Question

1. What would the Ns curve look like if the substitution effect = income effect? Explain your answer.

2. Derive the Ys curve in the classical model.

3.. Derive the Yd curve in the classical model.

Answer 1

2.The Yd slopes downward in the classical framework

Three reasons cause the aggregate demand curve to be downward sloping. The first is the wealth effect. The aggregate demand curve is drawn under the assumption that the government holds the supply of money constant. One can think of the supply of money as representing the economy's wealth at any moment in time. As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services. On the other hand, as the price level falls, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services than before. The wealth effect, therefore, provides one reason for the inverse relationship between the price level and real GDP that is reflected in the downward?sloping demand curve.

A second reason is the interest rate effect. As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP.

The third and final reason is the net exports effect. As the domestic price level rises, foreign?made goods become relatively cheaper so that the demand for imports increases. However, the rise in the domestic price level also means that domestic?made goods are relatively more expensive to foreign buyers so that the demand for exports decreases. When exports decrease and imports increase, net exports (exports ? imports) decrease. Because net exports are a component of real GDP, the demand for real GDP declines as net exports decline.

3.The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic. This has important implications. The classical view suggests that real GDP is determined by supply-side factors – the level of investment, the level of capital and the productivity of labour e.t.c. Classical economists suggest that in the long-term, an increase in aggregate demand (faster than growth in LRAS), will just cause inflation and will not increase real GDP.

What is NNs iin the first question?