ANSWERS:

1. b

Ø Fiscal policy used to combat a recession is known as expansionary fiscal policy. This includes increases in government spending or decreases in taxes. The government is running on a budget deficit (G > T) when implementing an expansionary fiscal policy.

2. b

Ø During a period of rapid expansion and inflation, a Keynesian would advocate we slow down aggregate demand through government intervention. Thus, a Keynesian would suggest we operate on a budget surplus (T > G) and implement a contractionary fiscal policy.

3. d

Ø If we are at 5% unemployment, our AD curve is near the vertical range on the AS curve. Thus, an increase in AD due to an increased level of federal purchases, will more likely cause prices to increase rather than real output.

4. a

Ø If a new reserve is discovered, AS will increase and shift to the right. The result is an increase in output and therefore employment, and a decrease in price levels.

5. a

Ø Multiplier = DY (Aggregate Income) / DSpending (Expenditures)

6. d

Ø DY = Multiplier x DSpending

Ø 400 = Multiplier x 100

Ø Multiplier = 400/100 = 4

7. b

Ø If people save more, then they’ll have less money to spend on goods thereby decreasing aggregate income.

8. a

Ø If we are at full employment and investment decreases, the AE line will shift down (decrease) leading to a decrease in output and a recessionary gap.

9. b

Ø Banks will lower interest rates in order to attract investors since the only real way the make any money is by extending loans to borrowers.

10. a

Ø Unemployment is increasing and inflation is decreasing. This most likely means that AD is decreasing (shifting to the left).

11. d

Ø Investment consists of capital and equipment, changes in inventory, and all forms of construction.

12. c

Ø Multiplier = 1 / 1 – MPC = 1 / 1 - .75 = 1 / .25 = 4

Ø DY = Multiplier x DSpending

Ø 100,000 = 4 x DSpending

Ø DSpending = 100,000 / 4 = 25,000

Ø Thus, a Keynesian would argue that we increase government spending by $25,000 in order to bring us to full employment. A tax cut of $25,000 would not bring us to full employment simply because we save part of our income and therefore the DSpending due to increased consumption would only be equal to 25,000 x .75 (MPC) = 18,750.

13. b

Ø If the unemployment rate is 9% and prices are stable, we are along the horizontal portion of the AS curve. A Keynesian would suggest we increase AE by increasing government spending or by cutting taxes. We would then be running on a budget deficit.

14. b

Ø D Income = $1,700 - $1,200 = $500

Ø D Saving = $100 – (-$100) = $200

Ø D Consumption = $500 - $200 = $300

Ø MPC = D Consumption / D Income = $300/$500 = 3/5

15. 5/2

Ø Multiplier = 1 / 1- MPC = 1 / 1 – (3/5) = 1 / (2/5) = 5/2 = 2.5

16. 250

Ø DY = Multiplier x DSpending

Ø DY = 2.5 x $100 = $250

17. c

Ø If I > S, AD will increase since it is derived from the AE curve.

18. d

Ø Expansionary fiscal policy will cause total spending in the economy to increase by the largest amount. Thus, an increase in government spending and reduction in taxes will lead to the largest increase.

19. a

Ø Keynesians believe savings will be larger than investment simply because they feel investors are different people and low interest rates won’t necessarily influence investment during a recession.

20. b

Ø Savings is the distance between the 45 degree line and the consumption schedule.

21. b

Ø Multiplier = 1 / 1- MPC = 1 / 1- ½ = 1/ ½ = 2

Ø DY = Multiplier x D Spending

Ø 400 billion = 2 x D Spending

Ø 200 billion = D Spending

22. Some of our economic goals include: economic growth, full employment, economic efficiency, price-level stability, economic freedom, equitable distribution of income, economic security, balance of trade.

23. The basic tools of fiscal policy are changes in government spending and taxation.

24. Discretionary fiscal policy consists of deliberate changes in taxes (tax rates) and government spending by Congress to promote full employment, price stability, and economic growth.

25. An inflationary gap will occur when the current AE curve is greater than (lies above) the full-employment AE curve.

26. A recessionary gap will occur when the current AE curve is less than (lies below) the full-employment AE curve.

27. The self-correcting mechanisms the Classical Model believed would stabilize the economy are wage-price flexibility and floating-interest rates. During recessions, wage decreases will be met by equal price decreases since business must move out inventories. The concept of floating-interest rates revolves around the idea that if people aren’t willing to borrow, banks will lower rates in order to attract investors.

28. The Keynesian’s Model believes the self-correcting mechanisms of the Classical Model will not work because wages and prices are realistically “sticky” and not flexible. In addition, even if banks lower interest rates during a recession, why would businesses want to invest when demand is so low? Keynesians believed savers and investors are different people with different motives.