In
the space below, discuss how the new
classical economists (hint, island) addressed the business fact that money
and output are positively correlated. In this part, be extremely specific in the model that was developed (tell a
story) and relate the assumptions in the model to the empirical fact
above. Be sure to explain exactly why the firm
changes their output, using the terms: relative shock and aggregate shock. Use
the bread making example that we used in class making sure you identify clearly,
the asymmetry with regard to the real wage the firm pays and the real wage the
worker receives. Include 2 graphs as we
did in class and explain the intuition as to why the workers change their
behavior and why the boss (firm) changes their behavior. Now draw an aggregate
demand and aggregate supply diagram explaining how your individual island
analysis (as given above) maps to the macro economy (include points A, B, and C
as we did in class). Write out the expression for the Lucas aggregate supply
curve explaining the intuition underlying the Lucas Aggregate supply
curve. In the last part of your essay,
discuss what determines the power of
monetary policy (in terms of changing output) in this model, what determines how long the short run is,
and whether or not you believe that this
model is a solid basis for conducting countercyclical monetary policy. Finish the essay by commenting on the
following: This model was developed back
in the 1960s and 1970s and it is now 2014.
Do you believe the model is more relevant or less relevant today
relative to when it was written?
Explain.
We drew a non-linear aggregate supply in class
with its shape depending on the state of the economy. Draw that aggregate supply
curve identifying the Keynesian portion and the Classical portion and provide
the intuition as to why the shape of the aggregate supply curve does depend on
the state of the economy. We now consider the Great Recession where the
unemployment rate went up to 10% and the corresponding GDP gap went from zero
to -7%. Write a brief essay explaining
why the unemployment rate went up to 10% and the GDP gap fell to -7% (think
about and mention what happened to all of the relevant shift variables for aggregate demand). Locate this point
as point A on your diagram with an aggregate demand curve going through point A
that corresponds to the conditions during the Great Recession. Now explain how
macroeconomic policy makers responded to these conditions and explain why we would
or wouldn’t expect these policies to work in terms of lowering unemployment and
eliminating the GDP gap. Locate as point B that corresponds to the conditions
as of the present, where the unemployment rate is 5.5% and the GDP gap is -3%
(still some slack but much less than before). Which of the policies would
Keynes favor and why? Are your results
consistent with the following pic of the misery index? Why or why not?
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