Week 3: The Keynesian model and Fiscal Policy

Question 1

What is the most important assumption underlying the Keynesian model?

Answer 1

Assumption of Fixed prices: when economy is in recessionary range, prices and wages were sufficiently inflexible so that income would adjust much faster then prices. For simplicity, price changes could be ignored.

Question 2

Illustrate the basic Keynesian model and a recessionary gap.

Answer 2

Aggregate expenditures, aggregate production model. AE=Consumption+Investment+Governement expenditures + net eXports. X-axis=real GDP, or income. Y-axis=production. Agg production is 45° line. There is also a AE curve. Where these curves meet is the equilibrium. Actual output is vertical line. If equilibrium Q is less then Actual ouput Q, we have a recessionary gap.

Question 3

What is a “leakage”? What is the most important leakage in the government sector?

Answer 3

Leakage: income not directly spent on domestic output, but is diverted from the circular flow model (say’s law). Most important is household savings.
Other: business savings, taxes, imports.

Question 4

Define aggregate production. How is it represented in the Keynesian model?

Answer 4

The total amount of goods and services produced in the economy. Represented by a 45° line. 45° because it creates an equal amount of income.

Question 5

Define aggregate expenditures.

Answer 5

Total spending: C + I + G + (X - M). Flatter line then Agg Production.

Question 6

What is the difference between autonomous consumption and induced consumption in the Keynesian model?

Answer 6

Even if income is zero, households still spend a certain amount of money on consumption (autonomous consumption). Induced consumption depends on an individuals disposable income (what you have left after paying taxes).

Question 7

Define the marginal propensity to consume and the marginal propensity to save.

Answer 7

MPC: Extra amount that people consume when they receive an extra dollar of dispable income.
MPS: Extra amount people save when they receive an extra dollar of disposable income.
MPS = 1 - MPC
MPC equals the slope of the consumption function (45°)
MPS equals the slope of the savings function.
X-axis =disposable income; Y-axis = consumption

Question 8

What is the slope of the aggregate expenditures curve?

Answer 8

Flatter then 45°.

Question 9

Why is the aggregate expenditures curve flatter than the 45-degree line in the Keynesian model?

Answer 9

Because MPC < 1 and MPC is 45° line. Main component of AE is Consumption, and because of MPC (not everything is consumed) the line is flatter then the Agg production curve where everything that is produced is also consumed. The other determinants of AE are horizontal lines, so they don’t add to the slope, but just raise it.

Question 10

What are the determinants of investment?

Answer 10

Purchases of residential structures; Investment in business plant and equipment (biggest); additions to a company’s inventory. It is assumed (simplified) that these investments occur independently of the level of income.
The determinants of investment are: 1) Changes in the interest rate (e.g. when the interest rate rises, investment falls). 2) Animal Spirits: the expectations businesses have regarding potential sales & profits. => bull & bear markets.

Question 11

Discuss the role of transfer payments in the macroeconomy.

Answer 11

These are automatic stabilizers. e.g. Unemployement compensation, welfare payment and subsidies to farmers. They automaticly rise during recessions, and fall during economic expansions.

Question 12

What is a “closed economy”?

Answer 12

No imports & exports. These are not central in the Keyn Model, thus a closed economy is assumed.

Question 13

Define the Keynesian expenditure multiplier. Why is it greater than 1?

Answer 13

The number by which a change in AE must be multiplied to determine the resulting change in output. It is greater then 1 because income is re-spent many times after the initial increase.

Question 14

How is the Keynesian expenditure multiplier calculated?

Answer 14

= 1/MPS = 1/1-MPC

Question 15

Suppose the economy is in equilibrium at $960 billion. But this is $60 billion above the full employment output of$900 billion. What do we call this situation? How would you use fiscal policy to address it, assuming a marginal propensity to consume of .75?

Answer 15

inflationary gap, demand pull. Use contractionary fiscal policy (less G expenditures, or a tax hike)
e.g. Raise taxes with 20 billion (tax multiplier is 3) or cut spending by 15 billion (exp multiplier is 4)

Question 16

Is it more preferable to increase government spending or cut taxes to eliminate recessionary gaps?

Answer 16

Liberals (want same government size) concervatives (want smaller government). So liberals favor tax hikes (infl) and increased government exp (recession). Concervatives favor tax cuts to close recessionary gap and decreased government spending to close inflationary gap.

Question 17

Use the Keynesian model to explain the Great Depression.

Answer 17

Animal spirits => Businesses lowered production & households lessened consumption => AE curve goes down => business and households save more => ….

Question 18

What is the paradox of thrift?

Answer 18

In attempting to save more, many individual households saved less because their incomes fell as aggregate expenditures fell. This can greatly contribute to recessions.

Question 19

What is crowding out?

Answer 19

A reduction in private sector investment that can be caused by increased government spending. e.g. government borrows money to finance its spending which raises interest rates, which lowers investment. This is a major critique of the keynesian model.

Question 20

Illustrate the relationship between the Keynesian and the Aggregate Supply­-Aggregate Demand models.

Answer 20

Draw the two models beneath each other, with the same equilibrium. Shows that in the classical range, expansive fiscal policy will induce some inflation (when in recessionary range) and if you go over the potential output, heavy inflation will occur.

Question 21

What is an investment injection?

Answer 21

Addition of income to the circular flow. e.g. investment, government spending, exports.

Question 22

On what does a macroeconomic equilibrium depend?

Answer 22

On the balance of injections and leakages.

Question 23

Define the consumption function

Answer 23

C = Czero (autonomous consumption) + MPC * Yd (disposable income) => induced consumption

Question 24

In a keynesian view, how are changes in investment and consumption counterbalanced?

Answer 24

By fiscal policy and government spending

Question 25

Why does a tax cut has a lesser impact than government spending?

Answer 25

Because consumers will not increase their expenditures by the full amount of the tax cut. Instead they save a portion of that tax cut, based on their marginal propensity to save.

Question 26

What is the Keynesion Tax multiplier?

Answer 26

Expenditure multiplier * MPC

Question 27

When and why are keynesian tactics powerfull tools?

Answer 27

• When the economy is in the keynesian or recessionary range the ‘fixed price assumption” mirrors reality (because increased output does not put upward pressure on prices).
• It can illustrate how a small imbalance between leakage and injections can multiply into a much larger unemplyement or inflation problem.

Question 28

What are the problems with the fixed price assumption? How can we fix/understand these?

Answer 28

Assumes away inflation, neglects the crucial influence of monetary factors on interest rates and interest-sensitive components of output such as investment. By using the aggregate supply-aggrate demand model whe can illustrate both price levels and real output.