Explain what will happen in a nation that tries to solve a structural unemployment problem using expansionary monetary and fiscal policy. Draw one AD/ AS diagram, based on the Keynesian model, for what the nation hopes will happen. Then draw a second AD/ AS diagram, based on the neoclassical model, for what is more likely to happen.
The Correct Answer and Explanation is:
To address structural unemployment, a nation might turn to expansionary monetary and fiscal policies, which include increasing government spending, lowering taxes, and reducing interest rates. These policies aim to boost demand, which could lead to increased employment and output in the short term.
Keynesian Model:
In the Keynesian framework, the economy is believed to be in a state where aggregate demand (AD) can be insufficient, leading to underemployment or structural unemployment. The government can stimulate demand through monetary (lowering interest rates) and fiscal policies (increasing government spending or cutting taxes).
What happens in the Keynesian model?
- The AD curve shifts rightward, indicating a rise in aggregate demand.
- The AS curve is relatively flat in the Keynesian model, meaning that in the short run, an increase in AD leads to higher output and lower unemployment without significant inflation.
- The economy can move from a state of underutilized resources to full employment, as firms increase production in response to higher demand, reducing unemployment.
Keynesian AD/AS Diagram:
- The AD curve shifts to the right from AD1 to AD2, leading to an increase in output (from Y1 to Y2) and a decrease in unemployment.
- The economy moves towards its potential output (full employment) in the short run.
Neoclassical Model:
In the neoclassical framework, however, the economy is viewed as more self-correcting, and it emphasizes that the long-term level of output is determined by factors like labor, capital, and technology rather than aggregate demand.
What happens in the Neoclassical model?
- The AD curve still shifts rightward due to expansionary policies.
- However, the AS curve in the neoclassical model is steep or vertical at full employment (potential GDP), meaning that once the economy reaches its potential output, further increases in aggregate demand will only lead to inflation, not higher output.
- While the expansionary policies may reduce unemployment in the short run, they will also increase inflationary pressures once the economy approaches full capacity.
Neoclassical AD/AS Diagram:
- The AD curve shifts to the right from AD1 to AD2.
- Initially, output rises, but eventually, the economy reaches the potential output level (Yp), beyond which inflation starts to rise without further reductions in unemployment.
Summary:
- In the Keynesian model, the policies are effective in reducing unemployment by boosting demand in the short run.
- In the neoclassical model, expansionary policies may only have temporary effects on output and unemployment. Once full employment is reached, the economy experiences inflation without further gains in employment.
