Unit 5 - Keynesian Macroeconomics

Question 1

What is Keynesian Economics?

Answer 1

Introduced by John Maynard Keynes, it challenges classical economics, which assumes the economy is self-regulating.
Keynes argued that insufficient demand can lead to extend economic downturns.

Question 2

Keynes vs. Classical Economics

Answer 2

Classical economics relies on Say’s Law: “Supply creates its own demand.”
Keynesian economics opposes this, stating that demand drives economic activity, and markets are not always self-correcting.

Question 3

Consumption Function

Answer 3

Describes how households allocate disposable income (income after taxes).
Consumption: The portion spent on goods and services.

Question 4

Marginal Propensity to Consume (MPC)

Answer 4

The fraction of additional income spent on consumption.
Example: If MPC = 0.8, 80% of extra income is spent.

Question 5

Saving Function:

Answer 5

Explains how households allocate income to saving.

Question 6

Marginal Propensity to Save (MPS)

Answer 6

The fraction of additional income saved.

Question 7

MPC + MPS = 1:

Answer 7

Households either spend or save their disposable income.

Question 8

Sticky Prices and Wages

Answer 8

Unlike classical views, Keynes argued that prices and wages don’t adjust quickly, leading to unemployment and underutilized resources.

Question 9

Role of Government

Answer 9

Keynesian economics emphasizes government intervention (e.g., increased spending) to boost demand during recessions.

Question 10

Consumer Behavior

Answer 10

Understanding MPC helps policymakers stimulate growth by encouraging spending.

Question 11

Saving Trends

Answer 11

Higher savings (reflected by MPS) can slow demand but support long-term investment.

Question 12

Economic Cycles

Answer 12

Consumer confidence about the future influences spending and saving, impacting economic stability.

Question 13

Data-Driven Models

Answer 13

Consumption and saving functions are derived from data, helping forecast economic behavior and guide policies.

Question 14

Multiplier Effect

Answer 14

A small increase in autonomous spending (e.g., consumption, investment, or government spending) triggers a chain reaction of increased income and spending, leading to a much larger increase in total economic output.

Question 15

What is the Multiplier effect formula?

Answer 15

Example:
If government spending increases by $10 billion and the MPC (Marginal Propensity to Consume) is 0.8, the multiplier is 5.
Total increase in GDP: $10 billion × 5 = $50 billion.

Question 16

Autonomous Spending

Answer 16

Independent changes in spending (C, I, G) shift the Total Expenditure (TE) and Aggregate Demand (AD) curves.

Question 17

Aggregate Demand-Aggregate Supply (AD-AS) Framework:

Answer 17

AD Curve: Represents total demand in the economy.
Keynesian AS Curve:
Horizontal section: Price stability, increased demand raises output without inflation.
Vertical section: Economy at full employment; additional demand leads to inflation.

Question 18

Recessionary Gaps:

Answer 18

When the economy operates below its Natural Real GDP, creating unemployment and underutilized resources.
Requires government intervention to shift the AD curve rightward.

Question 19

Government’s Role in the Economy:

Answer 19

During recessions, increased government spending can stimulate demand and support recovery.

Question 20

Importance of Autonomous Spending

Answer 20

Changes in spending (C, I, G) directly influence total output.
Investment or government cuts reduce GDP; spending increases stimulate growth.

Question 21

AD-AS Dynamics

Answer 21

Horizontal AS curve: Encourages expansion without inflation.

Vertical AS curve: Indicates limits at full employment, requiring careful policy adjustments.

Question 22

Recessionary Gaps

Answer 22

Highlight the need for active fiscal measures to stimulate the economy and restore full employment.

Question 23

TE Curve and Fiscal Policy

Answer 23

TE reflects AD. Increases in consumption or investment shift TE upward, boosting output.

Question 24

Total Expenditure Equation (TE)

Answer 24

TE = C + I + G
C: Consumption (based on disposable income).
I: Investment by businesses.
G: Government spending.

Question 25

Equilibrium Output

Answer 25

Achieved when TE = TP (Total Production).
At equilibrium:
Inventories remain stable.
No need for production adjustments.

Question 26

Recessionary Gap

Answer 26

Occurs when RGDP < NRGDP (Natural Real GDP).
Resulting in high unemployment and unused resources.

Question 27

Government Intervention

Answer 27

Increased government spending (G) shifts the TE curve upward.
Stimulates demand and helps close the recessionary gap.

Question 28

Disequilibrium States

Answer 28

TE > TP: Inventories fall → Firms increase production.
TE < TP: Excess inventories → Firms cut production.

Question 29

Multiplier Effect

Answer 29

A small change in G or I leads to a larger overall impact on the economy.
Example: With a multiplier of 4, a $10 billion increase in G boosts GDP by $40 billion.

Question 30

Keynesian Cross Diagram

Answer 30

Graphical tool showing the relationship between aggregate expenditure (TE) and output levels (GDP).

Question 31

TE Equation Analysis

Answer 31

Breaking down TE helps analyze how different factors (C, I, G) drive economic activity.

Question 32

Equilibrium Output

Answer 32

Crucial for stability; firms adjust production to maintain balanced inventories.

Question 33

Recessionary Gap Solutions

Answer 33

During recessions, fiscal policies like increased G are essential to stimulate demand and reduce unemployment.

Question 34

Unplanned Inventory Changes

Answer 34

Firms adjust production based on the balance between TE and TP to manage inventory levels.

Question 35

Multiplier Effect Importance

Answer 35

Highlights how fiscal policies can have amplified effects on economic output.

Question 36

Equilibrium vs. Disequilibrium

Answer 36

Disequilibrium signals economic instability, requiring interventions to restore balance.