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CHAPTER 8: KEYNESIAN SYSTEM (IV): AGGREGATE
SUPPLY AND DEMAND
Additional Questions
Essay Questions and/or Problems:
1. Cite the difference(s) between the classical and Keynesian aggregate demand schedules.
What things shift aggregate demand in the classical model? What things shift aggregate
demand in the Keynesian model?
2. What happened to the price level, money wages, real wages, and unemployment during the
Great Depression? How would you explain these observations in the Keynesian model? In
the Classical model?
3. Consider the Keynesian model with a flexible price level and fixed money wage. Assume
that the money wage is at a level that leads to equilibrium in the labor market when the
expected price level is equal to 100.
4. Why is the IS-LM model a model of aggregate demand? Illustrate this using an IS-LM
graph.
5. During the recession of 1990-1991, interest rates in the U.S. dropped by nearly two
percentage points while output rose and inflation fell. Can you explain this result in the
Keynesian model? Show your explanation graphically using the IS-LM and AD-AS
models.
6. Do workers and firms care more about wage stability or employment stability? Why?
Explain what both Keynesian wage theories suggest.
Keynesian theories of wage stickiness suggest that workers and firms agree to stabilize
7. What is the key difference between the classical and Keynesian aggregate supply
functions? What is the key factor that drives these differences?
8. If the Keynesian model is correct, what should be the correlation between interest rates, the
price level, real wages, and output over the business cycle? Provide graphs of the labor
market, AD/AS, and IS/LM to illustrate.
9. If the classical model is correct, what should be the correlation between interest rates, the
price level, real wages, and output over the business cycle? Provide graphs of the labor
market, AD/AS, and IS/LM to illustrate.
Additional Problems and/or Essay Questions:
10. Suppose that, instead of depending solely on income, consumption also depended on the
level of real wealth (B + M)/P where B and M are the nominal values of bonds and money,
respectively. We would assume that an increase in real wealth would cause consumption to
rise. The consumption function would be
c = c[y, (B + M)/P].
82 CHAPTER 8
Explain how the IS schedule would be affected by a change in the price level with this more
complex form of the consumption function. Derive the Keynesian aggregate demand
schedule for this more complex consumption function and compare this schedule to the
aggregate demand function where consumption depends only on real income.
11. Suppose that the interest elasticity of money demand is zero within the Keynesian model
with a fixed money wage but a variable price level. Analyze the effects of an increase in
government spending within this model. Include in your answer the effects on the level of
real output, the price level, and the rate of interest. Discuss how your answer would be
different in the fixed-price Keynesian model as opposed to the flexible price model.
12. Compare the Keynesian and classical analyses of the effects on price and output of a supply
shock such as an autonomous increase in the price of oil on world markets. How would
your answer differ between the fixed-price and flexible-price versions of the Keynesian
model?
13. Within the Keynesian model with both a flexible price and flexible money wage, illustrate
graphically and explain the effect of a decline in expectations. Include in your answer the
effects of this policy shift on real output, the price level, employment, the money wage, and
the interest rate. Explain what this question has to do with the typical Keynesian view of
what causes recessions.
14. Within the Keynesian model with a variable price level and variable money wage, consider
the case where the demand for money is completely interest insensitive (interest elasticity =
0). For this case, illustrate and explain the effects on income, the price level, the money
wage, employment and the interest rate as the result of
(a). an increase in the money stock, and
(b). an increase in government spending financed by an increase in the money stock.
15. The table below provides data on GDP, the price level, and nominal interest rates. What is
the likely source of the changes in GDP? Justify your answer. If you were going to
recommend a fiscal or monetary policy action to stabilize the economy and return it to
where it was at the beginning of the period, what would it be? Why?
YEAR GDP Price Level Interest Rate
2003 275 100 3.5%
2004 268 75 5%
2005 267 69 7%
2006 255 65 8%
2007 230 35 8.5%
16. Incorporating the assumption that consumption depends upon not just current income but
also wealth, consider the impact of the stock market decline between 2007-09 on the US
economy. Analyze using IS/LM and AD/AS graphs.
17. Suppose that two countries differ on in the size of their MPC, where the MPC is high in
country A and low in country B. Draw IS/LM and AD/AS curves for each country. In
which country will monetary policy be most effective at changing income? Fiscal policy?
18. In addition to consumption being a function of income, suppose that it is also a function of
interest rates. Now, lower interest rates make borrowing to consume easier, encouraging
overall consumption.
a. How would such a change impact the shape of the IS and LM curves? AD curve?
b. How would such a change impact the effectiveness of monetary and fiscal policy?
Multiple-Choice Questions:
1. In the IS-LM model, the implicit assumption made about aggregate supply was that the
2. In the Keynesian model with a fixed money wage but a flexible price level, an increase in
taxes will lower
3. Suppose the government want to increase aggregate demand without increasing interest
rates. You would recommend
4. In the case of an increase in government spending where the price level varies while the
money wage is fixed, output
5. In the Keynesian model with a fixed price level and a fixed money wage, an increase in the
money supply will cause
6. If interest rates, prices, and output are all rising, then according to the Keynesian model,
these changes must be caused by
7. In the Keynesian model with both a variable price level and money wage, the aggregate
supply function will be
8. If inflation and unemployment is rising at the same time, then this is most likely the result
of a shift
9. An increase in price expectations in the Keynesian model will shift
10. In the Keynesian model with a variable money wage and variable price level, an increase in
the money supply lead to a rise in all of the following except
11. During the Great Depression we observed:
12. Assuming that as a result of observed past increases in the aggregate price level, workers’
expectation of the current price level rises. Then,
13. Compared to the fixed-price/fixed-wage model, in the Keynesian model with a flexible
price but fixed wage, an increase in the money stock will cause output to rise by
14. The Keynesian aggregate demand curve slopes downward because for any given money
supply, an increase in the price level ______ real money holdings which _____ the interest
rate and _____ income.
15. According to the Keynesian model with fixed money wages, real wages should be
16. Assuming a horizontal aggregate supply curve, output will change when
17. According to Keynes, money wages
18. In the Keynesian theory of labor supply, price expectations are based
19. According to the Keynesians, labor contracts
20. According to Keynesian theory, the profit-maximizing firm demands labor up to the point
at which
21. The Keynesian labor supply function is shown as
22. According to the Keynesian fixed wage theory, real wages should be
23. According to Keynes’ fixed money wage theory, when the price level is higher than
expected the real wage is ____ than expected and unemployment is ______ than expected.
24. An increase in the expected price level will
25. According to the contract theory of wages, firms and workers agree on a contract that fixes
26. According to the Keynesian fixed wage theory, real wages should be
27. An increase in the expected price level lead to
28. Which of the following variables will shift the classical aggregate demand curve?
29. Which of the following statements about the Keynesian model is correct?
30. The aggregate supply schedule is steeper where the money wage is more variable than
where the money wage is fixed because the rise in the money wage in the
31. The classical model differs from the Keynesian model in that
32. Which of the following assumptions is crucial to the classical model but not the Keynesian
model?
33. The classical labor supply function is shown as
34. Keynes believed that
35. The position of the Keynesian aggregate demand schedule does not depend on the
36. Which of the following statements is (are) correct? Keynesian economists
37. Keynesians view the economy as unstable as a result of the instability of aggregate demand.
Which component of aggregate demand is primarily responsible?
38. The United States and other industrialized countries experienced rising inflation
39. Stagflation can be explained by
40. In the Keynesian model, if the actual price level is higher than the expected price level, then
41. In the contract theory of wages, if workers and firms agree to enter into contracts in which
their money wage adjusts automatically to changes in the actual price level, then aggregate
supply
42. Which of the following statements is correct?
43. The difference between the Keynesian and classical labor supply functions is that in the
Keynesian version
44. The classical theory of aggregate supply where markets are perfectly flexible
45. The Keynesian model differs from the classical model in that
46. In the face of an increase in oil prices, if the government’s primary objective is to keep
prices from falling, then policymakers should
47. If everyone expects prices to fall but they do not, then
48. An decrease in the price of oil on the world market would cause aggregate output to
49. If business cycles are caused by changes in aggregate demand, you would expect to see
50. If business cycles are caused by changes in aggregate supply, you would expect to see
51. Which of the following explains why the AD curve is downward sloping?
52. All of the following will shift the AD curve to the right except a(n):
53. The Keynesian AD curve differs from the classical AD curve in that:
54. The Keynesian AS curve differs from the classical AS curve in that:
55. Which of the following statements is correct?