Question

In chapter 13 of his textbook, Froyen argues that the major controversy in macroeconomics remains between two positions – (1) the noninterventionist position that sees the private economy as inherently stable with its roots in the original classical system and (2) the Keynesian interventionist position that does not see the private economy as inherently economy.

A. Those classical and Keynesian roots are on display in the debate about crowding out in its various forms and the effectiveness of demand management through government spending.

Using a loanable funds diagram and a classical AS/AD diagram, explain and illustrate how Robert Barro’s argument that the peacetime government spending multiplier is zero is rooted in Classical economics of several decades ago of the responsiveness of investment and the demand for money to changes in interests.

Using IS/LM and Aggregate Supply / Aggregate Demand diagrams, explain and illustrate how Robert Pollin’s argument that “government spending will generate a relatively large multiplier” under the conditions he stipulates is rooted in Keynesian analysis of several decades ago about the responsiveness of investment and the demand for money to interest rates and Keynes’s attempt to incorporate uncertainty into macroeconomics.

B. New Classical Economics (rational expectations) and New Keynesian Economics are similarly rooted in original Classical and Keynesian economics. Explain and illustrate how these latest manifestations of two diametrically opposed positions, the New Classical rational expectations model and the new Keynesian model: (1) remain true to their respective Classical and Keynesian roots about the inherent stability of the macro economy and the effectiveness of demand management; and (2) at the same time altered the traditional Classical and traditional Keynesian analysis.

Answer 1

If the government were to increase its spending in peacetime, the aggregate supply would increase, which would lead to expansion of output and reduction of price level to P". Now at reduced prices, the aggregate demand will again see a jump and increase. This will lead to correction of prices to the earlier level, also reversing the multiplier effect.

This will also have an impact on the money market. At reduced interest rates, the demand for money would also increase and the quantity of loanable funds increase.

But according to the Keynesian school of thought, this would inadvertently lead to expansion of output.