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# Role of Interest Rate in the Aggregate Supply, Classical Model - Assignment Example

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The paper "Role of Interest Rate in the Aggregate Supply, Classical Model" highlights that a decrease in interest rate would allow more investment to occur and more investment would mean more output produced. This output produced would move the aggregate supply curve to the right…

## Extract of sample "Role of Interest Rate in the Aggregate Supply, Classical Model"

Download file to see previous pages If there is a decrease in income, the reasons are assigned to a decrease in government spending, an increase in taxes or a decrease in money supply and so on. The change in income leads to changes in a number of things out of which fall in demand is one of them. Aggregate demand depends on the real money supply. The real money supply is the value of money provided by the central bank and the banking system. If we write the number of dollars in the money supply as M' and the price level as P, we can write the real money supply as M'/P. When M'/P falls, interest rates increase and therefore the investment falls, leading overall aggregate demand to fall as well. When there is a fall in demand we need less output to cater to the market, this is another reason for fall in investment, and an increase in unemployment as well. This was a briefing of how things would change with a decrease in income. The given diagram shows AD as the aggregate demand before the reduction in income with E as the equilibrium. Once the demand decreases due to above-mentioned reasons another line AD' is formed showing the current level of demand at the given price level. We get a new equilibrium E' which depicts that once the demand has decreased we are producing less output at a higher price and then the price would consequently affect the wages of the employees. When we talk of wage we know that the labor market involves long-term relations between the firms and the market. Normally the wages are adjusted once a year. Wages are normally set in nominal terms.
Now consider how wages adjust when the demand for labor decreases and firms do not need any overtimes. In the short run when the demand decreases workers are being paid more as compared to the output produced. The employer would want to reduce the wage expense. Change in wages is a slow process hence the employer will have to look for an alternative like looking for those employees who would be willing to work at a lower wage. This would increase some of the unemployment. The employer has to be very careful in setting the wage through negotiations with the employee to consider the morale of the employee. If there is an overall decrease in demand then hiring new labor force may not be difficult, but if only one employer's demand of output has decreased then the employer may have to pay higher wage in order to keep the employees attracted to their current job.
The Keynesian theory believes that the employment offered by firms depends on the demand for their output, workers would be unemployed if the output produced exceeds the demand of the products excessively. Which would mean too much of unnecessary labor force? As such, demand-deficient unemployment is not caused by labor insisting on a wage incompatible with full employment. Since that unemployment is not the fault of the workers but is due to factors beyond their control, it may be termed 'involuntary unemployment'. ...Download file to see next pages Read More
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