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?
2. Graphically depict the determination of equilibrium income.
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?
4. Assume that the consumption function equals
a. Find the equilibrium level of income with G = 0.
b. Find the equilibrium level of consumption.
c. Find the equilibrium level of saving.
d. How much will income change if planned investment rises to 110?
5. Discuss two fiscal policies that a government could adopt that would increase both interest
rates and 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?
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.
8. a. Show the autonomous investment multiplier in the open-economy model.
b. Show the autonomous investment multiplier in the closed-economy model.
c. Which multiplier will be smaller? Explain the intuition behind this result.
9. Explain why the government spending multiplier is greater than the tax multiplier.
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.
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?
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
3. The short-run refers to a period
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
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
d. tax multiplier.
6. Keynes believed that an important source of instability in the economy was instability
7. In the Keynesian model, exogenous variables include
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
44 CHAPTER 5
9. In the equation Y = C + I + G,
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
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
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
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
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
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
16. Using the simple Keynesian model, consider the case where taxes are lump-sum. Compared
17. Which of the following are equilibrium conditions in the simple Keynesian model?
18. Assuming that C + Ir + G < C + I + G, then
19. In the Keynesian consumption function
20. According to Keynes, the level of consumer expenditures was a stable function of
21. Which of the following does not impact aggregate demand in the Keynesian model?
22. The marginal propensity to consume is
23. According to Keynes, the consumption-income relationship is shown as C = a + bYD.
Therefore, the saving-income relationship is
24. In the simple Keynesian model, total savings equals
25. Keynes thought that expectations are
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
27. Both Keynesians and supply-siders believe that tax cuts
28. The most important determinant of any multiplier in the Keynesian model is
29. An increase in the interest rate
30. Keynes believed that the instability in income was caused by variability in
31. In the circular flow model, injections and leakages are associated with
32. According to the simple Keynesian model, when planned expenditure exceeds income
33. An increase in taxes
34. In the Keynesian model, changes in aggregate supply
35. When firms incur unplanned inventories, they typically
36. An increase in the demand for our exports
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?
38. Total planned expenditure is composed as
39. In the simple Keynesian model, equilibrium exists when
40. Assuming that C + I + G > C + Ir + G, then
41. According to Keynes, the least variable component of aggregate expenditures is
42. Which of the following equations illustrates the equilibrium level of income with respect to
43. In the open-economy Keynesian model, it always has to be true that
KEYNESIAN SYSTEM (I): THE ROLE OF AGGREGATE DEMAND 49
44. Assuming that C + Ir + G > C + I + G, then
45. Income has risen in the simple Keynesian model. This could be the result of:,
46. A increase in net exports
47. Which of the following statements is (are) incorrect?
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
48. The Keynesian explanation of the Great Depression focuses on
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
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
52. The equation for the balanced budget multiplier can be written as
53. If the government decreases spending and taxes by 1,000 units and the marginal propensity
54. In the Keynesian aggregate expenditure graph (Figure 5-5), the 45 degree line is meant to
indicate that:
55. If the consumption function is C = 120 +_.8(Y-T) in the basic Keynesian model, then in the
57. At equilibrium income:
58. An increase in the interest rate leads to: