1.   The main feature of the classical IS-LM model that distinguishes it from the Keynesian IS-LM model is the classical model’s assumption that prices adjust quickly to restore equilibrium. Keynesians assume that prices are slow to adjust to restore equilibrium. The distinction is of practical importance because classicals are less likely than Keynesians to recommend government intervention to restore equilibrium.

3. A real shock is a disturbance to the real side of the economy that affects the IS curve or the FE line.
A nominal shock is a disturbance to money supply or money demand that affects the LM curve. Real shocks include changes in the production function, in the size of the labor force, in the real quantity of government purchases, or in the spending and saving decisions of consumers. Real business cycle theorists consider shocks to the production function to be the most important. These include the development of new products or production methods, the introduction of new management techniques, changes in the quality of capital or labor, changes in the availability of raw materials or energy, unusually good or unusually bad weather, and changes in government regulations affecting production.

6. The increase in government purchases does not affect labor demand, but causes an increase in labor supply at any given real wage. This occurs because workers are poorer due to the current or future taxes they must pay to finance the increased government spending. Since labor demand is unchanged but labor supply increases, the real wage declines and employment rises. The rise in employment raises output in the economy. If the shift in the FE line is much smaller than the shift in the IS curve, the combination of shifts to the right in the FE line and IS curve also leads to a rise in the real interest rate and the price level.

8. According to the misperceptions theory, an increase in the price level fools producers of goods into producing more, because they are unable to tell whether the increase in prices is a relative price increase or a rise in the general price level. The change in prices must be unexpected for this to occur, because to the extent that the price change was expected, producers would not be fooled into changing production.

10.   Rational expectations means that the public’s forecasts of various economic variables are based on reasoned and intelligent examination of available economic data. If the public has rational expectations, the central bank will not be able to surprise the public systematically, and so it cannot use monetary policy to stabilize output.

  1.   The efficiency wage is the real wage that maximizes effort or efficiency per dollar of real wages. It assumes that workers will exert more effort, the higher the real wage. The real wage will remain rigid even if there is an excess supply of labor, because firms won’t reduce the wage they pay; doing so would reduce their profits, since workers wouldn’t work as hard.

  3.   Price stickiness is the tendency of prices to adjust only slowly to changes in the economy. Keynesians believe it is important to allow for price stickiness to explain why monetary policy is not neutral.

  4.   Menu costs are the costs of changing prices. Menu costs may lead to price stickiness in monopolistically competitive markets but not in perfectly competitive markets, because a monopolistically competitive firm’s demand is not as sensitive to the price as is a perfectly competitive firm’s demand. Monopolistically competitive firms may meet the demand at a
fixed price when demand increases, because price exceeds marginal cost, so that profits still rise,
 and because the cost of changing prices may exceed the additional profit earned from doing so.
A perfect competitor would lose all of its customers if its price were a little above the price
charged by its competitors. But a monopolistically competitive firm would lose only some of its customers in this case.

  5.   In the Keynesian model, money is not neutral in the short run, but it is neutral in the long run. In
the short run, an increase in the money supply increases output and the real interest rate, while the price level and real (efficiency) wage are unchanged. In the long run, however, only the price level
is changed, with no change in output, the real interest rate, or the real wage. In the basic classical model, money is neutral in both the short run and the long run, so only the price level is affected by
a change in the money supply, just as in the long-run Keynesian model. The extended classical
model with misperceptions is similar to the Keynesian model. In the short run, an increase in the money supply increases output and the real interest rate, just as in the Keynesian model. However, unlike the Keynesian model, the price level rises, as does the real wage. The long run of the extended classical model is identical to the classical model or the long run of the Keynesian model—only
the price level is affected.

7.     In response to a recession, policymakers can (1) make no change in macroeconomic policy,
(2) increase the money supply, or (3) increase government purchases or decrease taxes.

        If they make no change in macroeconomic policy, then during the recession output is below its
full-employment level. Over time, the price level will decline to restore equilibrium. In the long run, the price level will be lower and employment will return to the full-employment level.

        If policymakers increase the money supply, the economy returns to full employment without a change in the price level. The composition of output is the same as when the economy returns to full employment without monetary or fiscal policy.

        If policymakers increase government purchases, again the economy returns to full-employment equilibrium without a change in the price level. However, the higher real interest rate caused by the expansionary fiscal policy reduces consumption and investment, and the higher taxes to pay for the government spending also reduce consumption relative to either the situation in which monetary policy is used, or in which there is no policy response at all.

        There are practical difficulties with increasing the money supply or increasing government purchases to return the economy to full employment. It is difficult to tell how far the economy is below full employment to know the right amount of fiscal or monetary stimulus to apply. We do not know exactly how much output will increase in response to a monetary or fiscal expansion. And since these policies take time to implement and more time to affect the economy, we really need to know where the economy will be six months or a year from now, not just where it is today, but such knowledge is very imprecise.

10.   In Keynesian analysis, a supply shock may reduce output in two ways: (1) a reduction in output, because the supply shock reduces the marginal product of labor, shifting the FE line to the left; and (2) a further reduction in output if the supply shock is something like an oil price shock that is large enough to cause many firms to raise prices, shifting the LM curve up and to the left so much that it intersects the IS curve to the left of the FE line. Supply shocks create problems for stabilization policy because: (1) policy can do nothing to affect the location of the FE line; and (2) using expansionary policy risks worsening the already-high rate of inflation.