Answer to Question #206313 in Macroeconomics for zara

Question

a hypothetical economy gets hit by an adverse shock that reduces the marginal productivity of capital furthermore the economists have estimated that this will affect the goods market more as compared to the labour market and aggregate supply.

analyze and explain the effects of these shocks on all broad macroeconomics variables both in the short run and the long run using the IS LM LAS framework.

Answer 1

A reduction in marginal productivity implies that there exists a marginally diminishing rate of production per unit produced after advantageous adjustments are made to inputs that drive production.

A reduction in the marginal productivity of capital implies that the marginal product of capital is positive but decreasing in the level of capital stock. In case of this situation in the short run, wages and the prices in the market will not be affected. They will remain the same as they are not subject to changes made in the economic conditions. In some specific labor and good markets, there may be changes in the prices of goods and wages but this the changes are not so fast enough to maintain equilibrium in the specific markets. This according to the keynesian theory, may prevent the economy from achieving its potential output and also the natural level of employment.

In the long run, the employment level will move to the natural level and the real output product to potential because there is room for wages and the prices in the market to respond to changes brought about as a result of decrease in the marginal productivity of capital.

Because decrease in marginal productivity of capital results in a negative change in capital stock, this will imply also change in the prices of factors of production that will make the short run aggregate supply curve to slope upwards. In the short run however, the equilibrium price level and equilibrium quantity of output will be less affected or rather will remain unchanged.

In the long run, the aggregate supply curve slopes upwards indicating the potential level of output product and the natural level of employment.