Question

Assume the economy is initially in equilibrium, and then firms expect future total factor productivity, z’,...

Assume the economy is initially in equilibrium, and then firms expect future total factor productivity, z’, to decrease. Using the New Keynesian Model framework, what are the implications on the following: a) Output supply (increase / decrease / indeterminate / no change)? b) Output demand (increase / decrease / indeterminate / no change)? c) Labor supply (increase / decrease / indeterminate / no change)? d) Labor demand (increase / decrease / indeterminate / no change)? e) Money supply (increase / decrease / indeterminate / no change)? f) Money demand (increase / decrease / indeterminate / no change)? g) Output (increase / decrease / indeterminate / no change)? h) Interest rates (increase / decrease / indeterminate / no change)? i) Employment (increase / decrease / indeterminate / no change)? j) Wages (increase / decrease / indeterminate / no change)? k) Prices (increase / decrease / indeterminate / no change)? l) If the goal of the Central Bank is to achieve economic efficiency, the bank should change the interest rate in which way (increase / decrease / no change)?

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Answer #1

a. Output Supply - Decline in total factor productivity will lead to decline in the output supply and thus there will be leftwards shift of aggregate supply curve of the economy or output supply curve.

b. Output demand = There will be decline in quantity of output demanded. This is because decline in total factor productivity will lead to decline in National output/ income of the country. Thus, consumption which is positively related to income will decline and thus output demanded will fall.

c. Labor Supply - Labor Supply will remain same in the labor market.

d. Labor demand - Decline in productivity will lead to decline in labor demand due to reduction in profits of the firm.This reduction in profits of the firm will lead to leftward shift of the labor demand.

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