UNDERSTANDING THE ECONOMY

Understanding the Economy



Abstract

This paper reviews the Keynesian IS-LM model and the neoclassical and endogenous economic growth models that are widely used in analysing fluctuations of output in the short run and economic growth in the long run. Numerical examples are provided to evaluate impacts to fiscal and monetary policy measures on aggregate demand with a sensitivity analysis of model results to various parameters contained in the model. It is an overview of simple macroeconomic models that are often applied for policy analysis.

Understanding the Economy

Ans 1: Faced with a slowing economy and a weak equity market, the Bank of England has been making major interest rate cuts and the UK government has recently introduced various fiscal stimulus packages to boost the UK economy. Now Keynesian Cross model will be used here to analyse and evaluate the impact of these measures on the UK macro- economy Macroeconomic models have been in use for formulation of economic policy almost in every country in the world. These models not only provide an analytical framework to link the demand and supply sides and the resource allocation process in an economy but also may help in reducing fluctuations and enhancing the economic growth, which are two major aspects of any economy. Classical, Keynesian, new classical and new Keynesian approaches have evolved over time to analyse fluctuations of output, employment and price level over years (Keynes (1936), Hicks (1937), Samuelson (1939), Phillips (1958), Friedman (1968), Phelps (1968), Tobin (1969), Barro and Gordon (1983), Sargent (1986) Goodhart (1989), Nickell (1990), Lockwood Miller and Zhang (1998), IMF (1992)). Empirical validity of these models are tested using either macro-econometric simulations models, applied multisectoral general equilibrium models or by using stochastic dynamic general equilibrium models (Wallis (1989), MPC (1999), Pagan and Wickens (1989), Kydland and Prescott (1977)). There is a considerable controversy about the causes, consequences and remedies for the macroeconomic fluctuations in the short run in the literature.

New classical and new Keynesian models use rational expectation and market imperfections and frictions in the labour market or technological shocks in explaining these fluctuations. There is less controversy in the literature about the economic events in the long run despite plenty of work that has been done in area of endogenous and exogenous growth models (Solow (1956), Lucas (1988), Romer (1990), Mankiw, Romer and Weil (1992), Parente and Prescott (1993)).

Real wages that equate demand for labour to its supply, determined the level of employment and that determined the level of output. Income is either spent on the 3 current consumption or saved for the future consumption. The real sector equilibrium is guaranteed by equality between the saving and investment. The price level is proportional to supply of money and the monetary neutrality is maintained by perfectly flexible real prices. Unemployment or glut cannot happen in the classical system because of the flexibility of prices. Aggregate demand always equals the aggregate supply. The major objective of government is to ensure law and order so that business enterprises could ...