Question

1. How do Classical economists and Keynesian economists differ in their perceptions of how well markets and prices function? 2. List and briefly explain the three market arenas. 3. Which are the four components of the macroeconomy? Explain the interaction between these components through a circular flow diagram. 4. Draw a graph of a business cycle. Label and explain the phases of a business cycle. 5. Define the following concepts: a) Sticky Prices b) Expansion and contraction c) Inflation, Deflation and Hyperinflation d) Fiscal Policy and Monetary Policy

Answer 1

1. The Classical and Keynesian Economist's perceptions differ broadly in terms of role of government policies in market functioning. The Classical sides believes in the idea of Free market. They believe that supply creates its own demand and price adjusts to remove the demand and supply because prices are assumed to be fully flexible. This ensures full employment in the economy because wages are also assumed to be flexible and therefore, government intervention is unnecessary. However, Keynesian Economics developed after the Great Depression of 1930s when markets failed. Keynesian Economists believe that prices and wages are sticky and therefore, at times markets fail. The demand supply curve if not checked can lead to falling output and increasing prices and wages. This leads to inflation and unemployment and needs to be checked through government fiscal policies. To summarize, Classical Economists believe in free market and flexible prices that ensure smooth functioning of the market while Keynesian Economists believe that prices are sticky and therefore, government intervention is necessary when markets fail to ensure equilibrium.

2. The three market arenas in macroeconimcs are:

a) Goods and Services Market: The market where goods and services are produced by the firms and sold to the Households, Government and firms in a closed economy at given prices. In an open economy rest of the world is also added as the fourth interacting agent in the market producing and consuming goods and services in the said market through exports and imports.

b) Labour Market: The market where household supply labour to the firms and government in return for the wages.

c) Money Market: the market deals with funds supplied by the households in return for dividends and interest payments. Firms, Government and the rest of the world engage in borrowing and lending through financial institutions

3. Four components of the Macroeconomy are Households, Firm, Government and Rest of the World.

Circular flow of Diagram:

factor of Production : Labor, and hand, Capital, Entrepreneurship Douments to tactor: Wages, sent ent, interest, Profit Goveinment Expenditu Government Taxes Taxes Payments Transfer Saning Investment Households saving Money Market Firms Dividends & Interest Pa Interest Labor Remittances Borawin import Paumat Export Receipts Rost of the world flow of Goods & services Payments for Goods & Services

4) A Business Cycle refers to the expansion and contraction of Economic activities around a long-term growth trend. A Business Cycle is identified with four phases: Expansion, Peak, Contraction and Trough.

Expansion refers to the phase of increasing output and employment and therefore, upward push on the prices. This is the phase of economic growth.

The Peak refers to the highest point in the business cycle where the level of output is maximum and there is full or more than full level of employment in the economy and the inflationary pressures are highest.

Contraction refers to the phase of declining output, increasing unemployment and therefore, reducing inflationary pressures.

The trough is the lowest point in the business cycle where the output is lowest, unemployment is highest and the inflationary pressures are also lowest. This is where, the nest business cycle will start.

Therefore, a business cycle is a wave like pattern around a long-term growth trend as shown in the following diagram:

Output long-team growth B trend conteaction Expansion Expansion Trough One Business Cycle Time