Question

For each of the following changes, what happens to the real interest rate and output in the long run, after the price level has adjusted to restore general equilibrium? How would the results differ, if at all, between the classical and Keynesian model? Draw a diagram for each part to illustrate your result.

(a)Wealth rises.

(b)Money supply rises.

(c)The future marginal productivity of capital increases.

(d)Expected inflation declines.

(e)Future income declines.

Answer 1

Answer a → Wealth rises.

If wealth rises real interest rate will go down in both models (Keynesian and Classical: no difference in result) as demand of money for both consumption and investment will go down, also the wealth will flow to market as supply of money which will lead to increase in money supply and decrease in rate of interest.

The output in both the cases will grow in longrun as more money enters for consumption and investment.

Rise in AD i Rise AET IM Outlu JAS, perice -bud ADR Rise in outpul y y

Ans. b: Money supply rises.

Money supply has the same effect as above mentioned wealth rises. In this case interest rate will go down and output will increase (same graph as given above will be applicable.

Ans. c: The future marginal productivity of capital increases.

If future marginal productivity of capital will increase, interest rate will go up as investment demand will go up (because profit increases) and money from consumption may also flow for investment. Output will grow in both models (Keynesian and Classical). Fig. 2.1 and 2.2.

C+I+I' Price feud (Reynes Modd) (classical model) сс AE Fig. 3 . 1ے 3 . 2 VY

Ans. d : Expected inflation declines

Decline in inflation will lead to rise in consumption demand successively rise in investment demand and rise in demand for money so interest rate will rise ultimately, and out put will also grow in longrun(in both the models Keynesian and Classical)  as consumption demand rising.  

Fig. 3.1 and 3.2