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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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. The Classicals believe that money is neutral and even if there is a reduction or an increase in the supply of money, the price level is changed but there is no effect on variables such as employment, output and real interest rate (Abel. 2001). From a Classical point of view, in the short and long-run, prices is fixed so therefore, the supply of real money balances can be changed by price flexibility, i.e. an increase in the level of money supply increases price level. Price of products, aggregate demand and expenditure depends on the quantity of products in which business firms can supply. If savings and investment is not balanced (as a result of interest rate failing and aggregate expenditure (AE) rising), unemployment will not rise because, according to the Classical model, changes in price level will be accommodated by AE. When people start saving, their AE normally decreases which changes price levels, thus, price levels decreases; this in turn, will increase the demand for products seeing as it is in a lower price level. This therefore guarantees that even though AE may fall as a result of saving increasing, it will not change employment level as long as the fall of prices is proportionate to the fall of AE (Ahuja, 2000). 

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However, Keynesians believe that the economy is not working under full employment. They argue that price flexibility is independent of full employment and that the economy is not on the full employment line, thus the labour market is not in equilibrium. Without an increase in the price level, the supply of output can be increased seeing as some workers and machines are unemployed and idle. Since prices are fixed, an increase in AE in the short-run will not increase price level but will increase output level (Backus et al., 1998). This illustration can be shown by a horizontal AS in ...

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