Answer to Question #301125 in Macroeconomics for Wasim Alam

Question

1. What would the LM curve look like in a classical world? If this really were the LM curve that we thought best characterized the economy, would we lean toward the use of fiscal policy or monetary policy? (You may assume your goal is to affect output.)

2. Show, using IS and LM curves, why money has no effect on output in the classical supply

case.

Answer 1

1. What would the LM curve look like in a classical world?

According to the Classical model, the economy is highly free-flowing, and prices and wages react easily to demand fluctuations throughout time. To put it another way, when things are good, wages and prices rise swiftly, and when times are bad, wages and prices fall easily. The aggregate supply curve is shown vertically in the classical model. The aggregate supply curve is vertical in the classical model because it assumes that the economy is at full employment.

If this really were the LM curve that we thought best characterized the economy, would we lean toward the use of fiscal policy or monetary policy?

We will lean toward the use of the fiscal policy. Taxation and government expenditure are efficient fiscal policies because they ensure that production is distributed equally.

2. Show, using IS and LM curves, why money has no effect on output in the classical supply

Money is neutral in the classical model. A percentage increase in the money supply increases the entire price level by the same amount, with no influence on real variables such as actual quantities or relative prices.

When production is at full employment, the classical AS-curve is vertical. In this instance:

• Any rise in aggregate demand as a result of expansionary monetary policy will result in a price increase but no increase in output.
• The LM curve will initially shift to the right if the money supply is increased.
• This means a rightward shift in the AD curve, resulting in an increase in demand for goods and services.
• Real money balances begin to decline as the price level rises, finally reverting to their previous level.
• This means that the expansionary monetary policy's shift of the LM-curve to the right (and the accompanying shift of the AD-curve) will be exactly offset by the price adjustment, which causes the LM-curve to shift back to the left (resulting in a movement along the AD-curve to the new long-run equilibrium).
• The level of output and interest rates will not have changed at the new long-run equilibrium, while the price level will have altered proportionately to the nominal money supply, leaving real money balances constant.