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Using IS/LM model, discuss the extent to which price flexibility can return and economy to full employment. Explain how the analysis can help account for Japan's recent slump.

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Introduction

Using IS/LM model, discuss the extent to which price flexibility can return and economy to full employment. Explain how the analysis can help account for Japan's recent slump. In this essay, ISLM will be defined and it will be used to explain what it gives us, in terms of solution to the economy. The focus will be on price flexibility, showing how it can restore and economy back to full employment using the ISLM model. The Classical and Keynesian view of price flexibility will be discussed to show whether it can restore and economy to full employment. Following this, the Keynes effect will be discussed and criticised in relation to ISLM model. All this will be linked into the Japanese economy to help identify the cause of their recent slump. The ISLM model consists of two model which are, Investment and Savings (IS) which is in the goods market and liquidity preference and money supply (LM) is in the money market. The IS curve is downward sloping and relates output to the interest rate whereas the LM curve is downward sloping and related interest rate to output (Blanchard. 2006). It has a fixed price version and a flexible price version. Real money balances can be changed because of flexibility of prices. ...read more.

Middle

The full employment line is vertical. Y is the level of output which is supplied by firms when prices have adjusted fully, so hence, employment is at its full level. In addition to the above, the affect of price flexibility on LM curve can be seen on the next page: In order to reduce full employment output from Y1 to Y2 and to shift FE line to the left from FE1 to FE2, a temporary adverse shock must occur because "N is reduced by the supply shock which lowers the amount of output that can be produced". FE2 becomes the new equilibrium as it is where intersection occurs but the IS curve remains unchanged (temporary adverse shock to the IS curve is movement along the curve, not a shift, so therefore, the IS curve is unchanged). The LM curve shifts up and to the left from LM1 to LM2 until it passes through E as a result of price level increase, thus as can be seen from the diagram above, price level is higher (Abel, 2001). This in turn, changes the real money supply, M/P. If price levels are flexible downwards, then the LM curve shifts downwards, to the right; this increases the real money supply, reduces interest rates and increases aggregate demand and investment. ...read more.

Conclusion

If deflation and liquidity trap continues to persist and cause the real interest rate to remain at a high point, then the economy will sink further into long-lasting deflation and recession which has negative consequences. This causes unemployment to rise and a further decrease in aggregate demand which brings prices down (Svensson, 2003). In order to move out a liquidity trap, monetary policy and fiscal policy can be used if combined properly. Fiscal expansion will shift the IS curve to the right (from IS1 to IS2) and monetary expansion will shift the LM curve to the right also, from LM1 to LM2, therefore, full employment will be restored at point B (Abel et al., 2001). In conclusion, the Keynesians have taken the view that flexible prices are independent of the full economy and that prices adjust slowly so economy does not reach full equilibrium. However, the Classical view took the stance that prices adjust rapidly to full employment equilibrium. The general equilibrium being where the FE line intersects the LM and IS. When price is adjusted, this changes real money supply (M/P) and the LM curve to shift till it meets the point where IS curve and FE line intersect. This in fact, can be juxtaposed with the Japanese liquidity trap where they deemed to shift the economy back to full employment using a combination of policies and at the same without violating the requirements of the nominal interest not going below zero. ...read more.

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