Economics 12th Edition Arnold Solutions Manual 1

Economics 12th Edition Arnold
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CHAPTER 10
Keynesian Macroeconomics and Economic Instability: A
Critique of the Self-Regulating Economy
Chapter 9 introduced the idea of a self-regulating economy. According to classical economists,

the economy can move back to its long-run equilibrium without direct government intervention in
the market. Some economists take the opposite point of view: the economy is inherently
unstable and not self-regulating. Chapter 10 looks at the Keynesian approach to the economy.
The chapter both critiques the concept of the self-regulating economy and introduces the simple
Keynesian model and the concepts of the consumption function, the marginal propensity to
consume and save, and the multiplier. The simple Keynesian model is analyzed both in terms of
the aggregate demand and aggregate supply framework, and in terms of the total expenditure-
total production (TE-TP) framework to explain how the economy adjusts to disequilibrium and
why the economy may be unable to get out of a recessionary gap by itself.
 KEY IDEAS
1. John Maynard Keynes challenged all four of the beliefs on which the classical position of
the economy was based, concluding that the economy could get stuck in a recessionary
gap.
2. The simple Keynesian model is a prominent macroeconomics model.
3. The simple Keynesian model can be analyzed in terms of the aggregate demand and
aggregate supply framework, and can be used to show why Keynes believed that
government has an economic role to play.
4. The simple Keynesian model can be analyzed in terms of the TE-TP framework, and can
be used to show why Keynes believed that government has an economic role to play.
 CHAPTER OUTLINE
169
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170 Chapter 10
I. QUESTIONING THE CLASSICAL POSITION AND THE SELF-REGULATING

ECONOMY
John Maynard Keynes, the English economist, challenged all four of the beliefs on which
the classical position of the economy was based.
A. Keynes’s Criticism of Say’s Law in a Money Economy
Keynes believed that Say’s law might not hold in a money economy. He believed
that an increase in savings might not be matched by an equal increase in
investment, since both saving and investment depend on a number of factors
that may be far more influential than the interest rate. In other words, according
to Keynes, aggregate demand could fall if saving increases.
Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy 171
B. Keynes on Wage Rates
Keynes believed that wage rates may be inflexible in a downward direction if

employees and labor unions resist wage cuts, and that this inflexibility means
that the economy may not be self-regulating.
C. Different Markets, Different Rates of Adjustment
Not all markets adjust to their equilibrium values at the same speed. In particular,
in the labor market, the wage rate may be inflexible downward (due to long-term
labor contracts or because firms at times find it in their best interest to pay wage
rates above equilibrium levels). If wage rates are inflexible downward, then the
self-regulating properties of an economy (discussed in Chapter 9) are in
question. Specifically, an economy might get stuck in a recessionary gap
D. Keynes on Prices
Keynes believed that anticompetitive or monopolistic elements in the economy

could sometimes prevent prices from falling.
E. Is It a Question of the Time It Takes for Wages and Prices to Adjust?
Many economists today take a position somewhere between Keynes and the
classical economists. For them, the question is not whether wages and prices are
flexible downward, but how long it takes for wages and prices to adjust
downward. The classical position is that the time required before wages and
prices adjust downward is short enough to call the economy self-regulating. The
Keynesian position is that the time is long enough to say that the economy is not
self-regulating.
II. THE SIMPLE KEYNESIAN MODEL
This section identifies and discusses a few of the key components and themes of the
simple Keynesian model.
A. Assumptions
In the simple Keynesian model, the price level is assumed to be constant until
the economy reaches its full-employment level; there is no foreign sector (i.e., the
model is representative of a closed economy); and the monetary side of the
economy is excluded.
B. The Consumption Function
Keynes was particularly concerned with consumption since it is by far the largest
component of total spending. Keynes made three basic points about
consumption: consumption depends on disposable income; consumption and
disposable income move in the same direction; and when disposable income
changes, consumption changes by less. The statement specifying this
172 Chapter 10
relationship is called the consumption function. The consumption function is

written as:
C = C0 + (MPC) (Yd), where
C is total consumption, MPC (the marginal propensity to consume) is a fraction

between 0 and 1, C0 is autonomous consumption (consumption independent of
disposable income), and Yd is disposable income. Consumption can be
increased by increases in autonomous consumption, disposable income, or the
marginal propensity to consume.
C. Consumption and Saving
Since households can only consume and save, saving is the difference between
disposable income and consumption. Disposable income can be used only for
consumption or saving, so any change to disposable income can only change
consumption or saving. It follows that the marginal propensity to consume (MPC)
plus the marginal propensity to save (MPS) must equal 1.
D. The Multiplier
According to Keynes, an increase in autonomous consumption will act as a

catalyst to additional spending, and total spending will rise by more than the
initial increase in autonomous consumption. This is called the multiplier process.
The value of the multiplier determines the total spending change. The multiplier is
equal to 1/(1 – MPC).
Just as consumption has an induced spending component, so do investment and

government purchases. The multiplier process holds for these sectors too. In
general, the change in total spending equals the multiplier times the change in
autonomous spending.
E. The Multiplier and Reality
Two important points to remember are that the multiplier takes many months to
have an effect and that idle resources must be available to be brought into
production in order for increased spending to lead to more output, rather than to
higher prices.
III. THE SIMPLE KEYNESIAN MODEL IN THE AD-AS FRAMEWORK
This section analyzes the simple Keynesian model in terms of the aggregate demand
and aggregate supply framework.
A. Shifts in the Aggregate Demand Curve
Because there is no foreign sector in the simple Keynesian model, total spending
consists of consumption, investment, and government purchases. Because there
is no monetary side of the economy, changes in any of these variables can shift
the AD curve.
An increase in autonomous consumption ( CO will increase consumption (C) and

therefore shift the AD curve to the right by an amount that depends on the
multiplier.
B. The Keynesian Aggregate Supply Curve
Since the price level is assumed to be constant in the simple Keynesian model,
the Keynesian aggregate supply curve must have a horizontal section to it.
The Keynesian aggregate supply curve outlined in this chapter and implicit in the
simple Keynesian model is horizontal until Natural Real GDP, thereafter it
becomes vertical.
C. The Economy in a Recessionary Gap
Keynes believed that the private sector—consisting of the household sector and
the business sector—may not be able to move the economy out of a
recessionary gap.
D. Government’s Role in the Economy
According to Keynes, and for many Keynesians, if the private sector cannot self-
regulate the economy at its Natural Real GDP level, then maybe it is incumbent
for the government to help.
E. The Theme of the Simple Keynesian Model
This section lists the essence of the simple Keynesian model in the AD-AS
framework.
IV. THE SIMPLE KEYNESIAN MODEL IN THE TE-TP FRAMEWORK
This section analyzes the simple Keynesian model in terms of the total expenditure-total
production framework.
A. Deriving a Total Expenditures (TE) Curve
Total expenditures is the sum of consumption, investment, and government

purchases. The total expenditures curve is the sum of the components of TE.
1. Consumption
Consumption rises as Real GDP rises, but by a smaller percentage.

Consumption is drawn as an upward-sloping curve.
2. Investment
To simplify matters, we assume that investment is constant.
3. Government purchases
174 Chapter 10
Again, to simplify matters, we assume that government spending is constant.
B. Where the Consumption curve and the Total Expenditures Curve Cut the
Vertical Axis: More on Exhibit 11
The consumption curve and the total expenditures curve can cut the vertical axis
at a positive dollar amount when either disposable income or Real GDP is zero.
The distance from the origin to the point where the consumption curve cuts the
vertical axis indicates autonomous consumption, and when the TE curve cuts the
vertical axis, it equals autonomous consumption, plus investment, plus
government purchases.
C. What Will Shift the TE Curve?
The TE curve will shift upward if C, I, or G rises. The TE curve will shift
downward if C, I, or G falls.
D. Comparing Total Expenditures (TE) and Total Production (TP)
Total expenditures and total production can differ from one another if businesses
produce an amount of goods that differs from the amount that the three sectors
of the economy (household, business, and government) buy. The dollar value of
total production can be less than, greater than, or equal to the dollar value of total
expenditures.
E. Moving From Disequilibrium to Equilibrium
We do not know how much inventory business firms hold, but we do know that
there is some optimum inventory. This concept leads to two cases that illustrate
how business inventory levels play an important role in the economy’s
adjustment from disequilibrium to equilibrium in the TE-TP framework.
Case 1: TE < TP
If TE < TP, producers produce more than individuals buy and inventory levels
rise unexpectedly. This signals firms that they have overproduced. Consequently,
they cut back on production until TP equals TE.
Case 2: TE > TP
If TE > TP, individuals buy more than producers produce (making up the
difference out of inventory). This signals firms that they have underproduced.
Consequently, they increase production until TP equals TE.
1. The Graphical Representation of the Three States of the Economy in

the TE-TP Framework
The three states of the economy are presented in Exhibit 12. The (TP = Real
GDP) curve is represented by a 45-degree line. Q1 is representative of the case
where TE < TP, and Q2 is representative of the case where TE > TP. In the first
case (Q1), overproduction has occurred and inventories have built up, so firms
cut back on production. Real GDP falls to its equilibrium at QE. In the second
case (Q2), inventories fall below optimal levels and firms increase production.
Real GDP rises to its equilibrium at QE.
F. The Economy in a Recessionary Gap and the Role of Government
According to Keynes, the economy can be in equilibrium and in a recessionary

gap too, as shown in Exhibit 13. Keynes believed that government may be
necessary to get the economy out of a recessionary gap, by raising its purchases
for example.
G. Equilibrium in the Economy
As discussed in the previous chapter, some economists believe that the

economy is self-regulating and that an economy naturally ends up in the long run
producing Natural Real GDP. This chapter talks about economists who believe
that the economy can be inherently unstable and that it can naturally end up
producing a level of Real GDP less than Natural Real GDP.
H. The Theme of the Simple Keynesian Model
This section lists the essence of the simple Keynesian model in the TE-TP
framework.
 TEACHING ADVICE
1. Chapter 10 is written in such a way that the simple Keynesian model can be taught using
either the AD-AS framework or the TE-TP framework, or both.
2. Ask students to discuss the dynamics of the following situations: (a) they are offered a
raise; (b) they are asked to accept a pay cut. Use this to fuel a discussion about when
government intervention in the economy is most likely to be needed.
3. When discussing speed of adjustment, have students give examples of ways that prices
adjust more quickly than they used to (e.g., bar codes, consumer access to pricing
information via the Internet), and discuss the implications for the need for government
intervention in the economy.
4. One part of The American Recovery and Reinvestment Act of 2009 provided $300
million for rebates toward the purchase of energy efficient appliances, also known as
“Cash for Appliances.” Discuss how this rebate money could be expected to affect
disposable income and consumption, ceteris paribus.
5. Your students may enjoy reading Robert J. Barro and Charles J. Redlick, “Stimulus
Spending Doesn't Work,” The Wall Street Journal, October 1, 2009 for their description
of their research on the size of the Keynesian spending multiplier. They conclude that
176 Chapter 10
“the available empirical evidence does not support the idea that spending multipliers
typically exceed one, and thus spending stimulus programs will likely raise GDP by less
than the increase in government spending.” You can also access the original working
paper at http://www.nber.org/papers/w15369.
 ASSIGNMENTS FOR MASTERING KEY IDEAS

Assignment 10.1
Key Idea: John Maynard Keynes challenged all four of the beliefs on which the classical position
of the economy was based and concluded that the economy could get stuck in a recessionary
gap.
1. Explain why Keynes believed that Say’s law might not hold in a money economy.
2. Explain why Keynes believed that wage rates might be inflexible.
3. Describe the New Keynesian economists’ arguments as to why wage rates might be
inflexible.
4. Explain how inflexible wages can keep the economy from recovering from a
recessionary gap.
5. Describe why Keynes believed that the price level might not fall.
6. State the position taken by many economists today concerning wage and price flexibility.
Assignment 10.2
Key Idea: The simple Keynesian model is a prominent macroeconomics model.
1. List the basic assumptions of the simple Keynesian model.
2. State why Keynes was so concerned about consumption and define these terms:
a. Autonomous consumption
b. MPC
c. The consumption function
3. List the three ways in which consumption can change.
4. Describe the link between consumption and saving in the simple Keynesian model.
5. Describe the multiplier process.
6. State the formula for calculating the size of a multiplier effect.
7. Describe the shortcomings of the multiplier.
Assignment 10.3
Key Idea: The simple Keynesian model can be analyzed in terms of the aggregate demand and
aggregate supply framework, and can be used to show why Keynes believed that government
has an economic role to play.
1. List the variables that shift the AD curve in the simple Keynesian model.
2. Describe the Keynesian AS curve.
3. Use the AD-AS framework to depict an economy in equilibrium with a recessionary gap.
4. Tell why Keynes believed that the government may have a management role to play in
the economy.
Assignment 10.4
Key Idea: The simple Keynesian model can be analyzed in terms of the TE-TP framework.
1. List the different names for the TE-TP framework.
2. Explain how a total expenditures curve is derived, and what causes it to shift.
3. Describe the three possible states of the economy in the TE-TP framework.
4. Describe the role of business inventories in moving the economy from disequilibrium to
equilibrium in the TE-TP framework.
5. Use the TE-TP framework to graphically illustrate an economy in a recessionary gap.
 ANSWERS TO ASSIGNMENTS FOR MASTERING KEY IDEAS

Assignment 10.1 Answers
1. Keynes believed that Say’s law might not hold in a money economy because an
increase in savings might not be matched by an equal increase in investment, since both
saving and investment depend on a number of factors that may be far more influential
than the interest rate.
2. Keynes believed that employees and labor unions would resist wage cuts.
3. New Keynesians argue that employees and employers might resist wage cuts since
long-term contracts offer advantages for both employers and workers and employers
sometimes find it in their best interest to pay above-market-clearing wages.
4. If resistance from employees, labor unions, and firms prevent wage rates from falling,
then the SRAS curve will not shift to the right, the price level will not come down, and
buyers will not purchase more goods and services and remove the economy from a
recessionary gap.
5. Keynes believed that anticompetitive or monopolistic elements in the economy could
sometimes prevent prices from falling.
6. Many economists today believe that the appropriate question is not whether wages and
prices will fall but rather how long the wage rate and price level will take to fall.

1. In the simple Keynesian model, the price level is assumed to be constant until the
economy reaches Natural Real GDP, there is no foreign sector, and the monetary side
of the economy is excluded.
2. Keynes was concerned with consumption because it is by far the largest part of total
spending.
a. Autonomous consumption is the part of consumption that is independent of
disposable income.
b. The MPC measures the change in consumption as disposable income changes.
c. The consumption function, C, equals C0 + (MPC)(Yd)
3. According to Keynes, consumption will change in response to changes in autonomous
consumption, disposable income, or the marginal propensity to consume.
4. Since disposable income can only be used for consumption or saving, an increase in
saving will necessarily lead to a decrease in consumption, ceteris paribus.
5. The multiplier process is the process whereby an increase in autonomous consumption
will act as a catalyst to additional spending so that the overall change in total spending
will be greater than the initial change in autonomous consumption.
6. The multiplier is equal to 1/(1 – MPC).
7. The multiplier process may take many months to occur, and will not occur if there are no
idle resources in the economy.

1. Consumption, investment, and government purchases are the variables that shift the AD
curve in the simple Keynesian model.
2. The Keynesian AS curve is horizontal until Natural Real GDP, where it becomes vertical.
178 Chapter 10
3. This economy is in equilibrium at Q*, where AD = AS. However, a recessionary gap

exists since full employment occurs at a larger level of real GDP, QN.
4. Keynes believed that it is possible for the economy to be in equilibrium and in a

recessionary gap, too, and that government intervention may be necessary since the
private sector may not be able to increase C or I by enough to get to an equilibrium at
full employment.

1. The total expenditure-total production (TE=TP) framework is also known as the
Keynesian cross and income-expenditure framework.
2. A TE curve is the vertical summation of the consumption, investment, and government
purchases curves. It will shift if any of these factors rise or fall.
3. The total expenditures of the three sectors of the economy can be less than, greater
than, or equal to the dollar value of total production.
4. There is some optimum inventory level for businesses. If TE < TP, inventory levels rise
unexpectedly, sending firms the signal to cut production until TP equals TE. If TE > TP,
the opposite occurs.
5.
This economy is in equilibrium at Q*, where TE = TP. Unfortunately, a recessionary gap

exists since full employment occurs at a larger level of real GDP, QN.
 ANSWERS TO VIDEO QUESTIONS AND PROBLEMS

1. According to Keynesian economists, what is the explanation of why an economy
may not be able to remove itself from a recessionary gap?
When an economy is in a recessionary gap, there is a surplus in the labor market. If wages are
flexible, they will fall and the SRAS curve will shift rightward removing the recessionary gap.
However, Keynesian economists believe that wages are sticky downward. The SRAS curve
may not shift to the right and hence the economy may not be able to remove itself from a
recessionary gap.
2. Outline the differences between Keynes and the classical economists when it
comes to (a) Say’s Law in a money economy and (b) investment.
(a) Classical economists believed that Say’s Law is true for a money economy, which means
that supply creates its own demand. In other words, if the supply of a good generates an income
of $100, this amount will be split between consumption (say $80) and savings (say $20). The
$20 that has been saved will result in an equivalent amount of investment. Therefore, the total
amount of consumption demand and investment demand would equal $100.
However, Keynes did not believe that savings will result in an equivalent amount of investment.
Therefore, in the above example, out of the $20 that has been saved, investment may equal
only $15. The total amount of consumption demand and investment demand would equal $95
and not $100.
(b) Classical economists believed that investment depends on savings and the rate of interest.
As savings rise, the rate of interest will fall and investment will increase. However, Keynes did
not believe that investment is as responsive to interest rates as classical economists assumed it
to be.
180 Chapter 10
3. The shape of the aggregate supply curve matters to changes in the price level and
Real GDP, given a change in aggregate demand. Do you agree or disagree with
this statement? Explain your answer.
Agree. The aggregate supply curve can have two shapes:

(a) it may be upward sloping.
(b) it may be kinked, that is, horizontal up to the point of Natural Real GDP and vertical at
Natural Real GDP.
If the aggregate supply curve is upward sloping, then a rightward shift of the aggregate demand
curve will result in an increase in both the price level and the Real GDP of the economy.
If the aggregate supply curve is horizontal, then a rightward shift of the demand curve will only
increase Real GDP up to the point of Natural Real GDP. At the level of Natural Real GDP, a
rightward shift in the aggregate demand curve leaves Real GDP unchanged and increases the
price level.
4. Diagrammatically represent and explain the equilibrating process in the simple

Keynesian model in the TE-TP framework.
In the above graph, the 450 line represents the equality between total expenditure, total
production and Real GDP. The TE line shows the sum of the expenditures of consumption,
investment, and government purchases. The economy will be in equilibrium at point e, where
Real GDP is QN. If the economy is at point 1 where the level of output is Q2, TE>TP and
inventories will decline, prompting firms to produce more, until there is equilibrium at point e.
Similarly, if the economy is operating at point 2, at an output level of Q1, TE<TP. Since
expenditure is lower than production, inventories will increase. Firms will reduce production.
Output falls to QN and the economy reaches equilibrium at point e.
5. In the simple Keynesian model, an economy can be in equilibrium and in a

recessionary gap too. Do you agree or disagree? Explain and diagrammatically
represent your answer in terms of the AD-AS framework.
P AS
AD1
P1 Kink
0 Real GDP (Q)

Q1 QN
As shown in the figure, the economy is in equilibrium at Q1 output where the AD curve intersects
the horizontal section of the AS curve. However, the Natural Real GDP level is at QN where the
AS curve is kinked and becomes vertical. Thus, the economy is in equilibrium and also in a
recessionary gap.
 ANSWERS TO CHAPTER QUESTIONS AND PROBLEMS

1. How is Keynes’s position different from the classical position with respect to
wages, prices, and Say’s law?
182 Chapter 10
According to Keynes, wages and prices might not be as flexible as classical economists had
assumed, so Say’s law might not hold. It could take years for the economy to adjust to a new
equilibrium, leaving the economy in a recessionary gap for years before the self-regulating
economy moved back to its long-run equilibrium.
2. Classical economists assumed that wage rates, prices, and interest rates were
flexible and would adjust quickly. Consider an extreme case: Suppose classical
economists believed wage rates, prices, and interest rates would adjust
instantaneously. What would this imply the classical aggregate supply (AS) curve
would look like? Explain your answer.
Under this assumption, the classical aggregate supply curve would be a vertical line.
Instantaneous adjustment would mean that there would never be any deviations from the
natural unemployment rate or the Natural Real GDP level. Supply and demand in individual
markets would quickly respond to any shifts in supply and demand, eliminating recessionary
gaps and inflationary gaps very quickly.
3. Give two reasons explaining the possibility that wage rates may not fall.
Keynes believed that employees and labor unions may resist wage cuts. New Keynesians
believe that long-term contracts and efficiency reasons for firms paying higher-than-market
wages might explain wage rate inflexibility.
4. How was Keynes’s position different from the classical position with respect to
saving and investment?
Keynes believed that an increase in savings might not be matched by an equal increase in
investment, since both saving and investment depend on a number of factors that may be far
more influential than the interest rate. The classical position was that interest rate changes
would equate saving with investment.
5. According to some economists, why might business firms pay wage rates above
market-clearing levels?
The efficiency wage theory says that firms may perceive benefits from paying higher-than-
market wages, such as fewer labor negotiations and a decreased likelihood of worker strikes.
6. Given the Keynesian consumption function, how would a cut in income tax rates
affect consumption? Explain your answer.
A cut in income tax rates would increase disposable income (Yd), and with it, consumption (C),
in proportion to the MPC.
7. Look at the Keynesian consumption function: C = C0 + (MPC × Yd). What part of it

relates to autonomous consumption? What part of it relates to induced
consumption? Define autonomous consumption and induced consumption.
C0 relates to autonomous consumption. (MPC)(Yd) relates to induced consumption. Induced

consumption is the part of consumption that is dependent on disposable income, while
autonomous consumption is the part of consumption that is independent of disposable income.
8. Using the Keynesian consumption function, prove numerically that, as the MPC
rises, saving declines.
Since households can only consume or save, it follows that saving is the difference between
disposable income and consumption:
S = Yd – [C0 + (MPC)(Yd)]
So choosing any two values for Yd and C0, such as $10,000 and $1,000, when the MPC rises,
say from 0.7 to 0.8, savings falls (in this case from $2,000 to $1,000).
9. Explain the multiplier process.
The process under which an increase in an individual’s autonomous spending generates

additional income for another individual, which, in turn, increases the second individual’s
autonomous spending, and so on, is the multiplier process. By this process, a change in
autonomous spending generates a change in Real GDP greater than itself.
10. What is the relationship between the MPC and the multiplier?
The multiplier is equal to 1/(1 – MPC), which indicates that an increase in the MPC will increase
the strength of the multiplier.
11. Explain how a rise in autonomous spending can increase total spending by some
multiple.
An increase in autonomous consumption (C0) will increase consumption (C) and therefore shift
the AD curve to the right by an amount that depends on the multiplier.
12. In which factors will a change lead to a change in consumption?
Consumption will increase in response to an increase in autonomous consumption (C0),

disposable income (Yd), or the marginal propensity to consume (MPC).
13. According to Keynes, can an increase in saving shift the AD curve to the left?
Explain your answer.
According to Keynes, an increase in saving would result in lower consumption, which would shift
the AD curve to the left. Although the additional saving would lower interest rates, Keynes
believed that this would not automatically generate an increase in investment sufficient to offset
the reduction in consumption.
14. What factors will shift the AD curve in the simple Keynesian model?
Consumption, investment, and government purchases are the factors that will shift the AD curve
in the simple Keynesian model.
15. According to Keynes, an increase in saving and decrease in consumption may

lower total spending in the economy. But how could this happen if the increased
saving lowers interest rates (as shown in the last chapter)? Wouldn’t a decrease
184 Chapter 10
in interest rates increase investment spending, thus counteracting the decrease in

consumption spending?
In the Keynesian view, other variables, such as the expected rate of profit on investment, are
more important than the interest rate in determining the level of investment. Business
expectations can lower the investment demand at the same time that lower interest rates are
increasing the quantity demanded, offsetting each other and keeping investment low.
16. Can a person believe that wages are inflexible downward for, say, one year and
also believe in a self-regulating economy? Explain your answer.
Yes, since the concept of self-regulation does not require instantaneous adjustment. To some, a
one-year lag in the adjustment process would be short enough to permit them to believe in self-
regulation and laissez-faire policy.
17. According to Keynes, can the private sector always remove the economy from a
recessionary gap? Explain your answer.
According to Keynes, the economy can get stuck in a recessionary gap, if neither consumption
nor investment rise enough to shift the aggregate demand curve to a long-run equilibrium at
Natural Real GDP.
18. What does the aggregate supply curve look like in the simple Keynesian model?
The AS curve in the simple Keynesian model is horizontal until Natural Real GDP and vertical at
Natural Real GDP.
19. “In the simple Keynesian model, increases in AD that occur below Natural Real
GDP will have no effect on the price level.” Do you agree or disagree with this
statement? Explain your answer.
Agree. This is the case because the Keynesian model assumes the price level is constant until
the economy reaches its full-employment or Natural Real GDP level.
20. Suppose consumption rises while investment and government purchases remain
constant. How will the AD curve shift in the simple Keynesian model? Under what
condition will the rise in Real GDP be equal to the rise in total spending?
An initial increase in autonomous consumption leads to a much larger rightward shift of the AD
curve, once the multiplier effect is factored in. If the economy is operating with idle resources,
then the rise in Real GDP will equal the rise in total spending.
21. Explain how to derive a total expenditures (TE) curve.
This is illustrated in Exhibit 11. The total expenditures curve is the vertical summation of the
consumption, investment, and government purchases curves.
22. What role do inventories play in the equilibrating process in the simple Keynesian
model (as described in the TE-TP framework)?
Unexpected changes in inventories lead firms to change their production levels until TP equals
TE.
23. Identify the three states of the economy in terms of TE and TP.
The three states of the economy in terms of TE and TP include the case where TE < TP and
unexpected business inventory accumulation signals firms to decrease production, the case
where TE > TP and unexpected business inventory depletion signals firms to increase
production, and the case where TE = TP, where the economy is in equilibrium.
24. If Real GDP is $10.4 trillion in Exhibit 12, what is the state of business inventories?
If Real GDP is $10.4 trillion in Exhibit 12, then TE>TP and business draw out of their inventories
to meet the excess demand.
25. How will a rise in government purchases change the TE curve in Exhibit 12?
A rise in government purchases will shift the TE curve upward.
 ANSWERS TO PROBLEMS IN THE WORKING WITH NUMBERS AND

GRAPHS SECTION
Questions 1-2 are based on the second section of the chapter, questions 3-4 are based
on the third section, and questions 5-8 are based on the fourth section.
1. Compute the multiplier in each of the following cases: (a) MPC = 0.60; (b) MPC =
0.80; (c) MPC = 0.50.
(a) MPC = 1/(1 – 0.60) = 2.5

(b) MPC = 1/(1 – 0.80) = 5
(c) MPC = 1/(1 – 0.50) = 2
2. Write an investment function (equation) that specifies two components: (a)

Autonomous investment spending (b) Induced investment spending
The investment function can be written as I = I0 + i × (Yd), where I0 is the level of autonomous
investment, i is the slope of the investment function and Yd is disposable income.
3. Economist Smith believes that changes in aggregate demand affect only the price
level and economist Jones believes that changes in aggregate demand affect only
Real GDP. What do the AD and AS curves look like for each economist?
For Smith: AD is downward sloping; AS is vertical.

For Jones: AD is downward sloping; AS is horizontal.
4. Use the accompanying figure to explain the following two statements:
186 Chapter 10
(a) According to Keynes, aggregate demand may be insufficient to bring about

the full-employment output level (or Natural Real GDP).
(b) A decrease in consumption (due to increased saving) is not matched by an
increase in investment spending.
The economy is at equilibrium at point 2 in the figure. This point, however, is below the level of
Natural Real GDP. To reach Natural Real GDP, aggregate demand would have to shift to the
right (increase) to AD1 from AD2.
Suppose the economy was in equilibrium at point 1 where short-run AS equals AD1. When
consumption falls, investment does not rise to compensate, so the AD curve will shift left to AD2,
resulting in lower equilibrium GDP.
5. The TE curve in Exhibit 11(d) is upward-sloping because the consumption

function is upward-sloping. Explain.
Consumption, investment, and government are summed to create the TE curve. We add
together the levels of the three variables at each level of Real GDP and create the TE curve. If
consumption (or any of the other factors as well) has an upward slope to its individual
expenditure pattern, then that upward slope will be mirrored in the TE curve.
6. In Exhibit 11(d), what does the vertical distance between the origin and the point
at which the TE curve cuts the vertical axis represent?
The vertical distance between the origin and the point where the TE curve cuts the vertical axis
represents the sum of autonomous consumption, investment and government purchases.
7. In the accompanying figure, explain what happens if: a. The economy is at Q1

b. The economy is at Q2.
In the above figure, at Q1, total expenditure exceeds total production in the economy. There is
an unexpected decline in inventories and businesses will expand production, moving the
economy up to Q3.
At Q2, total expenditure is less than total production in the economy. There is an unexpected
rise in inventories and businesses will cut production, moving the economy
8. In the accompanying figure, if Natural Real GDP is Q2, in what state is the
economy at point A?
In the above figure, if Natural Real GDP is Q2, then the economy is in a recessionary gap at
point A, where TE = TP. Total expenditures are not high enough to maintain an equilibrium at
point B. The equilibrium level of output in this economy is Q3, which is less than Natural Real
GDP.

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Chapter 9 introduced the idea of a self-regulating economy. According to classical economists,

I. QUESTIONING THE CLASSICAL POSITION AND THE SELF-REGULATING

A. Keynes’s Criticism of Say’s Law in a Money Economy

B. Keynes on Wage Rates

Keynes believed that wage rates may be inflexible in a downward direction if

C. Different Markets, Different Rates of Adjustment

Keynes believed that anticompetitive or monopolistic elements in the economy

E. Is It a Question of the Time It Takes for Wages and Prices to Adjust?

II. THE SIMPLE KEYNESIAN MODEL

B. The Consumption Function

relationship is called the consumption function. The consumption function is

C = C0 + (MPC) (Yd), where

C is total consumption, MPC (the marginal propensity to consume) is a fraction

C. Consumption and Saving

According to Keynes, an increase in autonomous consumption will act as a

Just as consumption has an induced spending component, so do investment and

E. The Multiplier and Reality

III. THE SIMPLE KEYNESIAN MODEL IN THE AD-AS FRAMEWORK

A. Shifts in the Aggregate Demand Curve

An increase in autonomous consumption ( CO will increase consumption (C) and

B. The Keynesian Aggregate Supply Curve

C. The Economy in a Recessionary Gap

D. Government’s Role in the Economy

E. The Theme of the Simple Keynesian Model

IV. THE SIMPLE KEYNESIAN MODEL IN THE TE-TP FRAMEWORK

A. Deriving a Total Expenditures (TE) Curve

Total expenditures is the sum of consumption, investment, and government

Consumption rises as Real GDP rises, but by a smaller percentage.

To simplify matters, we assume that investment is constant.

Again, to simplify matters, we assume that government spending is constant.

C. What Will Shift the TE Curve?

D. Comparing Total Expenditures (TE) and Total Production (TP)

E. Moving From Disequilibrium to Equilibrium

1. The Graphical Representation of the Three States of the Economy in

F. The Economy in a Recessionary Gap and the Role of Government

According to Keynes, the economy can be in equilibrium and in a recessionary

G. Equilibrium in the Economy

As discussed in the previous chapter, some economists believe that the

H. The Theme of the Simple Keynesian Model

 ASSIGNMENTS FOR MASTERING KEY IDEAS

 ANSWERS TO ASSIGNMENTS FOR MASTERING KEY IDEAS

Assignment 10.2 Answers

Assignment 10.3 Answers

3. This economy is in equilibrium at Q*, where AD = AS. However, a recessionary gap

4. Keynes believed that it is possible for the economy to be in equilibrium and in a

Assignment 10.4 Answers

This economy is in equilibrium at Q*, where TE = TP. Unfortunately, a recessionary gap

 ANSWERS TO VIDEO QUESTIONS AND PROBLEMS

Agree. The aggregate supply curve can have two shapes:

4. Diagrammatically represent and explain the equilibrating process in the simple

5. In the simple Keynesian model, an economy can be in equilibrium and in a

0 Real GDP (Q)

 ANSWERS TO CHAPTER QUESTIONS AND PROBLEMS

7. Look at the Keynesian consumption function: C = C0 + (MPC × Yd). What part of it

C0 relates to autonomous consumption. (MPC)(Yd) relates to induced consumption. Induced

9. Explain the multiplier process.

The process under which an increase in an individual’s autonomous spending generates

12. In which factors will a change lead to a change in consumption?

Consumption will increase in response to an increase in autonomous consumption (C0),

15. According to Keynes, an increase in saving and decrease in consumption may

in interest rates increase investment spending, thus counteracting the decrease in