Start with the neoclassical model and assume that its equilibrium solution is (yf , nf , r∗, P∗). Suppose a reduction in investment reduces aggregate demand. Discuss the following:

(a) Within the context of the neoclassical model, analyze the behavior of firms if they face imperfect competition and are hit with a fall in the demand for their products.

If this analysis shows that employment is reduced below nf , present the likely consumption response of households. If these responses of firms and households imply a movement away from (yf , nf , r∗, P∗), what equilibrating mechanisms will come into play to bring the economy back to (yf , nf , r∗, P∗)? Which do you think is more powerful and has a faster response: the economy’s equilibrating mechanisms or the (contrary) responses of firms and households which worked to take the economy away from (yf , nf , r∗, P∗)?

(b) In the context of a Keynesian model with nominal wage contracting, redo the questions in (a).

(c) Within the context of a neoKeynesian model, redo the questions in (a).