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Chapter 12: The Keynesian Perspective

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Chapter 12: The Keynesian Perspective

7 problems · 2 figures

12-1 §12.1 source ↗

In the Keynesian framework, which of the following events might cause a recession? Which might cause inflation? Sketch AD/AS diagrams to illustrate your answers.

a. A large increase in the price of the homes people own.

b. Rapid growth in the economy of a major trading partner.

c. Business confidence increases.

d. The interest rate rises.

e. The good imported from a major trading partner become much less expensive.

Answer

a. 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.

b. 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.

c. Increased profit opportunities will increase business investment. AD will shift to the right and may cause inflation if it goes beyond potential GDP.

d. Higher interest rates reduce investment spending. AD will shift to the left and may cause recession if it falls below potential GDP.

e. Demand for cheaper imports increases, reducing demand for domestic products. AD will shift to the left and may be recessionary.

12-2 §12.1 source ↗

In a Keynesian framework, using an AD/AS diagram, which of the following government policy choices offer a possible solution to recession? Which offer a possible solution to inflation?

a. A tax increase on consumer income.

b. A surge in military spending.

c. A reduction in taxes for businesses that increase investment.

d. A major increase in what the U.S. government spends on healthcare.

Answer

a. A tax increase on consumer income will cause consumption to fall, pushing the AD curve left, and is a possible solution to inflation.

b. 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.

c. 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.

d. A major reduction in what the U.S. government spends on healthcare will cause the AD curve to shift to the left. If the real GDP is less than potential GDP then this spending decrease would make the existing recession worse. If the real GDP is to the right of potential GDP, then this AD curve shift to the left will cause the price level to decrease, offering a potential solution to inflation.

12-3 §12.2 source ↗

Use the AD/AS model to explain how an inflationary gap occurs, beginning from the initial equilibrium in Figure 12.6.
Figure 12.6 A Keynesian Perspective of Recession in the book ↗
This figure illustrates the two key assumptions behind Keynesian economics. A recession begins when aggregate demand declines from AD0 to AD1. The recession persists because of the assumption of fixed wages and prices, which makes the SRAS flat below potential GDP. If that were not the case, the price level would fall also, raising GDP and limiting the recession. Instead the intersection E1 occurs in the flat portion of the SRAS curve where GDP is less than potential.

Answer

An inflationary gap is the result of an increase in aggregate demand when the economy is 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. This is easy to see if you draw AD1 to the right of AD0.

12-4 §12.2 source ↗

Suppose the U.S. Congress cuts federal government spending in order to balance the Federal budget. Use the AD/AS model to analyze the likely impact on output and employment. Hint: revisit Figure 12.6.
Figure 12.6 A Keynesian Perspective of Recession in the book ↗
This figure illustrates the two key assumptions behind Keynesian economics. A recession begins when aggregate demand declines from AD0 to AD1. The recession persists because of the assumption of fixed wages and prices, which makes the SRAS flat below potential GDP. If that were not the case, the price level would fall also, raising GDP and limiting the recession. Instead the intersection E1 occurs in the flat portion of the SRAS curve where GDP is less than potential.

Answer

A decrease in government spending will shift AD to the left.

12-5 §12.3 source ↗

How would a decrease in energy prices affect the Phillips curve?

Answer

A decrease in energy prices, a positive supply shock, would cause the AS curve to shift out to the right, yielding more real GDP at a lower price level. This would shift the Phillips curve down toward the origin, meaning the economy would experience lower unemployment and a lower rate of inflation.

12-6 §12.4 source ↗

Does Keynesian economics require government to set controls on prices, wages, or interest rates?

Answer

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.

12-7 §12.4 source ↗

List three practical problems with the Keynesian perspective.

Answer

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.

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Problems and answers are adapted from Principles of Macroeconomics 3e by Steven A. Greenlaw, David Shapiro and Daniel MacDonald, OpenStax, and are used under the CC BY-NC-SA 4.0 licence. Access for free at https://openstax.org/books/principles-macroeconomics-3e/pages/1-introduction. Illustrations: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license. This adaptation is released under the same licence, is non-commercial, and is neither affiliated with nor endorsed by OpenStax or Rice University.