Question

As an economic analyst, you were asked to provide your opinion about the impact of the financial crisis on the economy by using the new classical model. If the Malaysian government implemented monetary expansion policy that is less than expected, what would your expectations be when it comes to the effects on real output in the short-run and the long-run?   

Answer 1

The new classical model says that people form rational expectations. Due to this the anticipated policy is not successful even in the short run. However, if the policy is unanticipated, then it will be effective in the short run only.

For instance, in the diagram, economy is in long run equilibrium at A, point where long run and short run aggregate supply intersects the aggregate demand.

Now, due to unexpected exoansionary monetary policy, investments will rise and aggregate demand shifts in the forward direction.

However, this will lead to rise in prices. Rise in prices will lead to workers demanding more wages after a time lag (when they realise about the expansionary policy). Due to this, firms will start laying off workers and short run aggregate supply moves in the backward direction.

Due to this, firm moves from short run equilibrium at B to C, new long run equilibrium.

There is no impact on the output level. Only the prices increased.

Real output rises in the short run but stays the same in the long run.