12 The Keynesian School
12.1 aggregate demand in the Keynesian school
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Practice Problems
No practice problems in this section.
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12.2 the building blocks of Keynesian analysis
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Practice Problems
Problem 12.2.1: 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.
Problem 12.2.2: 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.
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
12.3 fiscal policy
Review Activities
Practice Problems
Problem 12.3.1: 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
External Resources
Khan Academy: Automatic Stabilizers
12.4 issues with fiscal policy
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Practice Problems
No practice problems for this section.
External Resources
Khan Academy: Crowding Out
12.5 Three Historical Events: Fiscal Policy
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12.6 Keynesian response to a supply shock: The double-edged sword
Review Activities
Practice Problems
Problem 12.6.1: 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.)
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No external resources for this section.