1. The classical economists believed that our economy was always at full employm
ID: 1191701 • Letter: 1
Question
1. The classical economists believed that our economy was always at full employment or tending toward full employment. If our economy were operating below full employment, what would happen, according to the classicals, to move the economy back toward full employment?
2. When the price level increases, the quantity of goods and services purchased declines. Why does this happen?
3. Explain the difference between the long-run aggregate supply curve and the short-run aggregate supply curve.
4. What were the major areas of disagreement between John Maynard Keynes and the classical economists?
5. Describe the chain reaction that is set off when (a) aggregate demand exceeds aggregate supply; (b) aggregate supply exceeds aggregate demand.
6. If you lived in a village cut off from the rest of the world, show how Say's law would apply to your village's economy.
7. Describe the differences between an inflationary gap and a recessionary gap.
8. Explain why large deficits are so bad.
Explanation / Answer
1. Classical economist's theory has its roots in Say's Law, that is, supply creates its own demand. So when the economy is operating at a level which is below the full employment would mean that there is excess supplyof workers. Classical economists believed that a large pool of unemployment implies that workers are simply refusing to work at the prevailing market rate and are choosing leisure for work. However, this alsoo implies that with excess supply of workers, the wages would fall and hence the firm would start demanding for more workers at this lower wage. Gradually, the full employment level would be achieved.
2. As the price level increases(keeping the income constant), the purchasing power decreases, and hence the demand for goods and services decline. For example : it you have $10 with you, with this you can buy 2 candies woth $5 each. Now if the price of the candy goes up to $7, your demand for candy will fall from 2 to 1 (keeping income constant at $10). The increase in price has just lowered the purchasing power and hence the aggregate demand.
3. In the short run the AS curve is upward sloping, whereas in the long run the AS curve is vertical. The AS slopes upward in the short run because we assume the cost of production (wages) do not change to offset changes in prices, that is, as the prices increase, the firm hires more workers to produce more and do not pass this higher prices to the workers in the form of wages and in turn earn a higher profit in the short run. Also, because in the short run the level of capital is fixed, only the existing factors can increase their utilistion (worker's overtime, etc). But in the long run all the factors of production are variable so the utilising them full employment level is achieved and the AS curve becomes vertical. Also, in the long run all the costs will adjust completely to change in prices, so neither profit nor increase in output will increase.
4. The base of disagreement between Keynes and classical economists is the belief that classicals had of LAISSEZ-FAIRE economy, to which a completely contrasting belief of Keynes, of GOVERNMENT INTERVENTION emerged. The classical viewd government intervention as hinderance to free market, whereas Keynes believed that without government intervention equilibrium level is unattainable. Classical has thrie roots in Say's law, whereas Keynes argued that revenue generated by productionultimately ends up as household income and the entire income is not spent. so therefore there would be less demand in the next time period. Classical believed in flexible prices and wages, they thought any change in the demand or supply will quickly clear out the market by the flexible prices and wages. However, Keynes believed that this flexibility is not instantaneous, because only then short run mismatch would prevail.
5. a) AD>AS. When demand is greater than supply, the pile of unsold stocks get reduced, because of which firms start producing more and hire more factors of production. This generates employment and in the short run due to shortage of raw materials/factors of production leads to rise in price. This increase in price offsets the aggregate demand in the next period and simontaneously increase the supply so that the equilibrium is again restored.
b). AS>AD. When supply is more than demand, then the pile of unsold stock will increase and the firms will react to this by cutting the production in the next time period. They would also lay off some factors of production and generate unemployment. This fall in aggregate supply will be till the time it becomes equal to aggregate demand and the equilibrium is restored again.
6. In a village which is cut off from the rest of the world then it would be not possible to demand anything which is not available in the village. Say for example, if a farmer is growing potatoes, the consumers will demand only potatoes as they have no other option. In the same, whatever things are available in the market, consumer has to make a choice from within. And hence Say's law prevail that supply creates its own demand.
7. Recessionary gaps is when the real GDP is less than the full employment or potential GDP. This puts a downward pressure on prices as it builds a recessionary pressure on the economy. In contrast to recessionary gaps, when the real GDP is more than the potential GDP which puts a pressure on the economy to inflate prices as the economy is unable to fulfill the increased productive capacity. The economy has moved towards full employment.
8. Large deficits clearly implies more interest payments. This means less is spent on the economy for development and less employment or less fiscal policy per say. Secondly, more debt implies degradation from the credit rating agencies which play an important role in business environment (optimism/pessimism). Debt would increase the rate in interest, hence crowding out the private investment. Thirdly, it would also devalue the currency. With an icrease in government debt, the government will not be able to carry out the measures for automatic stabalization like unemployment benefits, hence making the economic environment worse.
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