Models in Macroeconomics - Assignment Example

Download file to see previous pages  The LM curve is derived from the assumption that money supply is not a function of interest rates and therefore given certain levels of money supply we can determine when the monetary at which levels the monetary sector is at equilibrium; the LM curve is derived. The above diagram shows the derivation of the LM curve, MS represents money supply, When there is an increase in national income from Y1 to Y2 then this will shift the money demand schedule to the right from MD1 to MD2 and for the purpose of attaining equilibrium in the money market interest rates will shift from IR1 to IR2 and this relationship helps us to derive the LM curve above. A policy mix is the use of both fiscal and monetary policies, fiscal policies include the use of government expenditure while the monetary policies include money supply. An example is where the government reduces expenditure, this will shift the IS curve to the left and because and the monetary policy measure here would be to decrease interest rates from IR1 to IR2 in order to push back the economy to the natural rate of output Yn. From the above diagram when the government decrease its spending this shifts the IS curve to the left from IS1 to IS2, this will lead the monetary policymakers to decrease the interest rates for this reason the new equilibrium will be at Yn and IR2. Economists view the labour market like any other market whereby labour has its own demand and supply, when the supply of labour is high then wage rates are low and on the other hand when the demand for labour is high then the wage rates increase. Therefore the demand and the supply will determine the equilibrium wage rates in an economy and also determine the workers bargaining power. Efficiency wage is a concept that states that wage rates are not only determined by the supply and demand of labour and for this reason, but there is also need to pay a higher wage rate to employees to increase efficiency and productivity of labour. This concept, therefore, states that wage rates should be set higher than the market-clearing rate in order to achieve efficiency which is achieved through the higher pay than the market-clearing.  The natural rate of unemployment is the unemployment level that exists in an economy in the absence of temporary frictions. These frictions include incomplete adjustments in the good and labour market. Blanchard on the good market he assumes in his model that in the short run the production will automatically adjust and therefore, in the long run, the economy will not have incomplete adjustments and for this reason, the economy will be experiencing natural unemployment. Therefore Blanchard motivates the concept of natural unemployment by assuming that in the long run, the only rate of unemployment in the economy is the natural rate of unemployment. The above diagram demonstrates the effect of an expansionary fiscal policy on the AS-AD model, when the government increases expenditure the aggregate demand shifts to the right from AD1 to AD2, this results into an increase in output from Y1 to Y2 and also an increase in prices from P1 to P2, for this reason in the short run the expansionary fiscal policy will be inflationary due to a rise in prices and also increase the level of output of an economy. ...Download file to see next pagesRead More