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1. Homework The main differences between the classical and Keynesian models are those dealing with unemployment and wages. In the classical model unemployment is optional and thus they are always at the NAIRU or the natural rate of unemployment. In this model the only people that don't work are the ones that choose not to because they are unhappy with the wage that is given. This is in strict contrast to the Keynesian model who says that unemployment is determined by the amount of aggregate demand. This is because in the Keynesian model people will lose their job based upon the level of demand of their product/service. The other difference is that of wages; in a classical model the wages are flexible as opposed to that of the Keynesian model in which wages are sticky. Flexible wages mean that any time there is a major change in output or in prices the firms will adjust the wages of the workers to still remain at the equilibrium. However, in the Keynesian model the wages are sticky and as such cannot be adjusted at any time until, for whatever reason, they become unstuck. This means that when there is a major change in wither price or output the firm must either fire or hire people and cannot simply tamper with the wages. 2. As an aggregate demand curve goes up so to does price, and as such the AD goes down. This is due to the fact that as price goes up the real value of monetary wealth falls and as a result AD will die down. The less your money is worth the less disposable income people had and thus the less amount of consumption will occur. In a single good demand curve as the demand curve goes up so does price but in this context we must view the item based upon its elasticity. If the item becomes expensive then the consumer
will simply find a comparable item or a substitute of a lower price and consume that. Aggregate demand takes into account all the items within a country while a single item must compete with others. 3. Currently the GDP has risen slightly under 2000 billions of chained dollars since the first quarter of 2002 to the current state. I believe the rise in GDP is in direct correlation to an increase in the amount of aggregate demand that America has. It seems that their has been an increase in all the factors that determine AD with the exception of net exports, with the largest rise being that of consumption. This can be attributed to the fact that people are getting paid more and have more confidence in the market today. Aggregate supply could also go up because the large amount of sticky wages that are out their with a corresponding increase in general prices (inflation) that leads to the upward sloping of the AS curve. 4. Expectations within the economy play a major role when dealing with consumption. If people are expecting to make a large amount of money within the short or long term they are more likely to spend money in the market today. Expectations also play a role in the amount the government will interfere within the economy overall. Since we are expecting a recession to occur the government is thus instituting a stimulus plan to drive it away. Finally, expectations play a role in investment because people are likely to invest only if they are expecting high future profits and a low interest rate. 5. Providing health care to your employees would result in higher efficiency amongst them because it can be viewed as a type of efficiency wage and as such keep workers with your company longer and have them producing at 100% efficiency. It would also allow workers to feel as if the company cares for them more thus giving them a since of
loyalty to a firm that results in a growth of the amount of incumbent workers a firm is going to have in the long run. Another potential benefit is that of overall environment within a work force that could make it seem like a better environment for attracting workers skilled to the industry. Overall however, the added cost to a company and the downgrade of efficiency would result in the loss of to much where health care is just an unnecessary added expense. It is adding a fringe benefit to everyone, including those who will not or do not want it, and as such should be held in the responsibility of individual firms to decide to whom, if at all, they should offer health care to. The main goal of a company is to maximize profit and if the government were to interfere with that by adding on unnecessary costs to the firm it would become to burdensome for some. 6. The upcoming tax cuts would allow the economy to prosper in both the classical and the Keynesian model. This is because that with tax cuts the amount of disposable income should rise (C[Y-T]) and hopefully that will increase the consumption of the people. Since demand is affected by the amount of consumption, as well as other things, it is plausible to say that in both models demand for goods will rise and that the economy will prosper because the people are putting back the tax-cut money into the economy. When dealing with unemployment the answers become different. In the classical model a tax cut would result in more money for the people and thus inflation. Since inflation is a general increase in price peoples wages simply become higher and we are still at the NAIRU. When dealing with the Keynesian model though the inflation still occurs but instead of a raise in wages we are dealing with sticky wages. Since all the other inputs around the employment are the same that makes labor as the cheapest input and with the formula for real wage (W/P) it proves that the firms will hire more people because they
have a higher incentive to produce and thus employ more to produce more. This subsequently causes aggregate supply to increase. 7. The tax cuts that are currently being mulled over by Congress would have the immediate effect of increasing the amount of consumption that people would have and as such increase aggregate demand. Since the tax cuts will allow people to have a higher amount of disposable income it, in theory, assumes that they will consume more goods and services. With the boost in the amount of consumption and possibly investment by having the profitability of investments for companies rising it is foreseeable that the economy as a whole will begin to do better and (hopefully) be able to fight off the potential of a large scale recession. 8. An increase in price in a product would cause a firm to produce less thus lowering its output in a classical model. If price rises then the amount of demand for the item will go down and thus the willingness of the firm to produce will lower. In a classical model if prices go up then the firm will use the flexible wages and lower the wages of the workers to still maintain the level of production. If we instead use the Keynesian model, then firms hire people because they have much more incentive to produce for because the cheapest input is now the labor force. This whole model changes if instead of a products price goes up we have an overall increase in price because then the firm will be willing to produce the same amount. This is due to the fact that with an overall increase in prices and non-sticky wages their output would be unaffected because of the overall increase in their input. This is mainly due to the general increase of the real wealth effect which means that if everything increased in price, the value of the dollar would thus fall. If wages were sticky however it would result in either a decrease or increase in production
(pending if they are sticky low or high) and the potential to fire people. Also there is a chance that they couldn't go back to maximum output until the wages become flexible or the wages become sticky at a different amount.