity of capital and explain that costs are also influenced by subjective factors like alternative use of the scarce resources.

4. The equation of exchange gives a relationship between money supply (M), Velocty of money (V), Price level (P) and Real GDP (Y). The equation is as follows:

Velocity of money is defined as the number of times money changes hand. P*Y is the nominal GDP. The equation basically addresses that the total spending (M*V) is equal to the Nominal GDP. SInce, V and Y are generally constant in short run, the equation concludes that any change in money supply will lead to a proportionate change in price level. Thereore, Keynesian economists believe that any disequilibrium in nominal variables can be corrected through change in money supply.