Question

Question 4 (20 marks)
a. In the presence of unemployment in the economy, explain why the Keynesian Aggregate Supply curve is upward-sloping, and not vertical as in the Classical model. (10 marks)

b. The Keynesians say that expansionary fiscal and monetary policies are more effective in influencing output level in the case of flexible-price, fixed money wage model compared to the flexible-price, flexible money wage model. Is this statement true? Explain.

Answer 1

Answers

a) Firstly Keynesian model is a short run model of economy whereas Classical model is long run model where all resources are fully employed at full capacity. Therefore, the supply curve is vertically sloped.

In the presence of unemployment Keynesian aggregate supply curve has positive slopeslope due to the less flexibility of prices and wage rate.

The assumption of classicals that economy is always at full employment is the main cause that there aggregate supply curve is vertical. On the other hand Keynese doesn't bleave on such an assumption. He assumes that economy is not always on full employment equilibrium, he thought that economy in short run experience underemployment equilibrium where employment can be increased. Hance, resulting in an upward sloping aggregate supply curve.

b) According to Keynese this statement is completely correct.

Explanation: Through fiscal policy to influence the output label can be done by either increasing the level of government expenditure or by reducing the amount of taxes. If the government expenditure is increased by an amount equal to the deflationary gap, it will restore the economy to the full employment equilibrium in the presence of flexible price but rigid money wages.

On the other hand monetary policy aims to cause an increase in investment expenditure by firms. This may be done in a two step manner. The first step is to increase the availability of credit by reducing the reserve ratios. The next step is to lower the interest rate by increasing the supply of money. The purpose of this step is to ensure the off take of the increased credit by firms.

Therefore increased government expenditure and increased private investment by fiscal and monetary policy respectively will increase aggregate demand and aggregate supply in the situation of flexible price and fixed money wages.