9.1 aggregate demand in the Keynesian school
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9.2 the building blocks of Keynesian analysis
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Practice Problems
NOTE: Similar to what was mentioned before problem 7.4.2 and problem 8.1.2, these problems are only templates and apply to any corresponding scenario from problem 7.4.1.
Problem 9.2.1: An economy is initially in a state of long-run equilibrium. Then, consumers become pessimistic about the future. The impact is expected to be temporary. Show the short-run impact on the aggregate market. How will price level, real GDP, and unemployment change? What is this situation called? Now, what would a Keynesian economist recommend in this situation? What type of fiscal policy could be used? Show how the Keynesian economist returns the economy to a state of long-run equilibrium graphically. As compared to the very beginning of the problem (when the economy was initially in a state of long-run equilibrium), what has happened to the price level, real GDP, and unemployment?
Answer: Answer: See video for graph. There will be an inward shift of the AD curve. This will cause a decrease in the price level, a decrease in real GDP, and an increase in unemployment. This is called a contraction or a recession. A Keynesian economist would recommend expansionary fiscal policy. This could be any of the following (or any combination): a decrease in taxes, a tax rebate check, an increase in government spending. This will cause the AD curve to shift outward and allow real GDP to return to its potential level. While each of the variables changed during the problem, price level, real GDP, and unemployment will return to their starting values.
https://youtu.be/JzY_ymQbUMM
Problem 9.2.2: An economy is initially in a state of long-run equilibrium. Then, the tax rate on income is cut meaning that disposable income has increased. The impact is expected to be temporary. Show the short-run impact on the aggregate market. How will price level, real GDP, and unemployment change? What is this situation called? Now, what would a Keynesian economist recommend in this situation? What type of fiscal policy could be used? Show how the Keynesian economist returns the economy to a state of long-run equilibrium graphically. As compared to the very beginning of the problem (when the economy was initially in a state of long-run equilibrium), what has happened to the price level, real GDP, and unemployment?
Answer: See video for graph. There will be an outward shift of the AD curve. This will cause an increase in the price level, an increase in real GDP, and a decrease in unemployment. This is called an expansion. A Keynesian economist would recommend restrictive fiscal policy. This could be accomplished through less government spending (austerity) or higher taxes. This will cause the AD curve to shift inward and allow real GDP to return to its potential level. While each of the variables changed during the problem, price level, real GDP, and unemployment will return to their starting values.
https://youtu.be/9fS5o3YmBxc
Problem 9.2.3: The government enacts a $250 billion stimulus program directed at consumers. Further, the government expects that people will spend 90 cents of each dollar received.
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Assuming no frictions exist, what total impact will this have on aggregate demand?
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Of that increase in aggregate demand, how much of it came from an increase in government spending? Consumption?
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Suppose that the government wants the stimulus to increase aggregate demand by a total of $750 million. In this case, how much of a stimulus should be instituted.
Answers: $2.5 trillion ($2,500 billion); Change in Government = $250 billion, Change in Consumption = $2.25 trillion ($2,250 billion); $75 billion
https://youtu.be/tAIHv2fkPjQ
Problem 9.2.4: If we expect people to save 30 cents on the dollar of stimulus received, how much impact will each dollar of a government stimulus have on aggregate demand? Note: People can only spend or save.
Answer: $3.33 per $1 of government spending.
https://youtu.be/mttbe_uN1-k
Problem 9.2.5: The government enacts a $150 billion stimulus package. The National Bureau of Economic Research estimates that the marginal propensity to consume is 0.80. Complete the chart below which shows the initial stimulus and first three rounds of spending.
| Round | Increase in AD | Increase in C |
| 1 | ||
| 2 | ||
| 3 |
Answers: $150, $120; $120, $96; $96, $76.8
https://youtu.be/vuz0jdMhdp8
External Resources
Khan Academy: Fiscal Policy to Address Output Gaps
Khan Academy: Calculating Change in Spending or Taxes to Close Gap (Note: Ignore the tax multiplier. We do not use these in our class.)
Khan Academy: MPC and Multiplier
9.3 fiscal policy
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Practice Problems
Problem 9.3.1: Suppose that a government begins with $0 in debt. Complete the table below. All values are given in billions of dollars.
| Year | Revenue | Spending | Deficit/Surplus | Debt |
| 2019 | $550 | $600 | ||
| 2020 | $575 | $600 | ||
| 2021 | $600 | $625 | ||
| 2022 | $650 | $625 |
Answers: Deficit of $50, $50; Deficit of $25, $75; Deficit of $25, $100; Surplus of $25, $75
https://youtu.be/FlW742e7evY
External Resources
Khan Academy: Automatic Stabilizers
9.4 issues with fiscal policy
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Khan Academy: Crowding Out
9.5 The great recession
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9.6 Keynesian response to a supply shock: The double-edged sword
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Practice Problems
Problem 9.6.1: An economy is initially in a state of long-run equilibrium. A war has decreased agricultural output by 30%. The impact is expected to be temporary. Show the short-run impact on the aggregate market. How will price level, real GDP, and unemployment change? What is this situation called? Now, what would a Keynesian economist recommend in this situation? What type of fiscal policy could be used? Show how the Keynesian economist returns the economy to a state of long-run equilibrium graphically. As compared to the very beginning of the problem (when the economy was initially in a state of long-run equilibrium), what has happened to the price level, real GDP, and unemployment? What is the issue with using fiscal policy in this situation?
Answer: See video for graph. There will be an inward shift of the SRAS. This will cause an increase in price level, a decrease in real GDP, and an increase in unemployment. This situation is called stagflation. We can boost aggregate demand by using expansionary fiscal policy. This includes: increased government spending, a decrease in taxes, and/or a tax rebate. This will cause AD to shift outward. But, compared to the start of the problem, the price level is now higher even though real GDP and unemployment have returned to their original levels. This is the trade-off with fiscal policy and stagflation…we can increase output at the expense of even higher inflation (considering that inflation is already high during stagflation.)
https://youtu.be/TvpYmIuRcNg
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