Question

AD AS problem

6) Government increases its spending and reduces personal income tax rates (assume no

crowding out). The economy is far from potential (recession). (Use the neoclassical

synthesis)

7) The economy experiences a significant increase in production technology (show a

classical model (LRAS))

Answer 1

6)

Neo classical synthesis assumes that keynesian approach is right in short run while classical thought holds true over the long run.

Economy is operating below the full employment or extra capacity is available. So reduction in taxes and rise in expenditure would invariably drive up aggregate demand. So output will also rise. There might be marginal rise in price level or sometime it might be possible that price does not rise at all as has been suggested keynese.

Diagram:

Increase in spending and fall in tax, will shift demand from AD1 to AD2. So equilibrium output level also increases from Y1 to Y2.

b)

Classical economists argue that long run supply curve is vertical. or economy operates at the full employment level. There is no change in the output level. Only change in inputs or technology would shift AS to right.

Following is diagram:

Change or development of technology will shift AS to right or LRAS1. It signifies rise in output level.