Question

Question 1

1. Outline the difference between " real business cycle model " and " new classical model " in examining the relatioship between money and output in the short run. (10 marks)

2. Explain the early Keynesian's structure model evidence and explain why monetarist objected to Early Keynesian's findings. (9 marks)

Answer 1

SOLUTION

DIFFERENCE BETWEEN " REAL BUSINESS CYCLE MODEL AND THE NEW CLASSICAL MODEL "

a) REAL BUSINESS CYCLE MODEL

Almost all micro economics analysis is based on the assumption that prices adjust to clear markets. The leading new classical explanation of economic fluctuation is called as new business cycle. According to this analysis, the assumption that have been used long - run may also apply for short run study. Most importantly , real business cycle theory holds that the economy obeys the classical dichotomy nominal variables are assumed not to influence real variables. To explain fluctuations in real variables, real business cycle theory emphasis real changes in the economy, such as changes in fiscal policy and production changes and technologies. This theory excludes the nominal variables to explain the economic fluctuations.

NEW CLASSICAL MODEL

Most economist believe that the classical model cannot explain the short run economic fluctuations because in this model the prices are being flexible. However the new classical economist believe that the new classical model can explain the short run economic fluctuations. It helps in assuming the prices are flexible even in the short run. It inherits the Keynesian and the neo classical elements. It involves the systematic application of inter portal optimization and rational expectations. New classical macro economics strives to provide neo classical micro economic foundations of macro economic analysis. This is in contrast with the Keynesian school that uses micro foundations such as price stickiness and imperfect competition to generate macro economic models similar to earlier Keynesian ones.

B) KEYNESIAN STRUCTURE MODEL EVIDENCE

Keynesian model structure is a theory that says the government should increase the demand to boost the growth. Keynesians believe consumer demand is the primary driving force in an economy. As a result, the theory supports expansionary fiscal policy. According to this theory the changes in aggregate demand, whether anticipated or unanticipated , have their greatest short run effect on real output and employment, not on prices so therefore the Keynesian structure model either assume or try to explain the rigid of prices. This theory also proposes the spending boosts aggregate output and generates more income, the resulting growth in the gross domestic product could be even greater than the initial stimulus amounts.

MONETARIST SUBJECTED TO EARLY KEYNESIAN FINDINGS

Monetarism focuses on the macro economic effects of the supply of money in the economic system. Monetarism began to deviate more from Keynesian economics however in the 70s and 80s as active implementation and the historical refection began to generate more evidence for the monetarist view. When the money supply is being expanded, individuals will be induced to higher spending in turn, when the money supply retracted individuals would limit their budgetary spending accordingly. This would theoretically provide some control over aggregate demand,