Keynesian Economics Concepts Quiz

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Questions and Answers

What is primarily responsible for low income and high unemployment during economic downturns according to the Keynesian model?

Low Aggregate Demand (AD) (correct)

High Aggregate Supply (AS)

Increased government spending

High interest rates

In the context of the Keynesian model, which statement is true regarding prices?

Prices are determined by market forces.

Prices fluctuate significantly over time.

Prices are assumed to be variable.

Prices are constant or exogenous. (correct)

What does the Keynesian Cross illustrate in a closed economy?

The determination of income by expenditure. (correct)

The impact of fiscal policy on interest rates.

The influences of external shocks on GDP.

The relationship between imports and exports.

Which of the following is NOT a characteristic of the Keynesian model?

It assumes an open economy. Signup and view all the answers

Which curve relates to the liquidity preference theory within the Keynesian model?

LM curve Signup and view all the answers

What happens to consumption (C) when there is an increase in taxes?

Consumption decreases Signup and view all the answers

What effect does a tax increase have on the economy's income (Y)?

Income falls toward a new equilibrium Signup and view all the answers

Why is the tax multiplier typically greater than one in absolute value?

A change in taxes amplifies its impact on income Signup and view all the answers

How do consumers typically respond to a tax cut regarding their savings?

They save a fraction of the cut Signup and view all the answers

What is the impact of a balanced budget multiplier on output compared to an unbalanced situation?

It raises output but less than an unbalanced budget Signup and view all the answers

If consumption is represented by the formula $C = MPC(Y - T)$, what does MPC indicate?

Marginal Propensity to Consume Signup and view all the answers

What does the equation $\Delta C = MPC(\Delta Y - \Delta T)$ represent?

The change in consumption concerning changes in income and taxes Signup and view all the answers

What results from an unplanned inventory buildup in an economy?

Firms reduce output, leading to decreased income Signup and view all the answers

What does the IS curve represent?

Combinations of interest rates and income levels where the goods market is in equilibrium Signup and view all the answers

What happens to investment spending when the interest rate falls?

Investment spending increases as the cost of borrowing decreases Signup and view all the answers

In the equation Y = C(Y - T) + I(r) + G, what does 'T' represent?

Tax revenue that households pay Signup and view all the answers

On the IS curve, what causes a shift in the AD curve?

An upward shift due to higher investment spending with lower interest rates Signup and view all the answers

Which point on the IS curve represents equilibrium in the goods market?

Where expenditure equals planned expenditure Signup and view all the answers

How is the initial point on the IS curve derived?

Through plotting combinations of interest rates and resultant income levels Signup and view all the answers

What is indicated by a lower interest rate on the IS curve?

Higher investment leads to an upward shift in the AD curve Signup and view all the answers

What is the relationship between the interest rate and the level of income at a given point on the IS curve?

There is an inverse relationship where higher rates reduce income levels Signup and view all the answers

What impact does an increase in government spending (G) have on the IS curve?

It shifts the IS curve to the right. Signup and view all the answers

How does an increase in taxes (T) affect the IS curve according to the Keynesian model?

It shifts the IS curve to the left. Signup and view all the answers

What does the horizontal distance of the IS curve shift represent?

The change in equilibrium output (Y). Signup and view all the answers

What are the three functions of money as outlined in the content?

Store of value, unit of account, and medium of exchange. Signup and view all the answers

What theory links the inflation rate to the growth rate of the money supply?

Quantity theory of money. Signup and view all the answers

What is the purpose of velocity in the context of the Quantity Theory of Money?

To measure the speed at which money is exchanged. Signup and view all the answers

What results from an increase in aggregate demand due to fiscal policy?

An increase in equilibrium output. Signup and view all the answers

What happens to the IS curve when aggregate consumption increases?

It shifts to the right. Signup and view all the answers

What happens when income (Y) increases, according to the LM curve dynamics?

Interest rate (r) must rise to restore equilibrium. Signup and view all the answers

Which equation represents the LM curve derived from the money market equilibrium?

$r = 1/h(kY - m/p)$ Signup and view all the answers

What does the LM curve illustrate about the relationship between interest rate (r) and income (Y)?

It illustrates a positive relationship between r and Y. Signup and view all the answers

What would cause a shift in the LM curve?

An increase in real money supply (m/p). Signup and view all the answers

Why is there excess demand in the money market when income increases?

Money demand increases and supply remains fixed. Signup and view all the answers

What does the term 'real balances' refer to in the context of the LM curve?

The quantity of money adjusted for the price level. Signup and view all the answers

What does it imply if the LM curve is upward sloping?

Higher income leads to a higher interest rate. Signup and view all the answers

What is the role of the interest rate (r) in achieving equilibrium in the money market?

It rises to balance excess demand. Signup and view all the answers

What does the equation MV = PY represent in economics?

The relationship between money supply and total output Signup and view all the answers

Which instrument is NOT used by the Central Bank to control money supply?

Taxation policy Signup and view all the answers

In the Theory of Liquidity Preference, which factor primarily determines the interest rate?

Money supply and money demand Signup and view all the answers

What do the parameters k and h in the demand for real balances L = kY – hr represent?

The level of income and interest rate sensitivity Signup and view all the answers

How is the real money balance defined?

M / P Signup and view all the answers

What occurs when the Central Bank uses Open Market Operations?

Sells or buys bonds and securities Signup and view all the answers

What happens to money demand when the interest rate increases?

Money demand decreases Signup and view all the answers

In the context of the money supply, what does the velocity measure?

The rate at which money circulates Signup and view all the answers

If the price level is assumed constant, what happens to the real money supply when nominal money supply increases?

It increases Signup and view all the answers

What does the equation L = kY – hr suggest about real money demand?

It is influenced by income and interest rates Signup and view all the answers

Study Notes

Aggregate Demand and Aggregate Supply Analysis in a Closed Economy

This chapter examines how aggregate demand and supply interact in a closed economy.
The Keynesian Cross, fiscal policy multipliers, the IS curve, the loanable funds model, the LM curve, and the theory of liquidity preference are key concepts.
The IS-LM model determines income and the interest rate in the short run when the price level is fixed.

Chapter 3.1 Introduction

This section discusses economic downturns and how policy interventions might correct them.
The Keynesian model suggests low aggregate demand (AD) is responsible for economic downturns, causing low income and high unemployment.

Basic Assumptions of the Model

Prices are exogenous and constant.
Output is determined by demand.
The analysis is short-term and static.
The economy is closed.

The Keynesian Cross

A model illustrating how income is determined by expenditure in a closed economy.
Notation includes real GDP (Y), planned expenditure (E), consumption (C), investment (I), government spending (G), and taxes (T).
The difference between actual and planned expenditure represents unplanned inventory investment, illustrating a connection between production and spending.

Elements of the Keynesian Cross

Consumption function: C = C(Y - T)
Government policy variables: G = G, T = T
Planned expenditure: E = C(Y-T) + I + G
Equilibrium condition: Y = E

Graphing Planned Expenditure

Planned expenditure (E) is graphed as a function of income (Y) to illustrate the relationship between the two
The equation for planned expenditure is E = C + I + G

Graphing the Equilibrium Condition

A 45° line crossing the planned expenditure line at equilibrium represents the equilibrium condition, Y = E

The Equilibrium Value of Income

The intersection of the planned expenditure line and the 45° line shows the equilibrium income level, where actual and planned expenditure are equal.

An Increase in Government Purchases (G)

An increase in government purchases (G) will increase income (Y).
The multiplier effect amplifies the initial increase in spending, leading to a larger change in income.

Fiscal Policy and the Multiplier

The change in equilibrium income (ΔY) is determined by the spending multiplier (1/(1-MPC)).
MPC (marginal propensity to consume) is the fraction of additional income spent on consumption.
The multiplier shows how a change in spending affects the final change in income.
The formula for the multiplier is (1 / (1 - MPC)).

The Government Purchases Multiplier

Definition: The increase in income resulting from a 1 unit increase in government spending (G).
Formula: ΔY/ΔG = 1/(1 - MPC)

Taxes Multiplier

Definition: The change in income resulting from a 1-unit increase in taxes is based on the effects of changes in taxes.
Formula: ΔY/ΔT = -MPC/(1-MPC)

Balanced Budget Multiplier

If both government spending (G) and taxes (T) increase by the same amount, the equilibrium real GDP increases by the same amount as the change in G (because ΔY/ΔG = 1/(1-MPC) = ΔY/ ΔT = -MPC/ (1- MPC)).
Equal changes in government spending and taxation do not affect the budget.

Calculating Equilibrium Income

Disposable income (Yd) is net income, Yd = Y + TR – TA, where TR are transfers and TA are taxes.
Consumption C = C + MPC(Yd)
Assume government purchases (G) and transfers (TR) are constant, and taxes (TA) are a proportion of income (tY).

Combining for Expenditure

Planned expenditure (E) is equal to C + I + G, where I = Planned investment.
Assuming the interest rate and investment are related E = C + c(TR) + c(1–t) Y + I (r) + G
E = A + c(1-t)Y – br
A denotes autonomous spending.

The IS-LM Model

Shows how income and interest rates are determined simultaneously in the goods and money markets.

The IS Curve

The IS curve illustrates combinations of interest rate (r) and national income (Y) where the goods market is in equilibrium.
It reflects the relation between income and interest rates.
The IS curve is negatively sloped. A lower interest rate leads to an increase in investment and consequently an increase in aggregate demand and the equilibrium level of output.

Deriving the IS Curve

The IS curve is derived from the goods market equilibrium condition.
Graphing the relationships at a given interest rate.
An increase in government spending moves the IS curve to the right.

Interest Rate and Investment

A negative relationship exists between the interest rate (r) and investment (I). For higher interest rates, the rate of return on investments reduces, which leads to lower planned investment spending.
Investment spending is denoted as I = I – br.

The IS Curve and the Loanable Funds Model

The IS curve and the aggregate demand function are shown to be related graphically in the diagram.

Fiscal Policy and the IS Curve

Changes in government spending and taxation affect the IS curve and thus income and interest rates.

The LM Curve

The LM curve is derived from the money market equilibrium condition and the money demand function.
The LM curve is positively sloped. An increase in income (Y) leads to an increase in money demand L(r, Y)
At an initial given level of money supply, the higher the income, the higher the interest rate. This relationship is represented by the positively sloping curve.

Deriving the LM Curve

The LM curve is derived by considering different interest rates and the corresponding levels of income that satisfy money-market equilibrium.
An increase in money supply shifts the LM curve to the right.

Why the LM Curve is Upward Sloping

An increase in income (Y) raises money demand.
The equilibrium interest rate (r) rises to reduce excess demand and restore equilibrium in the money market.
The LM curve reflects the positive relationship between income (Y) and the interest rate (r) in the money market.

The LM Equation

The LM curve demonstrates that the demand for real money balances (M) is linked to both income (Y) and interest rate (r).
Combining the money demand curve and fixed money supply creates the equation (mp=ky–hr), where k and h are constants related to money demand's sensitivity to income and interest changes.

How AM Shifts the LM Curve

Changes in money supply shift the LM curve. A decrease in money supply shifts the LM curve to the left, whereas, an increase shifts it to the right.

The Short-Run Equilibrium

The combination of interest rates (r) and income (Y) satisfying both goods-market and money-market equilibrium is the short-run equilibrium
The equilibrium is derived graphically by the intersection of the LM and IS curves.

Summary

A summary of the key concepts and models used to analyze short-run fluctuations in output and price levels in a closed economy.

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Description

Test your knowledge on key concepts of the Keynesian economic model. This quiz covers topics including income, unemployment, prices, and the Keynesian Cross. Dive into the characteristics and theories that define Keynesian economics.