Chapter 7. The Keynesian Perspective

# SOLUTIONS TO SELF-CHECK QUESTIONS

7.1 The Expenditure-Output Model

1. The following figure shows the aggregate expenditure-output diagram with the recessionary gap.

2. The following figure shows the aggregate expenditure-output diagram with an inflationary gap.

3. First, set up the calculation.

AE = 400 + 0.85 Yd + 300 + 200 + 500

AE = Y

Then insert Y for AE.

Y = 400 + 0.85 Y + 300 + 200 + 500

Y = 1400 +  0.85 Y

Y – 0.85Y = 1400

0.15Y = 1400

Y = 9333.33

Alternatively, the multiplier is that, out of every dollar spent, 0.85 goes into consumption.

Thus, using the formula, the multiplier is:

$$\frac{1}{1 – 0.85}$$ = 6.6

To increase equilibrium GDP by 300, it will take a boost of 300/6.6, which again works out to 45.45.

7.2 The Building Blocks of Keynesian Analysis

1. An inflationary gap is the result of an increase in aggregate demand when the economy was at potential output. Since the AS curve is vertical at potential GDP, any increase in AD will lead to a higher price level (i.e. inflation) but no higher real GDP.
2. A decrease in government spending will shift AD to the left.

7.3 Aggregate Demand in Keynesian Analysis

1. Question 1:
1. An increase in home values will increase consumption spending (due to increased wealth). AD will shift to the right and may cause inflation if it goes beyond potential GDP.
2. Rapid growth by a major trading partner will increase demand for exports. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
3. Increased profit opportunities will increase business investment. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
4. Higher interest rates reduce investment spending. AD will shift to the left and may cause recession if it falls below potential GDP.
5. Demand for cheaper imports increases, reducing demand for domestic products. AD will shift to the left and may be recessionary.

2. Question 2:

1. A tax increase on consumer income will cause consumption to fall, pushing the AD curve left, and is a possible solution to inflation.
2. A surge in military spending is an increase in government spending. This will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to the right of potential GDP, then the AD curve will shift farther to the right and military spending will be inflationary.
3. A tax cut focused on business investment will shift AD to the right. If the original macroeconomic equilibrium is below potential GDP, then this policy can help move an economy out of a recession.
4. Government spending on healthcare will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to the right of potential GDP, then the AD curve will shift farther to the right and healthcare spending will be inflationary.

7.4 The Keynesian Perspective on Market Forces

1. Keynesian economics does not require microeconomic price controls of any sort. It is true that many Keynesian economic prescriptions were for the government to influence the total amount of aggregate demand in the economy, often through government spending and tax cuts.
2. The three problems center on government’s ability to estimate potential GDP, decide whether to influence aggregate demand through tax changes or changes in government spending, and the lag time that occurs as Congress and the President attempt to pass legislation.