AD-AS Model - Fiscal and Monetary Policy Under Classical and Keynesian Cases

Fiscal and Monetary Policy Under Classical and Keynesian Cases

Keynesian Case: If there is a fiscal expansion i.e. there is an increase in the government spending or a cut in the taxes, it will shift the AD curve rightwards. The shift would then imply an increase in the equilibrium output and employment.

In the Classical case, the AS curve is vertical at the full employment level of output. Firms will supply the equilibrium level of output whatever the price level may be.

Now, the fiscal expansion shifts the AD curve rightwards, thus leading to an increase in the demand for goods, but the firms cannot increase the output as there is no labour force which can be obtained. As firms try to hire more labour, they bid up wages and their costs of production and thus they charge higher prices for the output. The increase in prices reduces the real money stock and leads to an increase in the interest rates and reduction in spending.

The equation for the aggregate supply curve in general terms for the case of excess supply in the labor market, called the short-run aggregate supply curve, is

where W is the nominal wage rate (exogenous due to stickiness in the short run), Pe is the anticipated (expected) price level, and Z₂ is a vector of exogenous variables that can affect the position of the labor demand curve (the capital stock or the current state of technological knowledge). The real wage has a negative effect on firms' employment of labor and hence on aggregate supply. The price level relative to its expected level has a positive effect on aggregate supply because of firms' mistakes in production plans due to mis-predictions of prices.

The long-run aggregate supply curve refers not to a time frame in which the capital stock is free to be set optimally (as would be the terminology in the micro-economic theory of the firm), but rather to a time frame in which wages are free to adjust in order to equilibrate the labor market and in which price anticipations are accurate. In this case the nominal wage rate is endogenous and so does not appear as an independent variable in the aggregate supply equation. The long-run aggregate supply equation is simply

and is vertical at the full-employment level of output. In this long-run case, Z₂ also includes factors affecting the position of the labor supply curve (such as population), since in labor market equilibrium the location of labor supply affects the labor market outcome.