Question

Is it possible to protect workers from losing their jobs without distorting the labor market? Explain what will happen in a nation that tries to solve a structural unemployment problem using expansionary monetary and fiscal policy. Draw one AD/AS diagram, based on the Keynesian model, for what the nation hopes will happen. Then draw a second AD/AS diagram, based on the neoclassical model, for what is more likely to happen.

a) Yes, by implementing targeted training programs. Expansionary policies may lead to short-term employment gains in the Keynesian model but result in inflation and inefficiencies in the neoclassical model.
b) No, any intervention distorts the labor market. Expansionary policies result in sustained employment in both Keynesian and neoclassical models.
c) Yes, through unemployment insurance. Expansionary policies lead to increased employment in both Keynesian and neoclassical models without negative consequences.
d) No, and expansionary policies worsen unemployment. Both Keynesian and neoclassical models predict increased inflation and reduced productivity.

Answer 1

Addressing structural unemployment with expansionary policies may result in short-term employment gains in the Keynesian model but only leads to inflation in the neoclassical model, where real GDP and unemployment levels are unaffected due to a vertical AS curve.

Step-by-step explanation:

When a nation tries to address structural unemployment with expansionary monetary and fiscal policy, it can lead to short-term employment gains according to the Keynesian model. These policies increase aggregate demand, which may temporarily boost employment, assuming that prices are somewhat sticky and that there is spare capacity within the economy. However, in the long term, the neoclassical model suggests that these policies will mainly cause inflation without affecting the real output or reducing natural unemployment, as the aggregate supply in this model is vertical at the level of potential GDP.

In the Keynesian model, an increase in aggregate demand (AD) leads to higher real GDP and employment in the short run because the aggregate supply curve (AS) is upward sloping. Economists depicting this scenario with AD/AS diagrams would show the shift of the AD curve to the right, resulting in a higher price level and an increase in output.

Conversely, the neoclassical model posits that increasing AD when the economy is at potential GDP results only in inflation, as depicted by a vertical AS curve. A rightward shift in AD would lead to a higher price level but no change in real GDP or employment levels. This is because, in the neoclassical model, long-term unemployment levels are determined by real economic factors such as technology and labor market institutions.