Question

Monetary Policy in Keynesian Models of the Macroeconomy (a) The Keynesian consumption function is: C d = C¯ + c(Y − T) − γcr. Provide an intuitive explanation for this equation. Define all terms. (b) Consider the AD-AS model. Assume that an economy is initially in an equilibrium with output equal to potential output. Then suppose the central bank alters its policy reaction function so that for any given inflation rate and output gap it sets a lower real interest rate. Explain what effect this change in policy will have upon the short run and the long run in the AD-AS model. Describe how inflation and output change over time.

Answer 1

(a)Ans: The given Keynesian consumption function is: C_d = C¯ + c(Y − T) − γcr

The above function says that consumption demand is a function (C_d) that depends positively on disposable income (Y − T). Y and T denotes income and Taxes respectively. C¯ is the fixed amount of consumption. γcr is the retained earnings, depends negatively on C_d.

(b)Ans: Considering the AD-AS model.

In the above diagram, e_sr is the short-run equilibrium. Short run aggregate supply (SRAS) and Aggregate demand (AD) intersect at this point. Y^_1​ is the current output and PL₁ is the ​current price level. Y1 is greater than Y_f. Here, the economy is producing more than full employment output. Hence, it has an inflationary gap.

Now check the diagram below for the long run impact.

Long run aggregate supply (LRAS) is always vertical. In economics, the long run is long enough to adjust all prices and achieve full employment output. When all prices have adjusted, the short-run output will also be the full employment output. Equilibrium occurs where all the three curves intersect each other.