Answer to Question #218766 in Macroeconomics for zain

Question

A hypothetical economy gets hit by an adverse shock that reduces the marginal productivity of capital. Furthermore, economists have estimated that this shock will affect the goods market more as compared to the labour market and aggregate supply. Answer the following questions in this context: a) Analyze and explain the effects of these shocks on all broad macroeconomic variables both in the short run and the long run using the IS-LM-LAS framework. b) Does the Keynesian explanation of the relationship between output and price-level hold in the long run equilibrium? c) What might a Keynesian policy maker recommend to bring the economy back to original equilibrium? Will this policy be successful? d) Will a classical policymaker agree with Keynes’ recommended policy? Explain

Answer 1

 

A.    

A reduction in marginal productivity implies a marginally diminishing production rate 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 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. There may be changes in the prices of goods and wages in some specific labor and good markets, but the changes are not so fast enough to maintain equilibrium in the specific markets. According to the Keynesian theory, this may prevent the economy from achieving its potential output and 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 a decrease in the marginal productivity of capital.

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

B.       

The Keynesian theory of the determination of equilibrium output and prices uses both the income‐expenditure model and the aggregate demand‐aggregate supply model. Keynes argues that prices will not fall further below a certain price level because workers and other resources will resist reducing their wages. This resistance will prevent suppliers from increasing their supplies. In the long run, these arguments will not hold because other underlying factors cause prices of various products to fall below a certain level. Price floors instituted by the government will lead to prices going below a certain price level. The argument will not hold in the long run also because the economy is not static. It changes from one cycle to another. Changes in the economy can favor price decrease.

C.     

The government should undertake deficit spending. The government ought to utilize its spending power to create demand and stimulate the economy. This is geared towards increasing investment and boosting consumer spending. This policy will help to stabilize aggregate demand. This policy can be successful if the government decides to borrow more to cater to budgetary deficits.

D.    

The classical theorist cannot support Keynes's policy on deficit spending. The classical theorist argues that the economy is always at the full employment level of output. This means that any increases or decreases in aggregate demand only lead to a higher or lower price, but economic output remains the same.