Chapter+13+-+Keynesian+Economics

Chapter+13+-+Keynesian+Economics - Chapter 13 Study Guide...

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Unformatted text preview: Chapter 13 Study Guide To Accompany Macroeconomics: Theory and Policy By B. Modjtahedit Prepared by T. J. McCarthy and B. Modjtahedi University of California, Davis Key Points Two propositions at the heart of Keynesian economics: Demand shocks are the main cause of business cycles. Wages and prices are rigid or sticky in the short run. Key Points Demand management policies in the Keynesian model: Money is not neutral. The interest rate is determined in the money market. Changes in money supply affect the rate of interest, which in turn affects consumption and investment, and hence, aggregate demand. There is no financial crowding out, especially in a recession. There will be plenty of financial resources for the government to tap into without retarding the private consumption and investment spending. Therefore, A balanced-budget increase in spending has a unit-multiplier effect . Deficit spending will be expansionary. For example, an increase in G will cause an increase in aggregate demand through the multiplier process. Monetizing the debt will be the most expansionary demand management policy, as it is a combination of fiscal and monetary policies. Key Points Reason for wage rigidity Labor contracts Efficiency wage theory Minimum wage laws Insider-outsider model Reason for price rigidity Price contracts Menu costs Coordination problem General Equilibrium P Y AS Along this line, the labor market clears. AD Along this line, the goods and money markets clear. At this point, all three markets clear: general equilibrium of the economy. Y P E Key Points Wage and price stickiness is a short-run phenomenon. In the long run wages and prices will adjust to economic conditions and we will get the classical results. So the effect of a shock on P and Y: Short run: Keynesian Long run: Classical P Y AS AD 100 Y P A demand shock shifts AD to the left. E A AD Due to wage rigidity, producers keep their prices unchanged and reduce production to meet the new lower demand. The economy moves to point A producing Y A < Y P . Y A We now have a recession with a GDP gap of (Y P- Y A ) and the resulting unemployment. This is called unemployment equilibrium. In the long run wages and prices will adjust and the economy will move to point E 2 . E 2 GDP Gap A Recession P Y AS AD 100 Y P A positive demand shock (an increase in C, I, or G) shifts AD to the right. E A AD Due to wage rigidity, producers keep their prices unchanged and increase production to satisfy the new higher demand. The economy moves to point A producing Y A > Y P . Y A In the long run wages and prices will adjust and the economy will move to point E 2 . E 2 A Positive Demand Shock A Supply Shock P Y AS AD 100 Y P An unexpected increase in the resource prices (price of oil, wage rate, etc.) E A This will cause the general price level (P) to increase....
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This note was uploaded on 04/03/2012 for the course ECN 001B 1b taught by Professor Baghermodjtahedi during the Spring '10 term at UC Davis.

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Chapter+13+-+Keynesian+Economics - Chapter 13 Study Guide...

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