Chapter 11: Keynesian ISLM Flashcards
State the significance of real wage rigidity, and how it can contribute to unemployment
Classical Explanation:
No such thing due to the fluidity of wage adjustment.
Keynesian Explanation:
Cyclical unemployment
Explain Akerlof’s gift exchange model
Workers are more productive when they are better paid and treated well, treating work as a gift exchange.
Explain the causes of price stickiness
Menu Costs
Concern over losing market share
Fixed costs, costs of changing input may outweigh the benefits of producing less due to a price change
Define the liquidity trap
(said to come up on the Final Exam)
https://en.wikipedia.org/wiki/Liquidity_trap
When monetary policy becomes ineffectual, reflected in the nature of the LM curve, which flattens out and is a horizontal line (with a curve at the end).
Why does the labor market not adjust efficiently and smoothly in the event of a recession from the Keynesian perspective?
Firms do not automatically fire workers in a downturn, and instead hoard labor.
What might be the problem with using monetary policy for macroeconomic stabilisation during a recession?
The Fed might “overshoot”, or cause the price level to increase beyond the new level required to equilibrate the asset market.
What might be the problem with using fiscal policy for macroeconomic stabilisation during a recession?
Recognition, implementation and legislative lags (the need to go through congress)
Therefore, fiscal policy is usually called a “blunt tool”
How might an adverse supply shock produce a new general equilibrium?
Primary Effect:
Recall that an adverse supply shock causes the FE line to shift to the left.
The LM curve also shifts to the left due to an increase in the price level resulting from the adverse supply shock.
Second Effect:
Since output is now beyond the full employment level, producers will start decreasing prices, causing the LM curve to shift slightly back to the right, producing a new general equilibrium.
Why is the SRAS curve positively sloped?
Because of unionised labor contracts. Since nominal wages are fixed in the short run, an increase in price level erodes the real value of wages, and thus causes output to increase.
Why does a rightward shift in the AD curve cause a leftward shift in the SRAS curve?
The AD shift, which causes output to exceed its full employment level, temporarily causes inflation to erode the real value of wages. Output, therefore, increases since producers now decide to hire more workers due to lower labor costs due to the cut in wages.
However, workers will eventually demand a readjustment in their nominal wages to match the increase in price level, causing the SRAS to shift back to the left.
