Question

4. Compare the effects of a once-and-for-all monetary expansion on the economy's output, rate of interest, and the price level under the assumption that the aggregate supply curve is horizontal (the Keynesian case), vertical (the classical case)?

Answer 1

In Keynesian Case: In this case, the AS curve is horizontal. An increase in money supply would cause the interest rates in the economy to decrease and this increases the consumer spending and investment spending. This will shift the aggregate demand curve to the right, which increases the output level but the price level remains same because AS is horizontal (prices and wages are sticky). The diagram is provided in the image.

In Classical Case: In this case, the AS curve is vertical. An increase in money supply would result in to increase in consumer spending which increases the aggregate demand and shifts the aggregate demand to right. As a result, the price rises and output remains constant. The price rises because AS is vertical (Prices and wages are flexible). Due to monetary expansion, the interest rates fall.