Question

2. In County X, in the early nineties, as unsustained reduction of the public debt to GDP ratio coincided with a sharp increase in the unemployment rate from 4 percent to 12 percent, followed by a steady decline of unemployment towards its natural rate. Apply the Keynesian model for the short-run and the classical model for the long-run to provide a unified explanation for the above observation.

Answer 1

The Keynesian model of macro economic equilibrium applies a simple two sector model of households and firms to achieve the savings and investment equality which is the crux of the macro economic equilibrium. Later on the other components were added to the basic Aggregate demand concept as stated by Keynes to include Government expenditure and imports and exports.

Keynesian model essentially believes in a near to full employment equilibrium since according to Keynes, full employment includes voluntary unemployment or the concept of the ‘idle rich’ as well as the idle poor who want to remain unemployed for non-economic reasons by choice. Since at any point of time there could be such cases of unemployment in the economy. What is projected as full employment equilibrium is actually a near to full employment situation of, say, 96% employment—or , 3-4% unemployment.

Country X’s government’s reducing public debt in an unsustained manner in proportion to the country’s total output of goods and services produced however would have led to   more income in the hands of the people who would have found the available disposable income a boon to spend and would have increased their aggregate spending .As long as the total output rises in proportion to the aggregate demand the rise in the aggregate spending would have a positive effect upon the economic growth of the country with Country X’s GDP growing , however, according to Keynes the aggregate supply curve becomes steeper as the economy approaches the full employment level.

A sharp increase in the aggregate demand at the full employment level could lead to a shortage of goods and services which would push the prices higher up , this leads to cost push inflation , or wage push inflation with the trade unions seeking a higher wage hike relative to the rising prices. This causes a situation of ‘an inflationary gap’ in the economy—where the available goods and services are unable to meet the aggregate demand—in such situations , the government generally undertakes certain measures like increasing taxation or reducing public debt, and so on to attain the macro economic equilibrium in the short run.

The classicals however believed in the possibility of a full employment equilibrium and did not advocate any situation of near to full employment equilibrium as being the actual macroeconomic equilibrium .They believed that a natural rate of unemployment would remain in the long run as the aggregate supply curve becomes vertical to the y-axis or to say in simpler words , supply becomes fixed in the long run as compared to aggregate demand , (since the resources are given while the desires or wants are unlimited.). A change in the general price level of all goods and services is expected to have no impact upon the aggregate supply and any deviation from the full employment situation is expected to lead to a point where the economy rapidly adjusts back to the equilibrium point, the general price level being the tool that will adjust the economy back to the full employment equilibrium in the long run , as envisaged by the classicals.

Given this explanation it can be understood why Country X’s unemployment rate steadily declined to its natural rate after a sudden and sharp rise from 4% to 12 %.