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.
Read more about this topic: AD-AS Model
Famous quotes containing the words monetary, policy, classical and/or cases:
“In our time, the curse is monetary illiteracy, just as inability to read plain print was the curse of earlier centuries.”
—Ezra Pound (1885–1972)
“Our policy is directed not against any country or doctrine, but against hunger, poverty, desperation and chaos. Its purpose should be the revival of a working economy in the world so as to permit the emergence of political and social conditions in which free institutions can exist.”
—George Marshall (1880–1959)
“Classical art, in a word, stands for form; romantic art for content. The romantic artist expects people to ask, What has he got to say? The classical artist expects them to ask, How does he say it?”
—R.G. (Robin George)
“The world men inhabit ... is rather bleak. It is a world full of doubt and confusion, where vulnerability must be hidden, not shared; where competition, not co-operation, is the order of the day; where men sacrifice the possibility of knowing their own children and sharing in their upbringing, for the sake of a job they may have chosen by chance, which may not suit them and which in many cases dominates their lives to the exclusion of much else.”
—Anna Ford (b. 1943)