Question

As I lectured in class, J.M Keynes is credited with three major changes to the Classical model which among other things made the determination of real output and employment dependent on fiscal policy (G*,T*):

(1) He introduced an liquidity motive for holding money;

(2) he introduced wage/price stickiness;

(3) he employed the consumption function in a new way.

A. Explain how (1)-(3) led to the conclusion that fiscal policy could have an impact on real output and employment (which the Classical theory had said could not happen).

B. In your opinion (that means there is not necessarily a “correct” answer), which would you argue is the most important “Keynesian” feature—i.e., (1), (2), or (3)—making real output and employment to depend on fiscal policies?

Note: It is your reasoning, not your choice, that matters in part B.

Answer 1

a) The difference between the classical model and the Keynesian model lies within theirassumptions. The classical model assumes that the economy produces at its potential and the aggregate supply curve is vertical. If the aggregate supply curve is vertical, then any allteration in the aggregate demand would fail to bring about changes in the outout of the economy. The Keyenesian model assumes that prices and wages are sticky, which is responsible for the upward slope of the supply curve. In this case, a change in the aggregate demand would affect the real output of the economy. When there are fiscal changes, it would have its effect upon the aggregate demand. An increase in the government expenditure or decrease in the taxes would shift the aggregate demand upwards and would increase the output and employment in the economy under Keyenesian model, while under the Classical model, the output remains unaltered.

b) Among the three options, the second one which says that there is price and wage stickiness, is responsible for the dependence of real output and employment in the economy. The stickiness of prices and wages would cause the upward shift of the aggregate supply curve, and ths,it would cause alteration in the output, when there is a change in the aggregate demand, due to fiscal policies.