Review Questions and Problems Solutions
1. Explain why, according to Keynes, the money wage would not adjust sufficiently to keep the
economy at full employment.
In Keynesian theory, money wages are sticky downward. Even when there is unemployment, wages
do not fall easily because of labor contracts, worker morale, social norms, and minimum wage laws.
Workers resist nominal wage cuts, leading to persistent unemployment. Since wages do not adjust
quickly, the economy cannot automatically return to full employment after a shock, unlike Classical
theory predictions.
2. Derive the Keynesian aggregate demand schedule for the case in which investment is completely
interest inelastic and therefore the IS schedule is vertical. Explain the resulting slope of the
aggregate demand-schedule for this case.
When investment is completely interest inelastic, the IS curve becomes vertical. Changes in the
interest rate do not affect investment and thus not output.
- The LM curve slopes upward.
- If price level falls, real money balances (M/P) rise, shifting LM curve rightward.
- As LM shifts, the vertical IS curve meets the new LM at higher output levels.
- Thus, a fall in price leads to higher real output.
Thus, the aggregate demand curve is downward sloping, even with vertical IS, because a fall in P
raises real money balances and shifts LM.
3. Explain the consequence of combining the Classical theory of aggregate supply with the
Keynesian system of demand schedule.
Combining Classical aggregate supply (vertical at full employment) with Keynesian aggregate
demand gives rise to the "Keynesian Cross" model for output determination.
- At output levels below full employment, Keynesian demand determines output.
- If AD intersects AS at full employment, there is no issue.
- If AD is insufficient, equilibrium occurs with unemployment (output below potential).
- No automatic price or wage adjustment ensures return to full employment.
Thus, persistent unemployment is possible if aggregate demand is deficient.
4. Why are fiscal policy multipliers smaller in magnitude in the variable price-fixed wage version of
the Keynesian model than in the fixed-price IS-LM model? Why are these multipliers still smaller
when we allow the money wage as well as the price level to be variable?
- In the fixed-price IS-LM model, fiscal policy causes full multiplier effect - government spending
leads directly to output increase.
- In the variable price-fixed wage model, an increase in output raises prices, reducing real money
balances, shifting LM leftward, and partly offsetting the output gain.
- When both money wage and price level are variable, rising prices and partial wage adjustments
create further shifts in LM and AS, further dampening the multiplier.
Thus, the fiscal multiplier shrinks because of price and wage flexibility that reduce the net increase
in output.
5. Return to the case considered in question 2, where investment is completely interest inelastic and
the IS schedule is vertical. Analyze the effects of an increase in government spending in this case
within the variable price-fixed wage version of the Keynesian model. Compare the effects with those
in the fixed price version of the model.
Fixed Price Version:
- IS vertical.
- Increase in government spending shifts IS rightward.
- Output increases fully by the multiplier; price level remains constant.
Variable Price-Fixed Wage Version:
- Increase in G shifts IS rightward.
- Output initially rises, but price level rises too.
- Higher prices reduce real balances, shifting LM left, reducing the final output gain.
Comparison Table:
Aspect | Fixed Price | Variable Price-Fixed Wage
-------|-------------|---------------------------
Output | Large increase | Smaller increase
Price Level | Constant | Rises
Fiscal Multiplier | Full | Reduced
6. Analyze the effects of a decline in government expenditure within the Keynesian model where
both the price level and money wage are assumed to be variable.
When government expenditure falls:
- Aggregate demand falls.
- Output (real income) falls.
- Firms reduce prices to stimulate demand.
- Reduced output leads to lower demand for labor.
- Money wages fall, but slower than prices.
Summary:
Variable | Effect
---------|--------
Real Income (Y) | Decreases
Price Level (P) | Decreases
Money Wage (W) | Decreases (less than P)
7. In the Keynesian system, increases in aggregate demand lead to increases in output because the
money wage rises less than proportionately with the price level in response to such increases in
demand.
Reasons why money wage does not adjust fully:
- Wage Contracts: Fixed over time.
- Money Illusion: Workers focus on nominal wages.
- Labour Market Frictions: Adjustment delays.
- Institutional Rigidities: Minimum wage laws, union contracts.
- Menu Costs: Costs of frequent changes.
- Expectations: Firms and workers think price rises may be temporary.
Thus, in the short-run Keynesian model, prices rise faster than wages, lowering real wages (W/P)
and encouraging employment and output increases.
