ECON 272
In Class Exercise Eleven - Keynesian Economics - Answers
1. According to Keynes, the economy is driven by what? Aggregate Demand
2. According to Keynes, the time period that is relevant to economists is the __short run___________ _________?
3. Explain two main differences between Keynes and the Classical School. There are more than two -- you should know all of them.
a. Savings = f (r) for Classical, Savings = f (income mostly) for Keynes
b. Say's Law - Productivity drives an economy for Classical, Demand drives an economy for Keynes.
And there are others....
4. What is the speculative demand for money? People hold their wealth in either money or bonds (interest bearing assets). People will demand or hold money when they speculate that the price or value of bonds or other interest bearing assets will go down.
5. How does the speculative demand for money relate to the idea that Keynes did not think monetary policy would be effective during the depression (when interest rates are very low)? The speculative demand for money relates to the monetary policy not working in the case of a liquidity trap. This happens when interest rates are very low, so people speculate that they will go up. Since the price of bonds and interest rates are inversely related - they also speculate that the price of bonds will go down. This means the speculative demand for money will be high (hold money over bonds). So if the government engages in monetary policy and increases the money supply in order to get people to spend - it won't work. People will just hold the money and not spend it - aggregate demand will not go up.
6. What are the four components of aggregate demand in the Keynesian model?
Actually in his short version there are only three: consumption, investment, government spending. In the larger model - we would also add net exports.
7. Why is an increase in income seen as an increase in real GDP in the Keynesian model? An increase in income (generated from spending) will then lead suppliers to produce more since they have more income generated from demand. This increase in production is an increase in real GDP.
Of course more simply -- GDP is measured as C + I + G + NX - if any of those are increased - GDP increases by definition.
8. Show the equilibrium situation on the 45 degree model (Keynesian model). See your notes.
9. Explain the Keynesian idea regarding the marginal propensity to consume? To save? For every increase in income of $1, how much of that dollar is spent? How much saved? If you spend 60 cents on every additional dollar earned - your MPC is = .6 and your MPS = .4.
10. What is the Keynesian multiplier effect? Example. Given, for example that there is an initial increase in G - as the government spends money (say buys something from you ), your income goes up. You then either consume or save that additional income. The amount you spend becomes someone else's income - and they either spend or save. The story continues. If we add up all of the changes in Y generated from the initial change in G -- that tells us how much additional Y is generated.
11. Explain why Keynes said that deficit spending (fiscal policy) would be the most effective policy tool to use during the depression and why he wanted to use deficit spending (and not have the government keep a balanced budget). He wants to increase aggregate demand. The planners can't control investment so that's out. So they look at either changing taxes (which will change consumption) or change government spending. If they lower taxes - that will increase demand but not by the entire amount of the drop in taxes (since some people will save and not spend the tax decrease). On the other hand, demand will increase by the entire amount of a government spending increase. So that's more effective. However, keeping a balanced budget would not work - because the government would have to increase taxes now in order to pay for the additional government spending. That would pull down consumption - offsetting at least part of the increase in government spending. So - defitic spend - that way there's no decrease in consumption NOW, only later - in the long run, when we are all dead.
12. What knowledge would Keynesian economic planners have to have in order to try to decrease unemployment with fiscal policy (deficit spending for example)? They would have to know the target level of income that would give us enough income to generate full employment. They would also have to know the MPC and MPS of people in an economy in order to determine how much Y will change with a given change in G or T. Of course, in reality, they would also have to know WHERE to spend the G in order for the money to create real value. This is the real knowledge problem -- where to spend that money? The answer: wherever Deb wants it to go!! (: