Answer to Question #218789 in Macroeconomics for SAV

Question

Q.3 Business Cycles

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)     Shocks originating in the goods and money markets are expected to be significant because it takes time for economic agents to recognize their actual implications. As a result, these shocks might raise concerns about important macroeconomic indicators such as CPI inflation and real GDP growth. Under, the effects of nominal and actual shocks are calculated, assessed, and contrasted. CPI inflation and real GDP are subject to both short-run and long-run constraints. In addition, multiple nations with varied resource structures are integrated to obtain a thorough and broad analysis in, structural VAR models are used in order to make short-run and long-run constraints functional. The analysis of impulse responses is carried out to examine the short-run impacts of nominal and real shocks on CPI inflation and real GDP as well as in the long run Variance decompositions are used to identify the primary causes of Inflationary pressures and real GDP growth are both subject to uncertainty. Product market shocks seemed to be more widespread in contrast to money market shocks

b)     Keynes opposed the notion of the economy returning to a natural state of equilibrium.

c)      Instead, he believed that once an economic slump occurs, for whatever reason, the dread and pessimism that it generates among companies and investors tend to become self-fulfilling, leading to a prolonged period of low business growth and joblessness. In response, Keynes recommended a monetary policy strategy in which, during times of economic adversity, the state should engage in deficit spending to compensate for a decrease in investment and stimulate consumer budget in order to balance consumer spending.

d)    Many analysts have slammed Keynes' method. They contend that companies reacting to economic incentives will tend to bring the economy towards homeostasis unless the law restricts them from it by meddling with pricing and wages, giving the impression that the marketplace is conscious. Keynes, on the other hand, wrote during a moment of profound economic downturn, was less enthusiastic about the market's inherent stability. When it came to building a strong economy, he thought the government was in a stronger position than economic forces.