AP Macroeconomics Page 1 of 4

Unit Review: Keynesian Economics and Fiscal Policy

Unit Review Checklist

You probably have study strategies you use before taking exams. Use this checklist to
supplement those strategies and guide you as you study. See if you can answer the
questions or perform the tasks listed below. If you can, check them off and keep moving! If
not, you may want to look into them further before taking the Unit Quiz.

Questions/Tasks Yes!
Can you explain the building blocks of the Keynesian model, including the
consumption function, the different components of aggregate expenditures,
and the concept of equilibrium in the Keynesian model?
Can you define the marginal propensity to consume, and explain its effects on
the Keynesian model?
Can you graph the Keynesian model?
Can you show how changes in the economy are reflected on a graph?
Can you make predictions about the economy based on the Keynesian model?
Can you show the same information about an economy in both the AD/AS
framework and the Keynesian framework?
Can you compare and contrast the AD/AS model and the Keynesian model?
Can you explain fiscal policy and show the effects graphically?
Can you categorize the situations in which you expect fiscal policy to be
effective and in which you expect it to be ineffective?
Can you describe the basic structure of government spending and taxation?
Have you printed and reviewed the Key Terms lists?
Have completed all activities in this unit?
Have you reviewed the Focus Sheets for this unit?
Have you reviewed the important concepts on the following pages of this Unit
Review?

What aspects economics do you better understand now that you've completed this
Unit?

What aspects of economics do you still find difficult and need to look into further
before taking the Unit Quiz?

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AP Macroeconomics Page 2 of 4
Unit Review: Keynesian Economics and Fiscal Policy

The Keynesian Model

Important Concepts

• Consumption
Consumption expenditure can be described by the following equation: consumption
equals autonomous consumption plus the share of additional disposable income spent on
consumption. The autonomous component is spending that occurs regardless of income.
The second term depends on the size of disposable, or after-tax, income.

• MPC
The marginal propensity to consume is the share of an additional dollar of disposable
income spent on consumption. The average propensity to consume is the average
amount of a dollar of disposable income spent on consumption. The marginal propensity
to save is the share of an additional dollar of disposable income saved. Since disposable
income is either saved or spent, MPC + MPS = 1.

• Changes in Consumption
The consumption function changes due to changes in expectations, wealth, interest
rates, stock of durable goods, and inflation.

• Investment
Investment is purchases of capital goods. Higher interest rates result in lower
investment, and lower interest rates in higher investment. The investment function will
change if there's a change in expectations, technology, capacity utilization, or taxes.

• Keynesian Equilibrium
In equilibrium, aggregate expenditures equal GDP. On a graph, this is the point where
the AE line intersects a 45-degree line drawn from the origin.

• Changes in Equilibrium
Changes in equilibrium are subject to the multiplier effect. A change in autonomous
expenditures results in a change in equilibrium GDP greater than the change in
spending. A change in taxes results in a change in equilibrium GDP that's greater than
the change in taxes.

If autonomous spending increases, equilibrium GDP increases. If autonomous spending

decreases, equilibrium GDP decreases.

If taxes increase, equilibrium GDP decreases, and if taxes decrease, equilibrium GDP
increases.

Keynes in AD/AS

Important Concepts

• Sticky Prices
The Keynesian model relies on sticky prices and wages. Keynes believed that prices and
wages aren't completely flexible, so he determined that prices and wages are not a big
determinant in a model of the economy.

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AP Macroeconomics Page 3 of 4
Unit Review: Keynesian Economics and Fiscal Policy

The AD/AS curve also allows for some price and wage stickiness, but doesn't discount
the importance of prices in influencing the equilibrium level of production.

• AS Curve
The horizontal segment of the AS curve is very similar to the Keynesian model. In this
range of output, producers will increase their production without requiring increases in
the price level. This matches the Keynesian idea that the level of production is
determined by how much people want to buy, and production automatically meets that
level of output.

• AD Curve
The AD curve, from the AD/AS model, and AE curve, from the Keynesian model, both
represent the sum of consumption, investment, government expenditure, and net
exports. The AD curve relates the level of expenditure with the price level. The AE curve
assumes the price level is fixed.

• Economic Change
Changes in economic equilibrium are subject to the multiplier effect. It makes no
difference if the economy is near full employment or not.

Fiscal Policy

Important Concepts

• Keynesian Analysis
Keynesian analysis uses the spending and tax multipliers to evaluate the effects of
fiscal policy.

Expansionary fiscal policy creates increases in GDP using increases in government

expenditure and/or decreases in taxes.

Contractionary fiscal policy creates decreases in GDP using decreases in government

expenditure and/or increases in taxes.

• AD/AS Analysis
The AD/AS analysis of fiscal policy demonstrates the potential drawback of fiscal policy –
inflation.

• Fiscal Policy Today

Fiscal policy is rarely used today. Inflation fears, distrust of the government, huge
national debt, and a slow reaction time all contribute to the decrease in the use of fiscal
policies. Also, indications that temporary changes have little effect on the economy, and
the effectiveness of monetary policy, have further contributed to the declines in fiscal
policy.

• Tax and Spend

The government collects money through taxes and borrowing and uses that money to
fund its spending.

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AP Macroeconomics Page 4 of 4
Unit Review: Keynesian Economics and Fiscal Policy

• Debt and Deficit

The federal debt is the total amount of money the government owes.

The federal deficit is the amount by which spending exceeds tax revenues in any one
year. The government may run a surplus instead, if its tax revenues exceed its
spending. And if tax revenues equal spending, the budget is balanced.

• Crowding Out
When the government borrows money to finance it's spending, it's decreasing the
amount of borrowing done by private businesses. The government crowds out private
investment. And, less investment may mean less long-term economic growth.

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