Keynesian Economics: Consumption and Equilibrium Quiz
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Keynesian Economics: Consumption and Equilibrium Quiz

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Questions and Answers

What is the relationship between planned consumption and disposable income in the Keynesian model?

  • Planned consumption is a quadratic function of disposable income.
  • Planned consumption is inversely proportional to disposable income.
  • Planned consumption is a linear function of disposable income. (correct)
  • Planned consumption is independent of disposable income.

    • What does the equation C̄ + c(Y − T̄ ) + Ī + Ḡ = Y represent?

  • The potential output of an economy.
  • The conditions for a government budget surplus.
  • The supply side constraints in the economy.
  • The relationship between planned and actual expenditure. (correct)

    • According to Keynesian economics, what can cause the economy to be trapped at a low output level?

  • High levels of private investment.
  • Insufficient government intervention. (correct)
  • A balanced budget leading to full employment.
  • Self-correcting tendencies in the economy.

    • How does an increase in autonomous government spending affect equilibrium output (Y)?

    <p>Increases equilibrium output (Y).</p> Signup and view all the answers

    Which of the following changes would decrease equilibrium output (Y)?

    <p>Increase in autonomous taxation (T̄).</p> Signup and view all the answers

    What does the term 'animal spirits' refer to in the context of Keynesian economics?

    <p>The psychological factors influencing consumer and investor behavior.</p> Signup and view all the answers

    In the expression Y = (C̄ − cT̄ + Ī + Ḡ) / (1 − c), what does 'c' represent?

    <p>The marginal propensity to save.</p> Signup and view all the answers

    Which law relates to the phenomenon of high unemployment during economic equilibrium in Keynesian economics?

    <p>Okun's Law.</p> Signup and view all the answers

    What does the government spending multiplier indicate about the relationship between government spending and national income?

    <p>National income increases more than the amount of government spending.</p> Signup and view all the answers

    If the marginal propensity to consume (c) is 0.2, what is the calculated increase in Y when Ḡ increases by $20 billion?

    <p>$25 billion</p> Signup and view all the answers

    What is the formula to determine the total effect of an increase in government spending on output?

    <p>$dY = rac{1}{1-c}dḠ$</p> Signup and view all the answers

    What would be the total effect on output if government spending is financed entirely through an increase in taxes?

    <p>Output increases by exactly the amount of government spending.</p> Signup and view all the answers

    What is the primary reasoning behind the multiplier effect?

    <p>Consumption from increased income leads to further increases in income.</p> Signup and view all the answers

    How does the increase in government spending affect the marginal propensity to consume in the economy?

    <p>It increases the marginal propensity to consume over time.</p> Signup and view all the answers

    What is the outcome of increasing both government spending and taxes simultaneously while keeping the budget unchanged?

    <p>Total output will increase one-for-one.</p> Signup and view all the answers

    Which statement best describes the overall impact of the balanced-budget multiplier?

    <p>It results in no change to national income.</p> Signup and view all the answers

    What is the key assumption of Keynesian economics regarding price adjustments?

    <p>Prices and wages do not fully adjust in the short run.</p> Signup and view all the answers

    According to Keynesian theory, what primarily drives business cycles?

    <p>Fluctuations in aggregate demand.</p> Signup and view all the answers

    What role does government expenditure play in Keynesian economics?

    <p>It is essential for stimulating demand during recessions.</p> Signup and view all the answers

    Which of the following is NOT a component of planned aggregate expenditure (P AE)?

    <p>Net exports (NX)</p> Signup and view all the answers

    What was a key criticism of Classical business cycle theory?

    <p>It ignores the impact of demand on supply.</p> Signup and view all the answers

    What is meant by the term 'sticky prices' in the context of Keynesian economics?

    <p>Prices that do not change even when demand fluctuates.</p> Signup and view all the answers

    Which concept describes the unpredictable nature of expectations that can affect the economy?

    <p>Animal spirits</p> Signup and view all the answers

    What is a common mechanism through which Keynesians believe recessions can be alleviated?

    <p>Implementing policies that stimulate demand.</p> Signup and view all the answers

    In the Keynesian model, planned consumption is a nonlinear function of disposable income.

    <p>False</p> Signup and view all the answers

    The Keynesian equilibrium can be reached when planned and actual expenditure are inconsistent.

    <p>False</p> Signup and view all the answers

    An increase in autonomous consumption will lead to a decrease in equilibrium output (Y).

    <p>False</p> Signup and view all the answers

    The equation Y = (C̄ − cT̄ + Ī + Ḡ) / (1 − c) can be used to determine how Y depends on various factors.

    <p>True</p> Signup and view all the answers

    Okun’s Law explains the relationship between output levels and unemployment.

    <p>True</p> Signup and view all the answers

    Fiscal policy can only affect the economy through changes in autonomous investment.

    <p>False</p> Signup and view all the answers

    In the Keynesian framework, a decrease in autonomous taxation will increase the equilibrium output (Y).

    <p>True</p> Signup and view all the answers

    High unemployment during economic equilibrium is often viewed as a threat to stability in classical economics.

    <p>False</p> Signup and view all the answers

    An increase in government spending results in a direct and indirect increase in national income (Y).

    <p>True</p> Signup and view all the answers

    If the marginal propensity to consume (c) is 0.5, an increase in government spending of $10b would lead to an increase in Y of $20b.

    <p>False</p> Signup and view all the answers

    The balanced-budget multiplier results in no change in income if government spending is financed fully by tax increases.

    <p>False</p> Signup and view all the answers

    In Keynesian economics, 'animal spirits' refer to the confidence and psychological factors that affect consumer spending.

    <p>True</p> Signup and view all the answers

    The government spending multiplier is always greater than one as long as the marginal propensity to consume is between zero and one.

    <p>True</p> Signup and view all the answers

    In the multiplier effect, the total impact on income is less than the initial change in government spending.

    <p>False</p> Signup and view all the answers

    A decrease in the marginal propensity to consume (c) would lead to a larger multiplier effect.

    <p>False</p> Signup and view all the answers

    The derivative of national income Y with respect to government spending Ḡ is equal to $1/(1-c).

    <p>True</p> Signup and view all the answers

    Keynesian economics suggests that supply creates its own demand.

    <p>False</p> Signup and view all the answers

    According to the Keynesian model, planned aggregate expenditure includes only consumption and investment.

    <p>False</p> Signup and view all the answers

    In the short run, prices and wages are assumed to be 'sticky' in Keynesian theory.

    <p>True</p> Signup and view all the answers

    Keynesian economics emphasizes the role of consumer expectations in driving economic fluctuations.

    <p>True</p> Signup and view all the answers

    Fiscal policy is typically viewed as counter-productive in Keynesian economics.

    <p>False</p> Signup and view all the answers

    In a Keynesian framework, a lack of demand can lead to economy-wide market failure.

    <p>True</p> Signup and view all the answers

    Classical business cycle theory claims that government intervention is necessary for stabilizing the economy.

    <p>False</p> Signup and view all the answers

    The Keynesian model assumes that planned aggregate expenditure is solely a function of consumer behavior.

    <p>False</p> Signup and view all the answers

    How can fiscal policy be used to address low levels of output in an economy?

    <p>Fiscal policy can be employed by increasing government spending or decreasing taxes to boost aggregate demand.</p> Signup and view all the answers

    What implication does Okun's Law have on unemployment during a Keynesian equilibrium?

    <p>Okun's Law suggests that high unemployment can persist in a Keynesian equilibrium due to output levels being below potential.</p> Signup and view all the answers

    In the Keynesian model, how does an increase in autonomous investment (Ī) affect equilibrium output (Y)?

    <p>An increase in autonomous investment (Ī) leads to an increase in equilibrium output (Y).</p> Signup and view all the answers

    What role does consumption play in the relationship defined by the equation C = C̄ + c(Y - T)?

    <p>Consumption is dependent on disposable income, where C̄ represents autonomous consumption, and c is the marginal propensity to consume.</p> Signup and view all the answers

    How do changes in government spending (Ḡ) influence the Keynesian equilibrium output (Y)?

    <p>An increase in government spending (Ḡ) results in higher equilibrium output (Y) due to boosted aggregate demand.</p> Signup and view all the answers

    What does the Keynesian Cross illustrate about planned and actual expenditure?

    <p>The Keynesian Cross illustrates that equilibrium occurs when planned expenditure equals actual expenditure, leading to consistent output levels.</p> Signup and view all the answers

    What does the term 'animal spirits' convey in relation to consumer behavior under Keynesian economics?

    <p>'Animal spirits' refer to the psychological factors and confidence levels that influence consumer spending decisions.</p> Signup and view all the answers

    What is a potential consequence of a decrease in autonomous taxes (T̄) in terms of equilibrium output (Y)?

    <p>A decrease in autonomous taxes (T̄) is likely to increase equilibrium output (Y) by enhancing disposable income available for consumption.</p> Signup and view all the answers

    What is the significance of the government spending multiplier in Keynesian economics?

    <p>The government spending multiplier indicates that an increase in government expenditure can lead to a larger than one-for-one increase in national income (Y). This occurs because part of the increased income is consumed, leading to additional rounds of spending.</p> Signup and view all the answers

    How does an increase in the marginal propensity to consume (c) influence the government spending multiplier?

    <p>An increase in the marginal propensity to consume (c) results in a larger government spending multiplier, meaning that increases in government spending will lead to a more significant overall increase in national income (Y).</p> Signup and view all the answers

    What happens to the overall effect on output (Y) when government spending is financed by an equivalent increase in taxes?

    <p>When government spending is fully financed by an equivalent increase in taxes, the overall effect on output (Y) results in a one-for-one increase, as the indirect effects of increased spending are neutralized by the tax increase.</p> Signup and view all the answers

    Explain the role of consumption in the multiplier effect.

    <p>Consumption plays a crucial role in the multiplier effect, as part of the increase in income leads to further consumption, which perpetuates and amplifies the increase in total income (Y).</p> Signup and view all the answers

    Define the term 'animal spirits' in the context of Keynesian economics.

    <p>'Animal spirits' refers to the emotions and psychological factors that influence consumer and business confidence, impacting their spending and investment decisions.</p> Signup and view all the answers

    What is the mathematical limit that represents the total effect of an increase in government spending in relation to the marginal propensity to consume (c)?

    <p>The mathematical limit can be expressed as $\lim_{n→∞} \frac{1}{1 - c}$, which reflects the total effect of rising government spending on national income by incorporating all indirect effects.</p> Signup and view all the answers

    How does the balanced-budget multiplier concept address the impact of changes in government spending and taxation?

    <p>The balanced-budget multiplier concept states that if government spending is increased while taxes are raised by the same amount, the net effect on output (Y) is unchanged, maintaining a predictable one-for-one relationship.</p> Signup and view all the answers

    What is the implication of a government expenditure increase for the economy's income in the Keynesian model?

    <p>An increase in government expenditure directly raises national income (Y) and indirectly further stimulates income through increased consumption, demonstrating how fiscal policy can drive economic growth.</p> Signup and view all the answers

    What do Keynesians believe about the relationship between aggregate demand and business cycles?

    <p>Keynesians believe that fluctuations in aggregate demand drive business cycles and can lead to economy-wide market failures.</p> Signup and view all the answers

    How does the concept of 'sticky prices' impact Keynesian economic theory?

    <p>'Sticky prices' imply that prices do not fully adjust in the short run, leading to potential discrepancies between demand and supply.</p> Signup and view all the answers

    What role does government expenditure play in stabilizing the economy according to Keynesian theory?

    <p>Government expenditure helps stabilize the economy by stimulating aggregate demand during economic downturns.</p> Signup and view all the answers

    Describe the significance of expectations or 'animal spirits' in Keynesian economics.

    <p>Expectations or 'animal spirits' refer to the confidence and psychological factors that can influence consumer spending and investment decisions.</p> Signup and view all the answers

    In Keynesian economics, what is the implication of output being demand-determined?

    <p>The implication is that output levels can vary based on demand rather than being solely supply-driven.</p> Signup and view all the answers

    What does the theoretical equation for planned aggregate expenditure (P AE = C + I + G) illustrate?

    <p>This equation illustrates that planned aggregate expenditure is the total of consumption (C), investment (I), and government spending (G).</p> Signup and view all the answers

    What criticism do Keynesians have toward Classical economics regarding market adjustments?

    <p>Keynesians criticize Classical economics for its belief that markets operate well without intervention and that supply creates its own demand.</p> Signup and view all the answers

    What common method do Keynesians propose for alleviating recessions?

    <p>Keynesians propose using fiscal policy measures to stimulate demand as a method for alleviating recessions.</p> Signup and view all the answers

    In the Keynesian model, planned consumption is a linear function of disposable ______.

    <p>income</p> Signup and view all the answers

    Keynesian equilibrium can be achieved when ______ and actual expenditure are consistent.

    <p>planned</p> Signup and view all the answers

    The equation C̄ + c(Y − T̄ ) + Ī + Ḡ = Y is used to find the Keynesian equilibrium level of ______.

    <p>Y</p> Signup and view all the answers

    A decrease in autonomous ______ leads to an increase in equilibrium output (Y).

    <p>taxation</p> Signup and view all the answers

    Okun's Law describes the relationship between output levels and ______.

    <p>unemployment</p> Signup and view all the answers

    In the Keynesian model, an increase in government spending (Ḡ) will lead to an ______ in equilibrium output (Y).

    <p>increase</p> Signup and view all the answers

    Fiscal policy, such as increasing Ḡ or decreasing T̄, is one way to bring output back to ______.

    <p>potential</p> Signup and view all the answers

    According to Keynesian economics, planned aggregate expenditure includes consumption, investment, ______, and government spending.

    <p>taxes</p> Signup and view all the answers

    An increase in government spending (Ḡ) increases national income (Y) by more than one-for-one due to the ______ effect.

    <p>multiplier</p> Signup and view all the answers

    In the Keynesian model, a $1 increase in government spending has a direct effect of $1 on ______.

    <p>Y</p> Signup and view all the answers

    The balanced-budget multiplier suggests that financing an increase in government spending with an increase in ______ will lead to no change in total output.

    <p>taxes</p> Signup and view all the answers

    If the marginal propensity to consume (c) is 0.2 and Ḡ increases by $20b, then Y increases by ______.

    <p>$25b</p> Signup and view all the answers

    In Keynesian economics, the total effect of an increase in Ḡ is greater than the direct effect due to ______.

    <p>indirect effects</p> Signup and view all the answers

    The limit formula for the sum of series in the context of the Keynesian model is expressed as lim ______.

    <p>1 + c + c^2 + c^3 + ...</p> Signup and view all the answers

    The derivative of national income Y with respect to government spending Ḡ is given by 1/(1-______).

    <p>c</p> Signup and view all the answers

    In the Keynesian framework, the multiplier effect amplifies changes in autonomous spending, which affects the ______ in an economy.

    <p>income</p> Signup and view all the answers

    In Keynesian theory, prices and wages are said to be 'sticky' in the ______ run.

    <p>short</p> Signup and view all the answers

    According to Keynesian economics, fluctuations in ______ demand drive business cycles.

    <p>aggregate</p> Signup and view all the answers

    The formula P AE = C + I + G represents planned aggregate ______.

    <p>expenditure</p> Signup and view all the answers

    Keynesian economics posits that government ______ can help stabilize the economy during fluctuations.

    <p>intervention</p> Signup and view all the answers

    Keynesian theory challenges the assertion of Say's Law that supply creates its own ______.

    <p>demand</p> Signup and view all the answers

    In a closed economy, P AE is the total planned spending on final domestically produced ______ and services.

    <p>goods</p> Signup and view all the answers

    Keynesian theory underscores the importance of ______, which refers to consumer confidence and expectations.

    <p>animal spirits</p> Signup and view all the answers

    A key assumption in Keynesian economics is that output can be ______-determined.

    <p>demand</p> Signup and view all the answers

    Study Notes

    Planned Consumption

    • A key building block of the Keynesian model
    • Planned consumption is a linear function of disposable income
    • Written as the equation: C = C̄ + c(Y − T)
    • Where:
      • C is planned consumption
      • C̄ is autonomous consumption (consumption when disposable income is zero)
      • c is the marginal propensity to consume (the change in consumption for each dollar change in disposable income)
      • Y is disposable income
      • T is taxes
    • The equation shows that an increase in disposable income will lead to an increase in planned consumption but by a smaller amount.

    Equilibrium Output

    • In a Keynesian model, the equilibrium level of output is where planned aggregate expenditure (P AE) equals actual expenditure (AE) or output (Y)
    • This can be written as the equation: C̄ + c(Y − T̄ ) + I¯ + Ḡ = Y
    • This equation can be solved for the equilibrium level of output ( Y )

    Keynesian Equilibrium (Keynesian Cross)

    • Keynesian equilibrium can be visually represented using the Keynesian Cross
    • On the Keynesian Cross, the equilibrium level of output is where the planned aggregate expenditure (P AE) line and the 45-degree line intersect.

    Keynesian Equilibrium

    • The Keynesian model suggests that economies can become stuck at an equilibrium level of output below potential output.
    • This can lead to high unemployment.
    • When there is a Keynesian equilibrium, there is no self-correcting tendency for output to change.

    Role of Government Expenditure

    • Government expenditure can affect the equilibrium level of output.

    How Can We Bring Output Back to Potential?

    • One approach is to use fiscal policy, like increasing government spending ( Ḡ ) or decreasing taxes ( T̄ ).
    • Fiscal policy can be used to shift the planned aggregate expenditure line (P AE ) and move the equilibrium level of output closer to potential output.

    How Y depends on Ḡ, T̄, C̄, and I¯

    • Increases in government spending ( Ḡ ) increase the equilibrium level of output ( Y )
    • Increases in taxes ( T̄ ) reduce the equilibrium level of output ( Y )
    • Increases in autonomous consumption ( C̄ ) increase the equilibrium level of output ( Y )
    • Increases in autonomous investment ( I¯ ) increase the equilibrium level of output ( Y )

    Government Spending Multiplier

    • The government spending multiplier shows how a change in government spending affects the equilibrium level of output.
    • The multiplier is greater than one, meaning that a change in government spending has an amplified effect on output
    • The government spending multiplier is calculated as 1 / (1 - c) where c is the marginal propensity to consume.
    • The size of the multiplier depends on the marginal propensity to consume.

    Balanced-Budget Multiplier

    • If the increase in government spending is financed by an increase in taxes, the balanced-budget multiplier is equal to 1.
    • This means that a 1increaseingovernmentspendingfinancedbya1 increase in government spending financed by a 1increaseingovernmentspendingfinancedbya1 increase in taxes will lead to a $1 increase in output.

    Planned Consumption

    • First building block of the Keynesian model
    • Defined as a linear function of disposable income
    • Disposable income is given by income minus taxes
    • C represents planned consumption
    • C̄ represents autonomous consumption (independent of income)
    • c represents marginal propensity to consume (change in consumption due to a change in income)
    • (Y − T ) represents disposable income
    • P AE represents planned aggregate expenditure

    Equilibrium Output

    • Second building block of the Keynesian model
    • Equilibrium output is the level of output at which planned aggregate expenditure equals actual output
    • This is where planned spending matches actual spending
    • Key condition for equilibrium is that planned aggregate expenditure equals actual output
    • To solve for equilibrium output we use the condition: P AE = AE = Y
    • Substituting the components, we get a single equation that can be solved for the equilibrium output

    Keynesian Equilibrium (Keynesian Cross)

    • Visual representation of the Keynesian equilibrium
    • Equilibrium is where the planned aggregate expenditure line (P AE) intersects the 45 degree line
    • The 45 degree line represents the relationship where planned aggregate expenditure equals actual output

    Keynesian Equilibrium

    • Key idea is that economies can get stuck at an equilibrium level of output below potential output
    • Potential output represents the maximum sustainable level of output
    • If the economy is stuck below potential output, it implies high unemployment
    • Okun's Law shows the relationship between unemployment and GDP growth
    • In this equilibrium, planned and actual expenditure are consistent
    • No self-correcting mechanisms are present to push the economy back towards potential output
    • This explains persistent high unemployment during the Great Depression

    Role of Government Expenditure

    • Can be used to increase aggregate demand and push the economy back towards potential output
    • Fiscal policies involve changing government spending and taxes
    • Increasing government spending or reducing taxes increases aggregate demand

    How can we bring output back to potential?

    • Fiscal policy can be used, such as increasing government spending or decreasing taxes
    • To see how output depends on government spending and taxes we need to solve for equilibrium output
    • Solve for output to see its dependence on government spending, taxes, autonomous consumption, and investment

    How Y depends on Ḡ, T̄ , C̄, and I¯

    • Fiscal policy effects:
      • Increase in government spending (Ḡ) increases output (Y)
      • Increase in taxes (T̄ ) decreases output (Y)
    • Other shifts in demand:
      • Increase in autonomous consumption (C̄) increases output (Y)
      • Increase in autonomous investment (I¯) increases output (Y)
    • Animal spirits represent the level of confidence in the economy. This impacts investment and consumption.

    Government Spending Multiplier

    • Represents the change in output (Y) resulting from a change in government spending (Ḡ)
    • Shows how much output will increase for each dollar increase in government spending
    • Multiplier effect is greater than one because government spending leads to further rounds of spending.
    • For example, if the marginal propensity to consume (c) is 0.2, a 20billionincreaseingovernmentspendingwillleadtoa20 billion increase in government spending will lead to a 20billionincreaseingovernmentspendingwillleadtoa25 billion increase in output

    Increase in Government Spending

    • Shows the impact of increased government spending on output
    • The equilibrium output shifts to the right, reflecting the higher output level after increased spending

    Government Spending Multiplier Intuition

    • Direct effect: Government spending directly increases output
    • Indirect effect: Part of the increase in output is consumed, leading to further increases in output.
    • Total effect: Greater than the direct effect, with the magnitude depending on the propensity to consume.

    Balanced-Budget Multiplier

    • This represents the change in output (Y) when government spending (Ḡ) and taxes (T̄) increase by the same amount, maintaining a balanced budget.
    • In this case, the multiplier effect is approximately one.
    • This is because the increase in taxes cancels out the indirect effects of the increase in spending.

    Learning Outcomes

    • Understand the key contributions and controversies surrounding Keynesian macroeconomic theory.
    • Understand the factors that determine aggregate expenditure and the difference between “animal spirits” and the marginal propensity to consume.

    Planned Consumption

    • Planned consumption is a key building block of the Keynesian model
    • It is a linear function of disposable income, meaning it increases based on disposable income.
    • The equation for planned consumption is C = C̄ + c (Y − T ), where:
      • C̄ is autonomous consumption, meaning consumption that is independent of income
      • c is the marginal propensity to consume (MPC), meaning the fraction of each additional dollar of disposable income that is spent
      • Y is disposable income
      • T is taxes

    Equilibrium Output

    • Keynesian equilibrium is the level of output that makes planned aggregate expenditure (P AE) equal to actual expenditure, which is also equal to output (Y).
    • The equation for Keynesian equilibrium is: C̄ + c(Y − T̄ ) + I¯ + Ḡ = Y
      • This equation can be solved for the equilibrium level of Y
    • This equilibrium is visualized using the Keynesian Cross

    Keynesian Equilibrium

    • The economy can be stuck at an equilibrium level of output below potential output
      • This can lead to high unemployment according to Okun's Law.
    • There is no self-correcting tendency for output to change when the economy is stuck at an equilibrium, which is why Keynes viewed this as an explanation for high unemployment during the Great Depression.

    Role of Government Expenditure

    • Government expenditure is a component of aggregate expenditure and can be used to influence the equilibrium level of output.

    What Can Be Done?

    • Fiscal policy can be used to bring output back to potential by increasing government spending or decreasing taxes.
    • The equilibrium level of output, Y, depends on government spending (Ḡ ), taxes (T̄ ), autonomous consumption (C̄), and autonomous investment (I¯).

    How Y Depends on Ḡ, T̄ , C̄, and I¯

    • An increase in autonomous government spending (Ḡ ) increases Y
    • An increase in autonomous taxation (T̄ ) decreases Y
    • An increase in autonomous consumption (C̄ ) increases Y
    • An increase in autonomous investment (I¯ ) increases Y

    Government Spending Multiplier

    • The government spending multiplier is the ratio of the change in Y to the change in Ḡ.
    • The multiplier is greater than 1, meaning an increase in Ḡ leads to an increase in Y that is greater than the change in Ḡ.
    • The multiplier effect is amplified both increases and decreases in autonomous expenditure

    Balanced-Budget Multiplier

    • The balanced-budget multiplier is the ratio of the change in Y to the change in Ḡ when the government finances the increase in Ḡ with an increase in T̄.
    • In this case, the balanced-budget multiplier is 1, meaning a 1increaseinGˉfinancedbya1 increase in Ḡ financed by a 1increaseinGˉfinancedbya1 increase in T̄ will lead to a $1 increase in Y.
    • The indirect effects are undone by the increase in taxation.

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