Week 4: The Keynesian Model and Fiscal Policy

Paradox of Thrift

(1930s) When, in their attempt to save more, many individual households actually wound up saving less because their incomes were plummeting as aggregate expenditures fell. This phenomenon is a contributor to recessionary events.

Induced C

.

Aggregate expenditures 1. Represents total spending 2. Equals consumption plus investment plus government spending plus net exports 3. Is the horizontal summation of four curves All of the above 1 & 2 only

1 & 2 only

What type of expansionary fiscal policies can be used to close a recessionary gap? 1. A tax cut 2. An increase in government expenditures 3. A decrease in the money supply All of the above 1 & 2 only

1 & 2 only

Which of these are the primary tools of fiscal policy? 1. Decreased or increased government expenditures 2. Decreased or increased taxes 3. Decreases or increases in the money supply All of the above 1 & 2 only

1 & 2 only

Defecit spending

A government's spending of more money than it recieves in revenue (usually by borrowing funds). This can drive up interest rates which, in turn, reduces private sector investment.

"Animals spirits" in the Keynesian model is important because: 1. If businesses are bearishly pessimistic on the economy, they will cut back on investment 2. If businesses are bullishly optimistic on the economy, they will increase investment 3. If businesses believe the economy will go bad, it could become a self-fulfilling prophecy All of the above 1 & 2 only

All of the above

Who was responsible for developing the textbook Keynesian model? Alvin Hansen and Paul Samuelson Delano Roosevelt Milton Friedman and Arthur Laffer

Alvin Hansen and Paul Samuelson

Closed Economy

An economy that does not interact with other economies in the world

Why is crowding out problematic?

Any fiscal policy stimulus may be partly, or fully offset, by a reduction in private sector demand. This, in turn means that the net expansionary effect of Keynesian fiscal policies might wind up being smaller than was intended.

Why does the AE curve intersect the vertical axis above zero? Autonomous consumption Induced consumption Fractional consumption

Autonomous consumption

In the Keynesian consumption function, total consumption equals: Autonomous consumption plus induced consumption Autonomous consumption divided by induced consumption Autonomous consumption minus induced consumption

Autonomous consumption plus induced consumption

Why are exports better for an economy than imports?

Because exports create domestic production, income, and employment for an economy, they must be added to aggregate expenditures. However, when we purchase imports from a foreign country, no such production, income, and employment is created, so that imports must be subtracted from aggregate expenditures.

Which is the largest component of Aggregate Expenditures? Consumption Government spending Investment Net Exports

Consumption

Aggregate Expenditure Model

Consumption Investments Government Expenditures

Which of these components of the aggregate expenditure function is not represented by a horizontal line? Consumption function Government function Investment function

Consumption function

Autonomous Consumption

Consumption spending that is not related to the level of disposable income. For instance, it occurs when an unemployed person dips into their savings

The amount of money left after paying taxes to the government is referred to as: Disposable income Disposable consumption Induced consumption

Disposable income

When the government increases its expenditures to close a recessionary gap and finances those expenditures through increased borrowing, this can: Drive up interest rates and drive down investment Drive down interest rates and investment Drive down interest rates and drive up investment Drive up interest rates and investment

Drive up interest rates and drive down investment

Which of these is an injection? Exports Imports Taxes

Exports

Which part of the net export function adds to aggregate expenditures? Exports Imports Exchange rates

Exports

Consumption Function

Function that illustrates the relationship between consumption spending and disposable income.

Expansionary Fiscal Policy vs Contractionary Fiscal Policy

G: Gov Expenditure T: Taxes

Expectations/ Animal Spirits

If businesses believe the economy was about to go bad, it could become a self fulfilling prophecy. Businesses would cut back on investment and production. And thereby help trigger a recessionary spiral.

Transfer Payments

Include such things as unemployment compensation to workers, welfare payments, and subsidies to farmers. They help stabilize the macro economy, because they automatically rise during recessions, and fall during expansion.

The Keynesian multiplier is greater than one because: Income is re-spent many times after the initial increase. Autonomous consumption is greater than zero Induced consumption is less than disposable income

Income is re-spent many times after the initial increase.

Investment increases when: Interest rates fall Interest rates rise Not sure Both prices and interest rates rise

Interest rates fall

Determinants of Investment

Interest rates, expectation/business confidence (animal spirit), technology

Achilles Heel of the Keynesian Model

Is that it relies on a model that is not a complete model of the economy. Particularly with respect to the monetary and financial sector.

Compared to increases in government expenditures, tax cuts have: Less of an expansionary effect More of an expansionary effect The same expansionary effect Not sure

Less of an expansionary effect

The aggregate expenditures curve is flatter than the 45 degree line in the Keynesian model because the MPC is: Less than one Greater than one Equal to one

Less than one

The extra amount people consume when they receive an extra dollar of disposable income is referred to as the: MPC MPS MPI

MPC (marginal propensity to consume)

A closed economy excludes: Net exports Investment Government expenditures Consumption

Net Exports

DPI Formula

Personal Income−Personal Income Taxes

Crowding Out

Refers to the reduction in private sector investment that can be caused by increased government spending. It can happen when the governent borrows money to finance these expenditures. (issue related to Keynesianism)

Which of these is a leakage in the Circular Flow Diagram? Savings Investment Government spending

Savings

The Fixed Price Assumption (issue with keynesian model)

The Keynesian model assumes away inflation, thereby neglecting the crucial influence of monetary factors on interest rates and interest-sensitive components of output such as investment.

Increase government spending, or cut taxes, to eliminate recessionary and inflationary gaps?

The answer is ideological:depends on one's view of the size of the government (liberal vs conservative)

Injections

The investment, government spending and export revenues that add spending to the circular flow of income.

Crowding out means that: The net effect of a fiscal policy stimulus may be less than intended The net effect of a fiscal policy stimulus may be more than intended The net effect of a fiscal policy stimulus is unaffected

The net effect of a fiscal policy stimulus may be less than intended

Leakages

The savings (business and consumer), taxes and import spending that remove spending from the circular flow of income.

Transfer payments like unemployment compensation and welfare payments act as automatic stabilizers because: They automatically rise during recessions and fall during expansions. They stimulate the economy They contract the economy

They automatically rise during recessions and fall during expansions.

What is the relationship between the Keynesian aggregate expenditures-aggregate production model, and the Classical aggregate supply-aggregate demand model?

They provide the same E.

Assuming the marginal propensity to consume is 0.8, how much will we have to increase government expenditures to close this gap?

To answer this question, let's first calculate the multiplier. It is simply 1 divided by 0.2, gives us a multiplier of 5. Therefore, to close the $100 billion recessionary gap, we must increase government spending by $20 billion, because 5 times 20 equals 100. Now alternatively, we can use a tax cut, instead of increased government expenditures, to close this same $100 billion recessionary gap.

Fiscal policy: Uses changes in government expenditures and taxes to stimulate the economy Uses changes in the money supply to stimulate or contract the economy Uses changes in the size of the trade deficit to stimulate or contract the economy.

Uses changes in government expenditures and taxes to stimulate the economy

Vertically summing the consumption, investment, and government expenditure curves yields the AE function. It's slope is: The MPC The MPS MV PQ

Vertically summing the consumption, investment, and government expenditure curves yields the AE(Aggregate Expenditure) function. Its slope is: The MPC The MPS MV PQ

Recessionary gap

What occurs when the equilibrium quantity of output is below potential output

Contractionary fiscal policy

a form of fiscal policy that involves increasing taxes, decreasing government expenditures or both in order to fight inflationary pressures.

Marginal Propensity To Consume (MPC) calculation

change in consumption divided by the change in income. ΔC / ΔY

Conservative view on Increase government spending, or cut taxes to eliminate recessionary and inflationary gaps

conservatives will generally favor tax cuts during recessions and cuts in government spending to fight demand pull inflation.

Investment Expenditures

include purchases of residential structures, investment in business plant and equipment, and additions to a company's inventory.

Government Expenditures

includes purchases of goods like tanks or road building equipment as well as the services of judges and public school teachers. Unlike private consumption and investment, this component of aggregate demand is determined directly by the government's spending decisions.

Marginal Propensity To Consume (MPC)

is defined as the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it. It is a component of Keynesian macroeconomic theory.

Disposable income, also known as disposable personal income (DPI)

is the amount of money that households have available for spending and saving after income taxeshave been accounted for

Keynesian expenditure multiplier

is the number by which a change in aggregate expenditures must be multiplied in order to determine the resulting change in total output. This multiplier is greater than 1 and the reason is that income is re-spent, not just once but many times after the initial increase.

Aggregate Expenditure

is the sum of all the expenditures undertaken in the economy by the factors during a specific time period. The equation is: AE = C + I + G + NX. It determines the total amount that firms and households plan to spend on goods and services at each level of income.

Autonomous Investment

is when a government or other body makes an investment in a project or to a foreign country without regard to the level of economic growth or the prospects for that investment generating positive returns. In other words, the investment is made whether or not economic conditions change or if the project is likely to succeed.

Liberal/democrat view on Increase government spending, or cut taxes to eliminate recessionary and inflationary gaps

liberals who think that there are many unmet social and infrastructure needs usually recommend increased government spending during recessions. And tax increases to fight demand-pull inflation.

Marginal Propensity to Save (MPS)

refers to the proportion of an aggregate raise in income that a consumer saves rather than spends on the consumption of goods and services. Put differently, it is the proportion of each added dollar of income that is saved rather than spent. It is a component of Keynesian macroeconomic theory.

Marginal Propensity to Save (MPS) calculation

the change in savings divided by the change in income MPS= 1-MPC

New Deal

was a series of programs, public work projects, financial reforms, and regulations enacted by President Franklin D. Roosevelt in the United States between 1933 and 1939. It responded to needs for relief, reform, and recovery from the Great Depression.