Question

Monetary Policy in Keynesian Models of the Macroeconomy

(a) The Keynesian consumption function is: C d = C¯ + c(Y − T) − γcr. Provide an intuitive explanation for this equation. Define all terms.

b) Consider the AD-AS model. Assume that an economy is initially in an equilibrium with output equal to potential output. Then suppose the central bank alters its policy reaction function so that for any given inflation rate and output gap it sets a lower real interest rate. Explain what effect this change in policy will have upon the short run and the long run in the AD-AS model. Describe how inflation and output change over time.

Answer 1

a)

Consumption is important components in determining the level of GDP.

C d = C¯ + c(Y − T) − γcr.

C- : means autonomous consumption. it is minimum consumption needed for survival.

C(Y-T): it is consumption that depends on the disposable income of the consumer. when disposable income rises, the consumption also rises.

Ycr: it is part of consumption that inversely related to the level of the interest rate.

Thus, consumption is affected by varied factors.

b)

The Economy is operating at the full employments over here. If the rate of interest is decreased, it will affect the economy distinctly in short-run and long-run:

Short-run: AD will shift to right and economy will start operating above the full employment. Resources would be overutilized. Thus, output and inflation would rise side by side. it will reduce unemployment further even below the natural rate of unemployment.

Long run: Over the long run, price and wage are flexible enough. So a rise in wage rate would increase the cost of production. So eventually, producers would be compelled to reduce the supply. AS will shift to left Thereby driving up the price further but output level and employment would relapse back to point corresponding to full employment or full potential level.