CHAPTER 8: KEYNESIAN SYSTEM (IV): AGGREGATE

SUPPLY AND DEMAND

ADDITIONAL QUESTIONS

Essay Questions and/or Problems:

1. Cite the difference(s) between the classical and Keynesian aggregate demand schedules. What things
shift aggregate demand in the classical model? What things shift aggregate demand in the Keynesian
model?

The classical aggregate demand schedule depends only on the level of the money stock. The
aggregate demand curve in the Keynesian system depends on the quantity of money, and on such
variables as the level of government spending, the level of tax collection, and the level of autonomous
investment expenditures.

2. What happened to the price level, money wages, real wages, and unemployment during the Great
Depression? How would you explain these observations in the Keynesian model? In the Classical
model?

Prices and output fell. Money wages rose, but not as much as the price level fell so that real wages fell.
This is consistent with the Keynesian flexible-price model in which money wages are inflexible. In this
model, a fall in aggregate demand would reduce the price level and output while increasing real wages.

3. Consider the Keynesian model with a flexible price level and fixed money wage. Assume that the
money wage is at a level that leads to equilibrium in the labor market when the expected price level is
equal to 100.

(a). Now assume that aggregate demand unexpectedly falls. Provide a graph of the labor market and
the AD/AS market and illustrate what happens.

A fall in aggregate demand reduces the actual price level. As a result of this fall in the price
level, real wages rise; the quantity of labor supplied is greater than the quantity of labor
demanded.

(b). If the economy was operating at the level of potential output before this change in aggregate
demand, what is true about equilibrium income now?

Now the equilibrium income is below the level of potential output.

4. Why is the IS-LM model a model of aggregate demand? Illustrate this using an IS-LM graph.

In the IS-LM model, an increase in the price level shifts the LM curve to the left and reducing
income. Thus, there is a negative relationship between the price level and the level of income,
illustrated by the aggregate demand curve.
 5. During the recession of 1990-1991, interest rates in the U.S. dropped by nearly two percentage points
while output rose and inflation fell. Can you explain this result in the Keynesian model? Show your
explanation graphically using the IS-LM and AD-AS models.

This is consistent with a fall in the IS curve which drives a reduction in aggregate demand. This is very
consistent with recessions as envisioned by Keynesians.

6. Do workers and firms care more about wage stability or employment stability? Why? Explain what
both Keynesian wage theories suggest.

Keynesian theories of wage stickiness suggest that workers and firms agree to stabilize nominal
wages, but at the cost of fluctuation in employment. There is quite a bit of empirical evidence that
suggest that in fact workers and firms do care more about wage stability than employment stability.

7. What is the key difference between the classical and Keynesian aggregate supply functions? What is
the key factor that drives these differences?

The main difference between the classical and Keynesian aggregate supply functions is the slope of
the function. The classical aggregate supply function is vertical whereas, in the short-run, the
Keynesian aggregate supply curve slopes upward to the right. The difference is that the classical
model is one of perfect competition, while in the Keynesian model wages and prices are imperfectly
flexible.

8. If the Keynesian model is correctt, what should be the correlation between interest rates, the price
level, real wages, and output over the business cycle? Provide graphs of the labor market, AD/AS,
and IS/LM to illustrate.

In the Keynesian model, changes in expectations drive changes in investment, shifting the IS curve
and AD to the right. As a result, interest rates, the price level, and income should be positively
correlated. In addition, the higher price level reduces the real wage; so real wages should be
negatively correlated with income.

9. If the classical model is correct, what should be the correlation between interest rates, the price level,
real wages, and output over the business cycle? Provide graphs of the labor market, AD/AS, and
IS/LM to illustrate.

In the classical model, changes in aggregate supply drive change in the business cycle. As a result,
prices will be negatively correlated with income. Because these changes in aggregate supply will
often be driven by changes in technology or increases in investment, which increase labor demand,
real wages will be positively correlated with income. Finally, because investment will typically rise
when income rises, interest rates should also be positively correlated with income.
Additional Problems and/or Essay Questions:

10. Suppose that, instead of depending solely on income, consumption also depended on the level of real
wealth (B + M)/P where B and M are the nominal values of bonds and money, respectively. We
would assume that an increase in real wealth would cause consumption to rise. The consumption
function would be

c = c[y, (B + M)/P].

Explain how the IS schedule would be affected by a change in the price level with this more complex
form of the consumption function. Derive the Keynesian aggregate demand schedule for this more
complex consumption function and compare this schedule to the aggregate demand function where
consumption depends only on real income.

11. Suppose that the interest elasticity of money demand is zero within the Keynesian model with a fixed
money wage but a variable price level. Analyze the effects of an increase in government spending
within this model. Include in your answer the effects on the level of real output, the price level, and
the rate of interest. Discuss how your answer would be different in the fixed-price Keynesian model
as opposed to the flexible price model.

12. Compare the Keynesian and classical analyses of the effects on price and output of a supply shock
such as an autonomous increase in the price of oil on world markets. How would your answer differ
between the fixed-price and flexible-price versions of the Keynesian model?

13. Within the Keynesian model with both a flexible price and flexible money wage, illustrate graphically
and explain the effect of a decline in expectations. Include in your answer the effects of this policy
shift on real output, the price level, employment, the money wage, and the interest rate. Explain what
this question has to do with the typical Keynesian view of what causes recessions.

14. Within the Keynesian model with a variable price level and variable money wage, consider the case
where the demand for money is completely interest insensitive (interest elasticity = 0). For this case,
illustrate and explain the effects on income, the price level, the money wage, employment and the
interest rate as the result of

(a). an increase in the money stock, and

(b). an increase in government spending financed by an increase in the money stock.

15. The table below provides data on GDP, the price level, and nominal interest rates. What is the likely
source of the changes in GDP? Justify your answer. If you were going to recommend a fiscal or
monetary policy action to stabilize the economy and return it to where it was at the beginning of the
period, what would it be? Why?

YEAR GDP Price Level Interest Rate

2003 275 100 3.5%
2004 268 75 5%
2005 267 69 7%
2006 255 65 8%
2007 230 35 8.5%
Multiple-Choice Questions:

1. In the IS-LM model, the implicit assumption made about aggregate supply was that the
a. aggregate supply schedule was vertical because prices were flexible.
b. aggregate supply schedule was horizontal because prices were fixed.*
c. aggregate supply schedule was upward sloping to the right because wages and prices were fixed.
d. supply of output was fixed.
e. none of the above.

2. In the Keynesian model with a fixed money wage but a flexible price level, an increase in taxes will
lower
a. output and the price level, but leave the interest rate unchanged.
b. output, the price level and the interest rate.*
c. output and the interest rate, but leave the price level unchanged.
d. output and the price level, but increase the interest rate.
e. the price level and the interest rate, but leave output unchanged.

3. Suppose the government want to increase aggregate demand without increasing interest rates. You
would recommend
a. reducing transfer payments and increasing the money supply.
b. increasing government spending and reducing the money supply.
c. increasing taxes and the money supply.
d. increasing government spending and the money supply.*

4. In the case of an increase in government spending where the price level

varies while the money wage is fixed, output
a. rises and prices fall by more than if the price level was fixed.
b. falls and price rise by more than if the price level was fixed.
c. rises by more and the price level rises by less than if the price level was fixed.
d. and the price level are fixed.
e. rises and prices fall by more than if the price level was fixed.*

5. In the Keynesian model with a fixed price level and a fixed money wage, an increase in the money
supply will cause
a. output to fall and interest rates to fall.
b. output to remain unchanged.
c. output to rise and the price level to fall.
d. output to rise and interest rates to fall.*

6. If interest rates, prices, and output are all rising, then according to the Keynesian model, these
changes must be caused by
a. an increase in aggregate supply.
b. a shift to the right of the LM curve.
c. a shift to the right of the LM curve.
d. a shift up in the IS curve.*
e. none of the above.

7. In the Keynesian model with both a variable price level and money wage, the aggregate supply
function will be
 a. upward sloping but flatter than for the variable-price/fixed-wage version of the model.
b. upward sloping but steeper than for the variable-wage/fixed-price version of the model.*
c. vertical.
d. horizontal.

8. If inflation and unemployment is rising at the same time, then this is most likely the result of a shift
a. downward in the aggregate demand schedule.
b. upward in the aggregate demand schedule.
c. downward in the aggregate supply schedule.*
d. upward in the aggregate supply schedule.
e. none of the above can explain this

9. An increase in price expectations in the Keynesian model will shift

a. labor demand and aggregate supply to the left.
b. labor demand to the left and aggregate supply to the right..
c. labor demand and aggregate demand to the right.
d. labor supply and aggregate supply to the left.*
e. labor supply to the right and aggregate supply to the left.

10. In the Keynesian model with a variable money wage and variable price level, an increase in the
money supply lead to a rise in all of the following except
a. price level.
b. output.
c. real wage.*
d. level of employment.
e. all of these rise

11. During the Great Depression we observed:

a. higher prices.
b. higher real wages.
c. lower output.
d. higher money wages.
e. both b and d.*

12. Assuming that as a result of observed past increases in the aggregate price level, workers’ expectation
of the current price level rises. Then,
a. less labor will be supplied at each money wage because with the higher expectation about the
aggregate price level since a given money wage corresponds to a lower real wage.
b. the firm has to pay a higher money wage in order to obtain a given quantity of labor.
e c. more labor will be supplied at each money wage because with the higher expectation about the
f aggregate price level since a given money wage corresponds to a higher real wage.
d. Both a and b*
e. Both b and c

13. Compared to the fixed-price/fixed-wage model , in the Keynesian model with a flexible price but
fixed wage, an increase in the money stock will cause output to rise by
a. less while the interest rate will fall by more.
b. less and the interest rate to fall by less.*
c. more but the interest rate to fall by less.
d. more and the interest rate to fall by more.
14. The Keynesian aggregate demand curve slopes downward because for any given money supply, an
increase in the price level ______ real money holdings which _____ the interest rate and _____ income.
a. increases; lowers; increases
b. reduces; raises; reduces*
c. reduces; lowers; increases
d. increases; raises; reduces

15. According to the Keynesian model with fixed money wages, real wages should be
a. negatively correlated with changes in output.
b. positively correlated with changes in unemployment.
c. negative correlated with changes in the price level.
d. fixed as well.
e. both a and c.*

16. Assuming a horizontal aggregate supply curve, output will change when
a. monetary or fiscal policy changes.
b. monetary policy changes.
c. fiscal policy changes.
d. capital, labor, or technology changes.
e. all of the above*

17. According to Keynes, money wages

a. would adjust in the short run in order to maintain full-employment.
b. are inflexible in the short run are cannot guarantee full-employment levels of output.*
c. are inflexible and fall as the price level rises.
d. are more flexible downward than upward direction.

18. In the Keynesian theory of labor supply, price expectations are based
a. only on the future behavior of the price level.
b. on the past, present, and future behavior of the price level.
c. on the present behavior of the price level.
d. on the past behavior of the price level.*

19. According to the Keynesians, labor contracts

a. are unimportant for modern labor markets because few worker are unionized.
b. mean that real wages are inflexible.
c. mean that money wages never adjust.
d. imply that nominal wages adjust, but only periodically.*

20. According to Keynesian theory, the profit-maximizing firm demands labor up to

the point at which
a. the real wage is equal to the marginal productivity of labor.
b. the money wage paid to labor is just equal to the money value of the marginal product of labor.
c. labor and capital costs are equal.
d. a and/or b are correct.*

21. The Keynesian labor supply function is shown as

a. Ns = g(W/P).
 b. Ns = g(P/W).
c. Ns = t(W/Pe).*
d. Ns = t(Pe/W).

22. According to the Keynesian fixed wage theory, real wages should be
a. positively correlated with income.*
b. not correlated with income.
c. fixed.
d. negatively correlated with income.

23. According to Keynes’ fixed money wage theory, when the price level is higher than expected the real
wage is ____ than expected and unemployment is ______ than expected.
a. lower; lower
b. higher, higher
c. lower; higher*
d. higher; lower

24. An increase in the expected price level will

a. increase labor supply, money wages, decrease the price level and income.
b. decrease labor supply, increase money wages, decrease the price level and income.*
c. decrease labor supply, decrease money wages, and decrease the price level and income.
d. increase labor supply, decrease money wages, decrease the price level, and increase income.

25. According to the contract theory of wages, firms and workers agree on a contract that fixes
a. money wages.*
b. real wages.
c. money wages and employment.
d. real wages and employment.

26. According to the Keynesian fixed wage theory, real wages should be
a. positively correlated with income.
b. not correlated with income.
c. fixed.
d. negatively correlated with income.*

27. An increase in the expected price level lead to

a. higher money wages and lower real wages.
b. higher money wages and real wages.*
c. no change in money wages but lower real wages.
d. lower money wages and higher real wages.

28. Which of the following variables will shift the classical aggregate demand curve?
a. An increase in government spending
b. A decrease in taxes
c. An increase in autonomous investment expenditures
d. An increase in the money stock*
e. All of the above
29. Which of the following statements about the Keynesian model is correct?
a. The economy would achieve full employment if left free from destabilizing government policies.
b. Active monetary is always effective while fiscal policies is rarely so.
c. Both Keynesians and classicists reach the same policy conclusions, but for different reasons.
d. The economy is inherently unstable because of the instability of aggregate demand, which is
primarily due to unstable expectations.*
e. both b and d.

30. The aggregate supply schedule is steeper where the money wage is more variable than where the
money wage is fixed because the rise in the money wage in the
a. fixed-wage case dampens the effect on employment and output from an increase in the price level.
b. variable-wage case dampens the effect on employment and output from an increase in the price
level.*
c. variable-wage case heightens the effect on employment and output from an increase in the price
level.
d. all of the above

31. The classical model differs from the Keynesian model in that
a. monetary policy does not impact output in the Keynesian model.
b. the classical model focuses on the long-run and the Keynesian model focuses on the short-run.*
c. fiscal policy is more powerful in the classical model than in the Keynesian model.
d. the classical model believes monetary policy is a powerful impact on output and fiscal policy is
not.
e. None of the above

32. Which of the following assumptions is crucial to the classical model but not the Keynesian model?
a. The real wage always equals the marginal product of labor.
b. Real wages are perfectly flexible.
c. nominal wages are perfectly flexible.*
d. monetary policy primarily affects aggregate demand.
e. both b and c.

33. The classical labor supply function is shown as

a. Ns = g(P/W).
b. Ns = g(W/P).*
c. Ns = t(W/Pe).
d. Ns = t(Pe/W).

34. Keynes believed that

a. perceived that declines in real wages caused by price-level increases would be resisted by labor,
whereas an equivalent fall in the real wage from a money wage cut would be accepted.
b. perceived that declines in real wages caused by price-level increases would be more readily
accepted by labor than an equivalent fall in the real wage from a money wage cut.*
c. workers preferred employment stability to wage stability.
d. would always be acceptable to labor.
e. both b and c.

35. The position of the Keynesian aggregate demand schedule does not depend on the
a. level of government spending.
 b. level of tax collections.
c. level of autonomous investment expenditures.
d. quantity of money.
e. the price of inputs such as oil.*

36. Which of the following statements is (are) correct? Keynesian economists

a. favor neither active monetary policies nor active fiscal policies to stabilize the economy.
b. favor both active monetary and fiscal policies to manage aggregate demand.*
c. are known as noninterventionists.
d. are perceived as favoring smaller, less active government policy.
e. Either b or d

37. Keynesians view the economy as unstable as a result of the instability of aggregate demand. Which
component of aggregate demand is primarily responsible?
a. Net export
b. expectations
c. Consumption
d. Private investment
e. both b and d.*

38. The United States and other industrialized countries experienced rising inflation accompanied by a
recession during the 1970s. This phenomenon was described as (a)
a. hyperinflation.
b. stagnation.
c. stagflation.*
d. depression.

39. Stagflation can be explained by

a. the IS curve shifting up.
b. the IS curve shifting down.
c. the LM curve shifting to the right.
d. the LM curve shifting to the left.
e. none of the above.*

40. In the Keynesian model, if the actual price level is higher than the expected price level, then
a. output is above potential output.
b. output is always at potential output.
c. output is below potential output.*
d. output is moving towards potential output.

41. In the contract theory of wages, if workers and firms agree to enter into contracts in which their
money wage adjusts automatically to changes in the actual price level, then aggregate supply
a. slopes upward and to the right.
b. shifts upward.
c. is horizontal.
d. is vertical.*
 42. Which of the following statements is correct?
a. The classical aggregate supply schedule is horizontal while the Keynesian aggregate supply
schedule slopes upward to the left.
b. The classical aggregate supply schedule is vertical while the Keynesian aggregate supply
schedule is horizontal.
c. The classical aggregate supply schedule is vertical while the Keynesian aggregate supply schedule
slopes upward to the right.*
d. The classical aggregate supply schedule slopes upward to the right while the Keynesian aggregate
supply schedule is vertical.
e. none of the above are correct.

43.The difference between the Keynesian and classical labor supply functions is that in the Keynesian
sion
a. workers know the real wage while in the classical system workers must form an expectation of the
price level.
b. workers must form an expectation of the price level while the workers know the real wage in the
classical system.*
c. workers are assumed to be interested in the money wage while in the classical version workers
know the real wage.
d. labor supply depends on the actual real wage while labor supply depends on the expected real
wage in the classical system.

44. The classical theory of aggregate supply where markets are perfectly flexible
a. may or may not be compatible with the Keynesian system.
g b. is easily added the IS-LM framework of aggregate demand.
c. is fundamentally incompatible with the Keynesian system.*
d. is consistent with the IS-LM framework if all shocks are to the IS curve.
e. none of the above.

45. The Keynesian model differs from the classical model in that
a. people do not have perfect information about the future in the Keynesian model.*
b. real wages are not flexible in the Keynesian model.
c. monetary policy affects aggregate demand in the Keynesian model.
d. expectations are crucial in the classical model.
e. all of the above.
h
46. In the face of an increase in oil prices, if the government’s primary objective is to keep prices from
falling, then policymakers should
a. reduce taxes.
b. reduce the money supply.*
c. increase government spending.
d. increase aggregate supply through regulation.
i
47. If everyone expects prices to fall but they do not, then
a. nothing happens.
b. the IS curve shifts to the left and the AD curve shifts to the right.
c. both IS and AD shift to the right.*
d. both IS and AD shift to the left.
e. the IS curve shifts to the right, the AD curve shifts to the left.

48. An decrease in the price of oil on the world market would cause aggregate output to
a. rise and the aggregate demand to rise.
b. rise and the aggregate demand to rise.
c. rise and the aggregate supply to rise.*
d. fall and the aggregate supply to fall.

49. If business cycles are caused by changes in aggregate demand, you would expect to see
a. prices and unemployment moving in the same direction.
b. price and unemployment moving in opposite directions.*
c. prices not moving with unemployment.
d. unemployment is not included in the Keynesian model.

50. If business cycles are caused by changes in aggregate supply, you would expect to see
a. prices and unemployment moving in the same direction.*
b. price and unemployment moving in opposite directions.
c. prices not moving with unemployment.
d. unemployment is not included in the Keynesian model.