ECON 401 chapter 11 and 10 csun

What are the advantages and disadvantages of each strategy?

- If policymakers increase the money supply, the economy returns to full employment without a change in the price level. The composition of output is the same as when the economy returns to full employment without monetary or fiscal policy.

9. What does the Keynesian model predict about the cyclical behavior of average labor productivity?

- The Keynesian theory assumes that demand shocks cause most cyclical fluctuations. This means that during expansions when employment rises, average labor productivity declines, so it is countercyclical

How does the idea of labor hoarding help bring the prediction of the model into conformity with the business cycle facts?

-But the business cycle fact is that average labor productivity is mildly procyclical. However, if labor hoarding occurs, so that a given measured amount of employment produces less output during recessions and more output during expansions, then measured average labor productivity would be procyclical.

Be sure to discuss the effects on employment, the price level, and the composition of output.

-If policymakers increase government purchases, again the economy returns to full-employment equilibrium without a change in the price level. However, the higher real interest rate caused by the expansionary fiscal policy reduces consumption and investment, and the higher taxes to pay for the government spending also reduce consumption relative to either the situation in which monetary policy is used, or in which there is no policy response at all.

According to the Keynesian analysis, in what two ways does an adverse supply shock reduce output?

-In Keynesian analysis, a supply shock may reduce output in two ways: (1) a reduction in output, because the supply shock reduces the marginal product of labor, shifting the FE line to the left; and (2) a further reduction in output if the supply shock is something like an oil price shock that is large enough to cause many firms to raise prices, shifting the LM curve up and to the left so much that it intersects the IS curve to the left of the FE line

What problems do supply shocks create for Keynesian stabilization policies?

-Supply shocks create problems for stabilization policy because: (1) policy can do nothing to affect the location of the FE line; and (2) using expansionary policy risks worsening the already-high rate of inflation.

Define efficiency wage. What assumption about worker behavior underlies the efficiency wage theory?

-The efficiency wage is the real wage that maximizes effort or efficiency per dollar of real wages. It assumes that workers will exert more effort, the higher the real wage.

Why can a monopolistically competitive firm profitably meet demand at its fixed price when actual demand is greater than the firm anticipated?

A perfect competitor would lose all of its customers if its price were a little above the price charged by its competitors. But a monopolistically competitive firm would lose only some of its customers in this case.

In this model, how is full-employment output affected by changes in productivity (supply shocks)?

A productivity shock does not lead to a change in the efficiency wage, since it does not affect work effort. But it does affect the marginal product of labor, so employment changes. A beneficial productivity shock, for example, leads to an increase in employment. Both the employment increase and the increase in productivity lead to an increase in full-employment output.

Define real shock and nominal shock. Give an example of each

A real shock is a disturbance to the real side of the economy that affects the IS curve or the FE line. A nominal shock is a disturbance to money supply or money demand that affects the LM curve. Real shocks include changes in the production function, in the size of the labor force, in the real quantity of government purchases, or in the spending and saving decisions of consumers.

According to classical economists, should fiscal policy be used to smooth out the business cycle? Why or why not?

According to classical economists, fiscal policy should not be used to smooth out the business cycle because free markets produce efficient outcomes without government intervention, and because imperfect knowledge of the economy, political constraints on policy actions, and time lags make such stabilization policies impractical

8. According to the misperceptions theory, what effect does an increase in the price level have on the amount of output supplied by producers? Explain.

According to the misperceptions theory, an increase in the price level fools producers of goods into producing more, because they are unable to tell whether the increase in prices is a relative price increase or a rise in the general price level.

How is full-employment output, Y, determined inthe Keynesian model with efficiency wages?

Full-employment output is the amount of output produced by firms with employment determined by the labor demand curve at the point where the marginal product of labor equals the efficiency wage.

. Describe three alternative responses available to policymakers when the economy is in recession.

In response to a recession, policymakers can (1) make no change in macroeconomic policy, (2) increase the money supply, or (3) increase government purchases

What does the Keynesian model predict about monetary neutrality (both in the short run andin the long run)?

In the Keynesian model, money is not neutral in the short run, but it is neutral in the long run. In the short run, an increase in the money supply increases output and the real interest rate, while the price level and real (efficiency) wage are unchanged. In the long run, however, only the price level is changed, with no change in output, the real interest rate, or the real wage. In the basic classical model, money is neutral in both the short run and the long run, so only the price level is affected by a change in the money supply, just as in the long-run Keynesian model

9. What conclusion does the basic classical model (with no misperceptions of the price level) allow about the neutrality or no neutrality of money?

In the classical model, money is neutral in both the short run and the long run.

Does it explain any business cycle facts less well?

It is not so successful at measuring or identifying the productivity shocks that have caused business cycle fluctuations, or at explaining why unemployment occurs in downturns.

Why is the distinction of practical importance?

Keynesians assume that prices are slow to adjust to restore equilibrium. The distinction is of practical importance because classicals are less likely than Keynesians to recommend government intervention to restore equilibrium.

How is it affected by changes in labor supply?

Labor supply changes have no effect on the efficiency wage or employment; they simply affect the amount of unemployment. So they have no impact on full-employment output.

Define menu cost.

Menu costs are the costs of changing prices

Why might small menu costs lead to price stickiness in monopolistically competitive markets but not in perfectly competitive markets?

Menu costs may lead to price stickiness in monopolistically competitive markets but not in perfectly competitive markets, because a monopolistically competitive firm's demand is not as sensitive to the price as is a perfectly competitive firm's demand. Monopolistically competitive firms may meet the demand at a fixed price when demand increases, because price exceeds marginal cost, so that profits still rise, and because the cost of changing prices may exceed the additional profit earned from doing so.

4. What major business cycle facts does the RBC theory explain successfully?

RBC theory is successful at explaining that employment is procyclical, that average labor productivity is procyclical, that the real wage is mildly procyclical, and that investment is more volatile than consumption.

What type of real shock do real business cycle economists consider the most important source of cyclical fluctuations?

Real business cycle theorists consider shocks to the production function to be the most important. These include the development of new products or production methods, the introduction of new management techniques, changes in the quality of capital or labor, changes in the availability of raw materials or energy, unusually good or unusually bad weather, and changes in government regulations affecting production

Does it matter whether the increase in the price level was expected?

The change in prices must be unexpected for this to occur, because to the extent that the price change was expected, producers would not be fooled into changing production

Compare the Keynesian predictions about neutrality with those of the basic classical model and the extended classical model with misperceptions.

The extended classical model with misperceptions is similar to the Keynesian model. In the short run, an increase in the money supply increases output and the real interest rate, just as in the Keynesian model. However, unlike the Keynesian model, the price level rises, as does the real wage. The long run of the extended classical model is identical to the classical model or the long run of the Keynesian model—only the price level is affected.

6. What effects does a temporary increase in government purchases have on the labor market, according to the classical theory?

The increase in government purchases does not affect labor demand, but causes an increase in labor supply at any given real wage. This occurs because workers are poorer due to the current or future taxes they must pay to finance the increased government spending. Since labor demand is unchanged but labor supply increases, the real wage declines and employment rises. The rise in employment raises output in the economy. If the shift in the FE line is much smaller than the shift in the IS curve, the combination of shifts to the right in the FE line and IS curve also leads to a rise in the real interest rate and the price level. What effects does it have on output, the real interest rate, and the price level?

1 What main feature of the classical IS-LM model distinguishes it from the Keynesian IS-LM model?

The main feature of the classical IS-LM model that distinguishes it from the Keynesian IS-LM model is the classical model's assumption that prices adjust quickly to restore equilibrium.

Why does it predict that the real wage will remain rigid even if there is an excess supply of labor?

The real wage will remain rigid even if there is an excess supply of labor, because firms won't reduce the wage they pay; doing so would reduce their profits, since workers wouldn't work as hard.

What are some of the practical difficulties in using macroeconomic stabilization policies to fight recessions?

There are practical difficulties with increasing the money supply or increasing government purchases to return the economy to full employment. It is difficult to tell how far the economy is below full employment to know the right amount of fiscal or monetary stimulus to apply. We do not know exactly how much output will increase in response to a monetary or fiscal expansion. And since these policies take time to implement and more time to affect the economy, we really need to know where the economy will be six months or a year from now, not just where it is today, but such knowledge is very imprecise.

In what ways is this conclusion modified by the extended classical model based on the misperceptions theory?

This is modified in the misperceptions theory in that anticipated monetary changes are neutral in the short run, but unanticipated monetary changes are not neutral in the short run. Both anticipated and unanticipated monetary changes are neutral in the long run.