Economic Environment

Course book

Prof Ashok Thomas

IIM Kozhikode
 Session 7: Keynesian Framework: Building Blocks

Introduction
In the period from 1929 to 1933, referred to as the beginning of the Great Depression,
economists had expected that competitive markets would reduce unemployment and reduce
surpluses, as had occurred often in prior recessions. In this case, however, wages were falling
but unemployment continued to increase, reaching approximately 25% in the United States in
January 1933. Thus, many began to question the prevailing Classical view of the economic
world. John Maynard Keynes, writing in the United Kingdom in the 1930s, particularly felt
that wage and price rigidities could keep an economy for a prolonged period of time in a below
full-employment equilibrium.

Essentially, the Keynesian view argues that there are impediments to wages and prices falling
to equilibrium levels. This phenomenon can be referred to as “sticky” wages and prices,
“downwardly rigid” wages and prices, or “downwardly inflexible” wages and prices. While
over a longer period of time, excess supply could pressure downward wages and prices, there
can be significant periods of excess supply, generating unemployment in labor markets and
surpluses in product markets.

Within labor markets, wage inflexibility can result from legal minimum wages above
equilibrium or union contracts. Also, employers may find it profitable over the long run to pay
a wage premium to attract good workers (sometimes referred to as “efficiency wages”) and to
maintain higher wages even in periods of slack demand. Within product markets, large firms
wishing to avoid destabilizing competition may maintain prices above equilibrium and have
temporary surpluses.

If the economy has the tendency to settle below full employment, with significant
unemployment, an appropriate government policy response would be to stimulate demand, to
increase employment and to increase the purchasing of products, moving the economy towards
full employment. Governments can prompt an increase in demand by directly buying goods
and services, reducing taxes to stimulate private spending, or lowering interest rates to
encourage investment and interest-sensitive consumer purchases. These stabilization policies
are frequently referred to as fiscal and monetary policy. In this Keynesian view of the world,
unlike the Classical view of the world, aggregate demand is very important as a determinant of
macroeconomic equilibrium and the level of unemployment in the economy. Inadequate
aggregate demand can lead to a short-run macroeconomic equilibrium with significant
unemployment, well above the full-employment rate of 4.5 to 6%.
Multiple choice questions

Question 1) According to the Keynesian view, the Great Depression could be characterized
as a period during which:

a) Prices and wages increased rapidly.

b) Prices stayed low, but wages increased rapidly.
c) There was a prolonged excess supply of labor.
d) There was a prolonged excess demand for labor.
e) Prices increased rapidly, but wages stayed low.

Question 2) According to the Keynesian view, which of the following is an inappropriate

short-term policy if the economy is in a recession?
a) Increasing government spending
b) Decreasing the deficit
c) Decreasing sales taxes
d) Decreasing interest rates
e) Decreasing income taxes

Question 3) According to the Keynesian view, unemployment caused by inadequate demand

could persist because:
a) Workers do not have the skills that firms need.
b) Workers receiving unemployment benefits have no incentive to look for employment.
c) Wages are rigid.
d) Government has set an interest rate that is too low.
e) Technological developments have induced firms to replace workers with machines
and robots.

Activity 1: Assume that a country is concerned about experiencing a high level of unemployment.
How would Classical and Keynesian economists differ in their approaches to reducing unemployment?
Activity 2

Referencing the animation above, which of the tfollowing best describes the economic effect?

a) Decrease in Quantity of Aggregate Demand caused by the Interest Rate Effect

b) Increase in Quantity of Aggregate Demand caused by the Interest Rate Effect
c) Decrease in Quantity of Aggregate Demand caused by the Real Balances Effect
d) Increase in Quantity of Aggregate Demand caused by the Real Balances Effect
e) Decrease in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
f) Increase in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
Activity 3

Referencing the animation above, which of the the following best describes the economic
effect?

a) Decrease in Quantity of Aggregate Demand caused by the Interest Rate Effect

b) Increase in Quantity of Aggregate Demand caused by the Interest Rate Effect
c) Decrease in Quantity of Aggregate Demand caused by the Real Balances Effect
d) Increase in Quantity of Aggregate Demand caused by the Real Balances Effect
e) Decrease in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
f) Increase in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
Activity 4

Referencing the animation above, which of the the following best describes the economic
effect?

a) Decrease in Quantity of Aggregate Demand caused by the Interest Rate Effect

b) Increase in Quantity of Aggregate Demand caused by the Interest Rate Effect
c) Decrease in Quantity of Aggregate Demand caused by the Real Balances Effect
d) Increase in Quantity of Aggregate Demand caused by the Real Balances Effect
e) Decrease in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
f) Increase in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
Conclusion
You should now be comfortable with the three reasons the aggregate demand curve has a
negative slope when graphed as the relationship between the general price level and output
measure as Real GDP. You should note that all three reasons begin with a change in the price
level and that you are explaining the impact of that change.

Be careful as you move forward to avoid confusing a change in some other variable other than
price level, which, as you will see, will cause a shift in the entire aggregate demand curve.

In this section, you have explored movements along the aggregate demand curve -- and
strengthened your ability to explain the causes for movements along the curve.

Aggregate demand

Question 4) As a result of a higher price level, domestic consumers have less purchasing power
with their cash balances in checking and savings accounts and therefore decrease their quantity
demanded for goods and services. This decrease is most likely due directly to:

a) Real Balance effect

b) Foreign Purchase effect
c) Interest Rate effect
d) An increase in imports
e) A decrease in exports

Question 5) As a result of higher interest rates, consumers buy less interest sensitive goods
like automobiles. This is an example of the:

a) Real Balance effect

b) Foreign Purchase effect
c) Interest Rate effect
d) All of the above
e) None of the above

Question 6) As a result of a higher price level, consumers need more money to make purchases
that they want. This increase in demand for money causes higher interest rates. The higher
interest rates cause consumers and businesses to reduce their demand for interest sensitive
goods. This effect is known as:

a) Real Balance effect

b) Foreign Purchase effect
c) Interest Rate effect
d) All of the above
e) None of the above
Question 7) As a result of a higher price level, consumers need more money to make
purchases that they want. This increase in demand for money causes higher interest rates. The
higher interest rates cause consumers and businesses to reduce their demand for interest
sensitive goods. This effect is known as:

a) Real Balance effect

b) Foreign Purchase effect
c) Interest Rate effect
d) All of the above
e) None of the above

Question 8) Assume all other factors remain constant when interest rates fall. Then
consumers would be able to borrow easier and the demand for real goods and services would
rise. This is an example of:

a) Interest Rate effect

b) Real Balance effect
c) Foreign Purchase effect
d) All of the above
e) None of the above

Question 9) Assume that income rises in Germany and Germans demand more U.S. goods
and services as a result. This is an example of:

a) the Interest Rate effect

b) the Real Balance effect
c) the Foreign Purchase effect
d) all of the above
e) none of the above

Determinants of Aggregate Demand

Introduction

In this section, you will learn the determinants of aggregate demand. A change in one of these
variables will actually cause a shift of the aggregate demand curve as opposed to a movement
along the curve. In essence, any change that affects aggregate demand, other than price level
changes, will shift the aggregate demand curve.

As mentioned in the previous section, it will be important for you to know these determinants
and how they affect aggregate demand, so that you will be able to understand how monetary
and fiscal policies are implemented and how they work.
Activity 1) Show the shifts in AD

Situation A

Assume the government increases government spending to build more interstate highways
and repair bridges along existing highways.

Situation B
Assume interest rates rise as a result of increased government borrowing to finance the highway
improvement projects.

Situation C
Assume the U. S. dollar increases in value (or appreciates) on the foreign exchange market. In other
words, it costs more Japanese Yen to buy a U. S. Dollar.

Situation D
Assume business confidence rises.

Situation E
Assume the general price level rises.

Situation F
Assume the level of income in China rises faster than the level of income in the U.S.

Activity 2
Consider the following economic fluctuations and what effect they would have on aggregate demand.

Draw your own graphs

1. Increase in Interest Rate

2. Higher Price Level

3. Decrease in Government Spending

4. Increase in Real Balances due to Decrease in Price Levels

5. Increase in Exports due to Decrease in Dollar Value (Foreign Exchange)

6. Increase in Personal Income Taxes

7. Increase in Consumer Confidence

You should now understand that changes in some economic factors, like the exchange rate or the
nominal interest rate, will shift the aggregate demand (AD) curve. Expansionary changes, like a tax
reduction or lower interest rate, will shift the AD curve to the right or increase AD at every price
level. Contractionary changes, like a reduction in government spending, will shift the AD curve to the
left or decrease AD at every price level.

Question 1) An increase in which of the following will increase aggregate demand?

a) Taxes
b) Government spending
c) The federal funds rate
d) Reserve requirements
e) The discount rate

Question 2) An increase in the international value of the United States dollar will tend to
cause U. S. exports to:
a) fall and aggregate demand to increase.
b) rise and aggregate demand to increase.
c) fall and aggregate demand to decrease.
d) rise and aggregate demand to decrease.
e) not change and aggregate demand to not change.

Question 3) Which of the following changes would cause an economy’s Aggregate Demand
curve to shift to the right?
a) An increase in spending on imports
b) An increase in autonomous consumption spending
c) An increase in interest rates
d) A decrease in the money supply
e) A decrease in the overall price level in the economy
Question 4) Aggregate Demand may be measured by adding:

a) consumption, investment, savings, and imports

b) savings, government spending, and business inventories
c) consumption, investment, government spending, and net exports
d) domestic private expenditures and government spending
e) domestic expenditure and imports

Question 5) Which of the following would cause the aggregate demand curve to shift to the
left?
a) Providing investment tax credits for businesses
b) Higher value of the dollar on the foreign exchange market
c) Reducing personal income tax rates
d) Increase in consumer confidence
e) Faster increase in foreign countries’ income compared to the US

The Multiplier Effect

Introduction

You now know that a change in the price level will cause a movement along the aggregate
demand curve, reflecting a change in the amount of real goods and services demanded.

You also know that an autonomous change in any one of the four sectors of aggregate
demand (C, Ig, G, Xn) will cause a shift in the aggregate demand curve reflecting a change in
the amount of real goods and services demanded at every price level.

Activity

In this section, you will see that an autonomous change in any one of the four sectors can
result in a much greater change in aggregate demand (and even real GDP). The additional
increase in aggregate demand is called the multiplier effect. It is important to consider the
multiplier effect in determining the magnitude of necessary fiscal and monetary policy
changes in the effort to fine tune the economy. Activity Overview

Now you will try some exercises that will help you practice the multiplier effects. It is
important to bear in mind that any autonomous change in one of the four sectors of aggregate
demand (C, Ig, G, Xn) will result in a much greater change in aggregate demand as a result of
the multiplier effect.
Activity 1

Assume the government increases government spending by $10 billion to improve border
security. Also, assume the marginal propensity to consume is .75. What will be the maximum
total change in aggregate demand based on the increase in government spending?

Activity 2

Assume consumers become concerned about the direction the economy is headed and they
decrease their spending on consumer goods and services by $800 million. Assuming the
marginal propensity to save is .2, what will be the maximum total change in aggregate
demand?

Activity 3

Assume the exchange rate for the Mexican Peso changes such that it costs more Dollars to
buy a Peso. As a result, Americans buy less Mexican goods and services while Mexicans buy
more American goods and services. Assume the result of these changes is an increase in U.S.
Net Exports of $2 billion. Assuming the marginal propensity to consume is .8, what will be
the maximum total change in aggregate demand?

Question 1) An increase in the marginal propensity to consume causes an increase in which

of the following?

a) Marginal propensity to save

b) Spending multiplier
c) Savings rate
d) Exports
e) Aggregate supply

Question 2) In an economy with lump-sum taxes and no international sector, assume that the
marginal propensity to consume is equal to .8. Which of the following will necessarily be
true?

a) The economy will be running a deficit, since consumption expenditures exceed

personal saving.
b) Wealth will tend to accumulate in the hands of a few people.
c) A $10 increase in consumption spending will bring about an $80 increase in
disposable income.
d) The government expenditure multiplier will be equal to 5.
e) An increase in taxes of $80 million will result in a decrease in aggregate demand of
$5 million.

Question 3) Assume the government feels the economy is “overheated” and would like to see
aggregate demand decrease by $200 billion. By how much would the government need to
change government spending if the marginal propensity to save in the economy is .25?
 a) $50 billion increase
b) $50 billion decrease
c) $200 billion increase
d) $200 billion decrease
e) $25 billion decrease

Question 4) Assume the government increases government spending by $800 billion and the
ultimate change in aggregate demand is approximately $4 trillion, then the economy’s
marginal propensity to consume must be:

a) .2
b) .8
c) 5
d) $3.2 trillion
e) $800 billion

Question 5) Assume consumers have a new bright and positive attitude about the economy
and they increase spending on consumer goods by a total of $400 billion. As a result,
aggregate demand ultimately increases by approximately $1.6 trillion. Assuming the marginal
propensity to consume for the economy is .75, by what amount did the consumers initially
change their saving?

a) 4
b) .25
c) -$400 billion
d) -$1.2 trillion
e) no change in saving

Question 6) Assume the government increases government spending by $10 billion and the
Marginal Propensity to Consume (MPC) is .75. Then aggregate demand will eventually:

a) decrease and shift to the left by a maximum of $10 billion

b) increase and shift to the right by a maximum of $10 billion
c) decrease and shift to the left by a maximum of $40 billion
d) increase and shift to the right by a maximum of $40 billion
e) not change since this is an autonomous increase

Question 7) The three reasons the aggregate demand curve slopes down and to the right
when graphed as a function of the price level are:

a) real balance effect (or wealth effect), foreign purchases effect, and interest rate effect
b) real balance effect (or wealth effect), price level effect, and interest rate effect
c) real balance effect (or wealth effect), foreign purchases effect, and price level effect
d) income effect, wealth effect, and price level effect
e) income effect, personal gain effect, and price level effect
Question 8) Assume business confidence rises and as a result, business investment spending
rises by $4 billion dollars. Also, assume the marginal propensity to consume is .8. This
increase in spending would be considered:

a) The interest rate effect and aggregate demand would increase ultimately by $20
billion.
b) An autonomous change and aggregate demand would increase ultimately by $20
billion.
c) The interest rate effect and aggregate demand would increase ultimately by $4 billion.
d) An autonomous change and aggregate demand would increase ultimately by $4
billion.
e) An autonomous change and aggregate demand would increase ultimately by $3.2
billion.

Question 9) If the aggregate demand curve shifts to the left, a likely cause would be:
An increase in income in Germany

a) A decrease in the value of the dollar on the foreign exchange

b) An increase in the price level
c) An increase in interest rates
d) A decrease in taxes

Question 10) If you observe the aggregate demand curve shifting to the right by $50 billion
dollars based on an increase of $5 billion in business investment spending, then most likely:

a) Government spending was also increased by $40 billion.

b) Government spending was also increased by $10 billion.
c) The marginal propensity to save is .9.
d) The marginal propensity to consume is .9.
e) The marginal propensity to consume is $40 billion.

Question11) If you observe the quantity of aggregate demand increases by $4 billion with no
change/shift in aggregate demand, then a likely explanation is:

a) There has been a decrease in the price level.

b) There has been an increase in the price level.
c) Government spending has increased by 1 billion and the marginal propensity to
consume is .75.
d) Government spending has increased by 1 billion and the marginal propensity to
consume is .8.
e) Government spending has increased by 1 billion and the marginal propensity to
consume is 4.