Question

Explain very briefly if the following statements are true or false. Mathematical or graphic treatment will be appreciated wherever possible or necessary.

1. While in the classical model with flexible wages and prices both output and employment are determined in the goods market by the demand for and supply of goods, in Keynes’ model with fixed money wages they are not.

2. In Keynes’ model the important role of the interest rate is to bring the real demand in line with supply of money in the money market, and not aggregate savings in line with investment at full employment.

3. The neutrality of money in the classical model implies that afiscal policy increase in government expenditures has no real effects.

4. In order to maximize profits, the firm will hire extra labor until the nominal wage rate is equal to the marginal product of labor.

5. In Keynes’ model the labor market clears at such a real wage rate at which both households and firms maximize their utility and profit respectively.

6. In the classical model, the quantity theory of money holds at all times postulating that real money balances are demanded in proportion to real income. Therefore, we can express this as follows: .

Answer 1

1. False. In the classical model, it is assumed that the economy is at full employment level and working to its capacity producing at full employment level. So the aggregate supply curve is vertical. While the aggregate demand is downward sloping which then decides the level of prices in the economy. In the Keynesian model, the prices are assumed only sticky not fixed. So they do change as per the interaction of aggregate demand and aggregate supply curve.

2.True. The aggregate savings are used by the classical economists, while in the Keynesian economy, the rate of interest brings the demand and supply of money in line.

3. False. The neutrality of money means the changes in the money supply in the market affects only the nominal variables such as prices and wages while there is no change in the real variables such as employment, GDP etc.

4. False, As long as the marginal product of labor is higher than that of the real wage, not the nominal wage, it will be profitable for the firm an additional labor. The firm will only hire the labor where the marginal product of labor will be equal to the real wage.