Chapter 5: Keynesian System (I): The Role of Aggregate Demand

KEYNESIAN SYSTEM (I): THE ROLE OF AGGREGATE DEMAND 39 CHAPTER 5: KEYNESIAN SYSTEM (I): THE ROLE OF AGGREGATE DEMAND Additional Questions Essay Questions and/or Problems: 1. How do changes in expectations affect investment and output? How does this figure into Keynes’ explanation of business cycles? In Keynes opinion, volatile expectations drive volatile planned investment demand. Because of the multiplier associated with changes in planned investment, these changes lead to large changes in output and business cycles. 2. Graphically depict the determination of equilibrium income. a. Which points show an unintended inventory shortfall? An unintended inventory shortfall takes place at points below , such as point YL. b. When is unintended inventory investment taking place? Unintended inventory investment occurs at levels of income above . c. At what points do aggregate demand exceed output? Aggregate demand exceeds output at a level of income below , such as YL. 3. Assume that b = .75 and autonomous investment increases by $500 billion. By how much does equilibrium income increase? How much would this increase in investment increase income if b = .80 instead? With b=0.80, the multiplier is equal to 1/(1 – b)=4. Then, an increase in investment of $500 billion increases equilibrium income by $2 trillion. If b = .8 then the multiplier is 5 and income would increase by $2.5 trillion. 4. Assume that the consumption function equals a + b YD = 100 + 0.8Y, and I = Ir = 100. a. Find the equilibrium level of income with G = 0. Y=C + I + G Y= 1000 b. Find the equilibrium level of consumption. C = a + bYD C = 900 c. Find the equilibrium level of saving. S = –a+(1 – b)YD S = 100 d. How much will income change if planned investment rises to 110? Y = 1050 5. Discuss two fiscal policies that a government could adopt that would increase both interest rates and aggregate income. An increase in government spending financed with bonds or a decrease in taxes financed with bonds would increase the budget deficit and drive up interest rates. These changes in fiscal policy would also increase aggregate income. 6. Discuss the role of the price level and interest rates in the simple model of aggregate demand developed in this chapter. How do Keynesians justify this behavior? The price level and interest rates are fixed in this model. This is justified by the fact that this model is focused on the very short-run and as a result can be treated as constant. 7. Assume that a government increases both government spending and taxes by $200 billion so that the budget balance remains unchanged. What will happen to aggregate income? Explain the intuition behind this result. As a result of this balanced-budget fiscal policy, aggregate income will increase by $200 billion. The reason is that all of the $200 billion of government spending will go into the multiplier process, increasing income. However, some of the $200 billion tax increase will come from savings, so the actual fall in consumption will be less than $200 billion. As a result, the positive effect of the increase in government spending outweighs the negative effects of the tax increase. 8. a. Show the autonomous investment multiplier in the open-economy model. 1/(1 – b + v) b. Show the autonomous investment multiplier in the closed-economy model. 1/(1 – b) c. Which multiplier will be smaller? Explain the intuition behind this result. The multiplier in the open-economy model will be smaller because some of the increase in aggregate income will not be spend domestically but will go into purchasing imports. 9. Explain why the government spending multiplier is greater than the tax multiplier. The reason has to do with the change in autonomous expenditures. If government spending increases by $100, autonomous expenditures rise by the full $100. However, if taxes are reduced by $100, some of this money is saved by households (depending upon the size of the marginal propensity to consume) and autonomous expenditures do not rise by the full $100, reducing the size of the multipler. 10. Consider an alternative version of the Keynesian model, where planned investment is also a function of current income: I = d + e(Y-T). How would this change the autonomous expenditure multiplier in the closed-economy Keynesian model. Explain the intuition. The intuition here is that now investment is a function of current income, just as consumption is a function of current income. As a result, e (the marginal propensity to invest) is similar to the marginal propensity to consume, where 1 - b – e equals the marginal propensity to save. The new autonomous expenditure multiplier is (1/(1-b-e) Additional Problems and/or Essay Questions: 11. a. In studying the simple Keynesian model you found that tax changes and changes in government spending had effects of different magnitudes on GDP, per dollar of the policy action. Find expressions (multipliers) for the effects on GDP of a one-dollar increase in taxes and of a one-dollar increase in government spending. Explain why these expressions have different values. b. Now suppose that instead of the level of taxes being given, you have been dealing with an economy where taxes depended on income (T = tY). Find an expression for the government expenditure multiplier in this case. Why does it differ from the expression for the same multiplier derived in part (a)? 12. Suppose that, for a given economy, investment were equal to 100, government spending equaled 150, taxes equaled 90 and consumption were given by C = 120 + 0.75YD. a. What will be the level of equilibrium income? b. What is the value of the government expenditure multiplier and the tax multiplier? c. Now suppose that investment rose to 50 units. Find the new value of equilibrium income d. What is the formula for the autonomous investment multiplier? Use this formula to calculate how much income will change with a 10 unit increase in investment. Does the change in income you calculated in part (c) correspond with the change in income just calculated? 13. Explain the Keynesian theory of aggregate demand. How does this Keynesian theory differ from the classical theory of aggregate demand discussed in Chapter 4? 14. What is the role of aggregate supply in the Keynesian model? Is it important in the determination of output? Why or why not? 15. Use the Keynesian diagram to illustrate the impact of an increase in the interest rate on equilibrium income. How will the change in income change as the elasticity of investment demand changes? 16. Suppose that the MPC is 0.8 and the government was considering two possible fiscal actions: i. Raising government expenditures on goods and services by 10 units, and ii. Raising lump-sum tax collections by 10 units. a. What would be the effect on equilibrium GDP of policy (i) alone? b. What would be the effect on equilibrium GDP of policy (ii) alone? c. What would be the net effect on GDP of instituting both policies? Explain the economic reason why you find this effect. 17. Consider an economy where C = 300 + 2/3(Y-T), Ir = 400, G = 250, and T = 220. Calculate equilibrium income, private savings, and national savings. 18. Explain how the Keynesian model is a model of excess aggregate supply. Multiple-Choice Questions 1. If the marginal propensity to consume is 0.8 and if government spending (G) rises by 50 while investment (I) falls by 20, by how much will equilibrium income rise? a. 12 b. 10 c. 30 d. 120 e. 150* 2. If the government wishes to increase its spending on goods and services by $10 billion without increasing the overall level of aggregate demand, it should a. increase taxes by $10 billion. b. decrease taxes by $10 billion. c. increase taxes by more than $10 billion.* d. increase taxes, but by less than $10 billion. e. leave tax receipts unchanged. 3. The short-run refers to a period a. of a few days. b. when prices and wages cannot fully adjust.* c. of a few years. d. during which trend cannot change. e. of analysis used in the classical model 4. In the simple Keynesian model, if there is an autonomous investment falls by $20 billion and the MPC (b) is 0.60, the equilibrium income level will increase by a. $13.3 billion. b. $20 billion. c. $50 billion.* d. $100 billion. 5. In the equation Y = (1/1 – b + v)(a + I + G + X ? u), the term (1/1 – b + v) is referred to as the a. level of autonomous expenditures. b. autonomous expenditure multiplier.* c. balanced budget multiplier. d. tax multiplier. 6. Keynes believed that an important source of instability in the economy was instability a. of private investment demand. b. in the marginal propensity to consume (b). c. of expectations. d. in tax collections. e. Both a and c* 7. In the Keynesian model, exogenous variables include a. planned investment. b. taxes. c. planned inventories and government spending. d. planned investment and government spending. e. all of the above* 8. If the consumption function is given by C = 100 + .6(Y-T) and planned investment is 150, government spending is 50, and T is 100, then equilibrium income is a. 600* b. 750 c. 400 d. 350 9. In the equation Y = C + I + G, a. only I is an exogenous variable determined by factors outside the model. b. only G is an exogenous variable determined by factors outside the model. c. C is an endogenous variable determined by factors inside the model.* d. I and G are exogenous variables determined by factors outside the model. e. A, b, and c 10. If an increase in government spending of 40 units accompanied by an equal increase in taxes caused equilibrium income to rise by 40 units, the autonomous expenditure multiplier must be a. 10. b. 1. c. 4. d. not enough information is given to calculate the multiplier.* 11. If a fall in investment demand of 100 units causes equilibrium income to fall by 150 units in the simple Keynesian model, then the marginal propensity to save must be a. .25. b. 1.5. c. .5. d. 1/3.* e. 2/3. 12. Let C = 200 + .8(Y-T), planned investment equals 150, and T equals 200. If the equilibrium level of income is 2,000, then the level of government spending needed to make this true is a. 210.* b. 250. c. 50. d. 10. e. none of the above. 13. If the marginal propensity to save is equal to 0.5 in the simple Keynesian model, then a 10-unit increase in government spending will cause output to rise by a. 5 units. b. 10 units. c. 20 units.* d. 25 units. e. 40 units. 14. Compared to the closed economy Keynesian model, the open economy model in which imports are a function of income has an investment multiplier that is a. smaller.* b. larger. c. equal. d. equal to 1. 15. In the simple Keynesian model (no money market) assume that equilibrium output falls short of potential output by 300 units and the MPC = 0.8. The size of the tax cut needed to reach full employment is a. 30. b. 60. c. 75.* d. 300. 16. Using the simple Keynesian model, consider the case where taxes are lump-sum. Compared to the model without taxes, the investment multiplier in this model will a. not change.* b. be larger. c. be smaller. d. be equal to 1. 17. Which of the following are equilibrium conditions in the simple Keynesian model? a. Ir = I b. G = T c. S + T = I + G d. Y = C + I + G e. A, c, and d* 18. Assuming that C + Ir + G < C + I + G, then a. there is an unintended inventory accumulation. b. there is an unintended inventory shortfall. c. aggregate demand is less than output. d. Both b and c* 19. In the Keynesian consumption function a. consumption is a constant fraction of income. b. the marginal propensity to consume is constant. c. disposable income determines consumption. d. All of the above* e. None of the above 20. According to Keynes, the level of consumer expenditures was a stable function of a. national income. b. gross income. c. disposable income.* d. net income. e. None of the above 21. Which of the following does not impact aggregate demand in the Keynesian model? a. Changes in the supply of labor* b. Net exports c. Household consumption d. Desired business investment demand e. Government purchases of goods and services 22. The marginal propensity to consume is a. the change in consumption associated with a change in income.* b. equal to the marginal propensity to save minus 1. c. equal to 1 minus the marginal tax rate. d. the change in consumption associated with a change in wealth. 23. According to Keynes, the consumption-income relationship is shown as C = a + bYD. Therefore, the saving-income relationship is a. S = a + (1 ? b)YD. b. S = ? a + (1 ? b)YD.* c. S = a + (1 ? b)/YD. d. S = ? a + (1? b)/YD. 24. In the simple Keynesian model, total savings equals a. total investment minus the budget deficit. b. total planned and unplanned investment.* c. planned investment. d. planned investment plus the budget deficit. e. none of the above. 25. Keynes thought that expectations are a. a function of current income. b. predictable and stable. c. an important determinant of consumption. d. unpredictable and influences planned investment. 26. Assume that people experience a one-time 50 unit increase in their consumption (i.e. the intercept of the consumption function increases by 50). In this case a. equilibrium income will rise by 50 units times the investment multiplier.* b. equilibrium income will rise by 50 units. c. equilibrium income will rise by 50 units times the tax multiplier. d. equilibrium income will not change because this increase is temporary. 27. Both Keynesians and supply-siders believe that tax cuts a. will increase income by increasing aggregate supply. b. will increase income by increasing aggregate demand. c. will increase income but for different reasons.* d. will increase income in the Keynesian model but decrease income in the Supply-side model. 28. The most important determinant of any multiplier in the Keynesian model is a. the level of planned investment. b. the level of unemployment. c. the marginal propensity to consume.* d. the level of excess demand. 29. An increase in the interest rate a. reduces planned investment but increases unplanned investment by increasing inventories.* b. reduces planned investment as well as unexplained investment by reducing inventories. c. has no impact on planned investment because it is autonomous. d. changes inventories in a way that cannot be predicted. 30. Keynes believed that the instability in income was caused by variability in a. investment.* b. taxes. c. consumption and savings. d. government spending. 31. In the circular flow model, injections and leakages are associated with a. saving and investment.* b. consumption and investment. c. realized investment and desired investment. d. saving and taxes. 32. According to the simple Keynesian model, when planned expenditure exceeds income a. prices rise. b. unplanned inventory investment is negative.* c. income falls. d. planned expenditure falls. e. both b and d. 33. An increase in taxes a. reduces income by more than the total fall in consumption. b. reduces income by the same amount as the total fall in consumption.* c. reduces income and consumption by the same amount as taxes fall. d. reduces income by the amount of the initial fall in consumption. 34. In the Keynesian model, changes in aggregate supply a. are the primary determinant of inflation. b. could only destabilize the economy. c. are ignored.* d. None of the above 35. When firms incur unplanned inventories, they typically a. build new plants. b. call for more government spending. c. hire more workers and increase production. d. lay off workers and reduce production.* 36. An increase in the demand for our exports a. increases aggregate demand and income by the amount of the investment multiplier.* b. increases imports as well, having no impact on aggregate demand. c. increases aggregate demand and income by less than the amount of the investment multiplier. d. does not impact aggregate demand because this is consumption by foreign countries. 37. In the simple Keynesian model, if the equilibrium level of income is $300 billion, the MPC is 0.75, and government expenditures increase by 20 billion. What is the new equilibrium level of income? a. $320 billion b. $380 billion* c. $220 billion d. $520 billion 38. Total planned expenditure is composed as a. planned investment. b. planned government spending and taxes. c. total investment, total consumption, and government spending. d. planned investment, planned government spending, and planned taxes.* 39. In the simple Keynesian model, equilibrium exists when a. actual investment equals realized investment. b. exports equal imports. c. savings is equal to government spending plus desired investment minus taxes.* d. national product is equal to consumption minus desired investment plus government spending. e. None of the above 40. Assuming that C + I + G > C + Ir + G, then a. aggregate demand exceeds than output. b. unplanned inventories are negative. c. there is an unintended inventory accumulation. d. Both a and c* e. None of the above 41. According to Keynes, the least variable component of aggregate expenditures is a. consumption.* b. inventories. c. total investment. d. imports 42. Which of the following equations illustrates the equilibrium level of income with respect to the simple Keynesian closed-economy model? a. Y = [1/(1 ? b)](a ? bT ? I + G) b. Y = [1/(1 ? b)](a + bT + I + G) c. Y = [1/(1 + b)](a ? bT ? I ? G) d. Y = [1/(1 ? b)](a ? bT + I + G)* e. Y = (1 ? b)(a + bT + I + G) 43. In the open-economy Keynesian model, it always has to be true that a. planned savings equals planned investment. b. planned savings is greater than planned investment. c. planned savings is less than planned investment. d. none of the above.* 44. Assuming that C + Ir + G > C + I + G, then a. there is an unintended inventory accumulation.* b. there is an unintended inventory shortfall. c. aggregate demand is less than output. d. Both b and c 45. Income has risen in the simple Keynesian model. This could be the result of:, a. an equal increase in government spending and taxes.* b. an increase in unplanned investment. c. an increase in taxes d. a decrease in autonomous consumption. e. none of the above 46. A increase in net exports a. shifts the aggregate demand schedule upward* b. shifts the aggregate demand schedule downward. c. does not shift the aggregate demand schedule. d. decreases saving. 47. Which of the following statements is (are) incorrect? a. Consumption plays a central role in the Keynesian theory of income determination b. Consumer expenditure is the largest component of aggregate demand c. In recent years, consumption has totaled between 60 and 70 percent of GDP d. Keynes believed that investment was largely determined by expectations e. all of the above are correct* 49. If policy makers desire a $30 increase in output and the consumption function is C = 100 + .75(Y-T), then they must a. increase government spending by $8. b. increase taxes by $10. c. cut government spending and taxes by $10.* d. decrease taxes by $10. 48. The Keynesian explanation of the Great Depression focuses on a. large rises in government spending. b. large increases in taxes c. large increases in planned investment.* d. an increase in expectations. 50. When comparing the autonomous expenditure multiplier in a closed-economy model to the autonomous expenditure multiplier in an open-economy model it can be concluded that a. the multiplier in the open-economy model will be larger than in the closed-economy model. b. the multiplier in the open-economy model will be smaller than in the closed-economy model.* c. both multipliers are the same. d. None of the above. 51. Within the simple Keynesian model with lump-sum taxes, if the MPC (b) were 0.75 then if taxes rise by $200 then income a. rises by $800. b. falls by $200. c. falls by $800. d. rises by $200. e. falls by $800.* 52. The equation for the balanced budget multiplier can be written as a. (1/1 – b) – (b/1 – b). b. (1/1 + b) + (? b/1 – b). c. (1/1 – b) + (b/1 + b).* d. (1/1 + b) – (b/1 + b). 53. If the government decreases spending and taxes by 1,000 units and the marginal propensity to consume is .9, then a. more information is needed. b. output will decrease by 900. c. output will decrease by 10,000.* d. output will increase by 10,000. 54. In the Keynesian aggregate expenditure graph (Figure 5-5), the 45 degree line is meant to indicate that: a. planned aggregate expenditure always equals aggregate income. b. savings must equal investment. c. actual aggregate expenditure must equal aggregate income.* d. actual income must equal planned income. e. none of the above. 55. If the consumption function is C = 120 +_.8(Y-T) in the basic Keynesian model, then in the government spending multiplier is: a. 5.* b. 4. c. 1.25. d. .8 56. Which of the following is FALSE? a. As the interest rate falls, planned expenditure must be greater than actual expenditure.* b. As the interest rate falls, planned expenditure rises. c. As the interest rate falls, the IS curve shifts to the right. d. As the interest rate falls, planned expenditure can be greater than actual expenditure. 57. At equilibrium income: a. planned and actual expenditure are equal. b. GDP will remained unchanged until an exogenous shock occurs. c. unplanned inventories are equal to zero. d. all of the above.* 58. An increase in the interest rate leads to: a. an increase in planned inventories. b. an increase in GDP. c. an increase in unplanned inventories.* d. an increase in consumption. e. none of the above.