Economic Environment

Course book

Prof Ashok Thomas

IIM Kozhikode
 Session 7: Keynesian Framework: Building Blocks

Introduction
In the period from 1929 to 1933, referred to as the beginning of the Great Depression,
economists had expected that competitive markets would reduce unemployment and reduce
surpluses, as had occurred often in prior recessions. In this case, however, wages were falling
but unemployment continued to increase, reaching approximately 25% in the United States in
January 1933. Thus, many began to question the prevailing Classical view of the economic
world. John Maynard Keynes, writing in the United Kingdom in the 1930s, particularly felt
that wage and price rigidities could keep an economy for a prolonged period of time in a below
full-employment equilibrium.

Essentially, the Keynesian view argues that there are impediments to wages and prices falling
to equilibrium levels. This phenomenon can be referred to as “sticky” wages and prices,
“downwardly rigid” wages and prices, or “downwardly inflexible” wages and prices. While
over a longer period of time, excess supply could pressure downward wages and prices, there
can be significant periods of excess supply, generating unemployment in labor markets and
surpluses in product markets.

Within labor markets, wage inflexibility can result from legal minimum wages above
equilibrium or union contracts. Also, employers may find it profitable over the long run to pay
a wage premium to attract good workers (sometimes referred to as “efficiency wages”) and to
maintain higher wages even in periods of slack demand. Within product markets, large firms
wishing to avoid destabilizing competition may maintain prices above equilibrium and have
temporary surpluses.

If the economy has the tendency to settle below full employment, with significant
unemployment, an appropriate government policy response would be to stimulate demand, to
increase employment and to increase the purchasing of products, moving the economy towards
full employment. Governments can prompt an increase in demand by directly buying goods
and services, reducing taxes to stimulate private spending, or lowering interest rates to
encourage investment and interest-sensitive consumer purchases. These stabilization policies
are frequently referred to as fiscal and monetary policy. In this Keynesian view of the world,
unlike the Classical view of the world, aggregate demand is very important as a determinant of
macroeconomic equilibrium and the level of unemployment in the economy. Inadequate
aggregate demand can lead to a short-run macroeconomic equilibrium with significant
unemployment, well above the full-employment rate of 4.5 to 6%.
Multiple choice questions

Question 1) According to the Keynesian view, the Great Depression could be characterized
as a period during which:

a) Prices and wages increased rapidly.

b) Prices stayed low, but wages increased rapidly.
c) There was a prolonged excess supply of labor.
d) There was a prolonged excess demand for labor.
e) Prices increased rapidly, but wages stayed low.

Explanation: The Great Depression was a period during which unemployment was high. In
other words, there was a prolonged excess supply of labor. Keynesian thinking doesn't see
wages as flexible and therefore the excess supply of labor can continue for extended periods.

Question 2) According to the Keynesian view, which of the following is an inappropriate

short-term policy if the economy is in a recession?
a) Increasing government spending
b) Decreasing the deficit
c) Decreasing sales taxes
d) Decreasing interest rates
e) Decreasing income taxes

Explanation: According to the Keynesian view, the government should increase demand in
the short term if the economy is in a recession. This could involve increasing spending or
lowering taxes. Each of these policies would lead to greater deficits. Decreasing the deficit on
the part of government would decrease aggregate demand. This would be inappropriate in the
Keynesian view.

Question 3) According to the Keynesian view, unemployment caused by inadequate demand

could persist because:
a) Workers do not have the skills that firms need.
b) Workers receiving unemployment benefits have no incentive to look for employment.
c) Wages are rigid.
d) Government has set an interest rate that is too low.
e) Technological developments have induced firms to replace workers with machines
and robots.

Explanation: According to the Keynesian view, recessions caused by inadequate demand occur
when unemployment persists due to rigid wages. If workers’ skills don’t match the skills needed by
firms, or if workers have an incentive to remain unemployed for the sake of benefits, or if
technological developments make certain workers obsolete, there would indeed be some
unemployment in the economy, but it wouldn’t be the type of unemployment caused by inadequate
 demand. When the government sets too low an interest rate, it would lead to an increase in demand
which would cause lower unemployment.

Activity 1: Assume that a country is concerned about experiencing a high level of unemployment.
How would Classical and Keynesian economists differ in their approaches to reducing unemployment?

Activity 2
Referencing the animation above, which of the following best describes the economic effect?

a) Decrease in Quantity of Aggregate Demand caused by the Interest Rate Effect

b) Increase in Quantity of Aggregate Demand caused by the Interest Rate Effect
c) Decrease in Quantity of Aggregate Demand caused by the Real Balances Effect
d) Increase in Quantity of Aggregate Demand caused by the Real Balances Effect
e) Decrease in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
f) Increase in Quantity of Aggregate Demand caused by the Foreign Purchases Effect

Activity 3

Referencing the animation above, which of the the following best describes the economic
effect?

a) Decrease in Quantity of Aggregate Demand caused by the Interest Rate Effect

b) Increase in Quantity of Aggregate Demand caused by the Interest Rate Effect
c) Decrease in Quantity of Aggregate Demand caused by the Real Balances Effect
 d) Increase in Quantity of Aggregate Demand caused by the Real Balances Effect
e) Decrease in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
f) Increase in Quantity of Aggregate Demand caused by the Foreign Purchases Effect

Activity 4

Referencing the animation above, which of the the following best describes the economic
effect?

a) Decrease in Quantity of Aggregate Demand caused by the Interest Rate Effect

b) Increase in Quantity of Aggregate Demand caused by the Interest Rate Effect
c) Decrease in Quantity of Aggregate Demand caused by the Real Balances Effect
d) Increase in Quantity of Aggregate Demand caused by the Real Balances Effect
e) Decrease in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
f) Increase in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
Conclusion
You should now be comfortable with the three reasons the aggregate demand curve has a
negative slope when graphed as the relationship between the general price level and output
measure as Real GDP. You should note that all three reasons begin with a change in the price
level and that you are explaining the impact of that change.

Be careful as you move forward to avoid confusing a change in some other variable other than
price level, which, as you will see, will cause a shift in the entire aggregate demand curve.

In this section, you have explored movements along the aggregate demand curve -- and
strengthened your ability to explain the causes for movements along the curve.

Aggregate demand

Question 4) As a result of a higher price level, domestic consumers have less purchasing power
with their cash balances in checking and savings accounts and therefore decrease their quantity
demanded for goods and services. This decrease is most likely due directly to:

a) Real Balance effect

b) Foreign Purchase effect
c) Interest Rate effect
d) An increase in imports
e) A decrease in exports

Explanation: The correct answer is the Real Balance Effect. A higher price level will cause
the nominal cash balances in consumers’ savings accounts and checking accounts to have less
purchasing power.

Question 5) As a result of higher interest rates, consumers buy less interest sensitive goods
like automobiles. This is an example of the:

a) Real Balance effect

b) Foreign Purchase effect
c) Interest Rate effect
d) All of the above
e) None of the above

Explanation: The answer is none of the above. Since there is no mention of a price level
change, then there is no simple movement along the Aggregate Demand Curve to be
explained by any of the effects in a-c. As you will see, this type of change will cause a shift
of the Aggregate Demand Curve.
Question 6) As a result of a higher price level, consumers need more money to make purchases
that they want. This increase in demand for money causes higher interest rates. The higher
interest rates cause consumers and businesses to reduce their demand for interest sensitive
goods. This effect is known as:

a) Real Balance effect

b) Foreign Purchase effect
c) Interest Rate effect
d) All of the above
e) None of the above

Explanation: The answer is the Interest Rate effect. Notice that the question began with a change in
the price level. The question then perfectly describes the Interest Rate effect.

Question 7) As a result of a higher price level, consumers need more money to make purchases
that they want. This increase in demand for money causes higher interest rates. The higher
interest rates cause consumers and businesses to reduce their demand for interest sensitive
goods. This effect is known as:

a) Real Balance effect

b) Foreign Purchase effect
c) Interest Rate effect
d) All of the above
e) None of the above

Question 8) Assume all other factors remain constant when interest rates fall. Then
consumers would be able to borrow easier and the demand for real goods and services would
rise. This is an example of:

a) Interest Rate effect

b) Real Balance effect
c) Foreign Purchase effect
d) All of the above
e) None of the above

Explanation: This is a tough question at this point. If you got it right, give yourself a star! The
correct answer is none of the above. The first three responses help describe changes in the
amount of real goods and services demanded as a result of changes in the price level. Here, we
are considering a change in interest rates autonomously and not as the result of a price level
change. It turns out this kind of autonomous change causes the entire demand curve to shift,
and that is the subject of our next section.
Question 9) Assume that income rises in Germany and Germans demand more U.S. goods
and services as a result. This is an example of:

a) the Interest Rate effect

b) the Real Balance effect
c) the Foreign Purchase effect
d) all of the above
e) none of the above

Explanation: The correct answer is none of the above. The type of change described in the
stem is an autonomous change, not the result of an initial change in the price level. Therefore,
a-c responses would not apply.

Determinants of Aggregate Demand

Introduction

In this section, you will learn the determinants of aggregate demand. A change in one of these
variables will actually cause a shift of the aggregate demand curve as opposed to a movement
along the curve. In essence, any change that affects aggregate demand, other than price level
changes, will shift the aggregate demand curve.

As mentioned in the previous section, it will be important for you to know these determinants
and how they affect aggregate demand, so that you will be able to understand how monetary
and fiscal policies are implemented and how they work.

Activity 1) Show the shifts in AD

Situation A

Assume the government increases government spending to build more interstate highways
and repair bridges along existing highways.

Situation B
Assume interest rates rise as a result of increased government borrowing to finance the highway
improvement projects.

Situation C
Assume the U. S. dollar increases in value (or appreciates) on the foreign exchange market. In other
words, it costs more Japanese Yen to buy a U. S. Dollar.
Situation D
Assume business confidence rises.

Situation E
Assume the general price level rises.

Situation F
Assume the level of income in China rises faster than the level of income in the U.S.

Activity 2
Consider the following economic fluctuations and what effect they would have on aggregate demand.

Draw your own graphs

1. Increase in Interest Rate

2. Higher Price Level

3. Decrease in Government Spending

4. Increase in Real Balances due to Decrease in Price Levels

5. Increase in Exports due to Decrease in Dollar Value (Foreign Exchange)

6. Increase in Personal Income Taxes

7. Increase in Consumer Confidence

You should now understand that changes in some economic factors, like the exchange rate or the
nominal interest rate, will shift the aggregate demand (AD) curve. Expansionary changes, like a tax
reduction or lower interest rate, will shift the AD curve to the right or increase AD at every price
level. Contractionary changes, like a reduction in government spending, will shift the AD curve to the
left or decrease AD at every price level.
Question 1) An increase in which of the following will increase aggregate demand?

a) Taxes
b) Government spending
c) The federal funds rate
d) Reserve requirements
e) The discount rate

Explanation: An increase in government spending will shift the Aggregate Demand Curve to
the right. An increase in taxes would shift it to the left as will all of the changes in monetary
policy to be studied later in the course.

Question 2) An increase in the international value of the United States dollar will tend to
cause U. S. exports to:
a) fall and aggregate demand to increase.
b) rise and aggregate demand to increase.
c) fall and aggregate demand to decrease.
d) rise and aggregate demand to decrease.
e) not change and aggregate demand to not change.

Explanation: The correct answer is "fall and aggregate demand to decrease" because U. S.
exports will now appear more expensive to foreigners. Thus, a decrease in Net Exports (Xn)
will then cause a decrease in aggregate demand.

Question 3) Which of the following changes would cause an economy’s Aggregate Demand
curve to shift to the right?
a) An increase in spending on imports
b) An increase in autonomous consumption spending
c) An increase in interest rates
d) A decrease in the money supply
e) A decrease in the overall price level in the economy

Explanation: The correct answer is "an increase in autonomous consumption spending." An

autonomous increase in consumption would increase the amount of Aggregate demand at every
price level thus shifting the Aggregate Demand curve to the right. Response "A decrease in the
overall price level in the economy" is interesting in that, the amount of aggregate demand
increases as a result of the decrease in the price level, but, as we have stressed in these first two
sections, this change is just a movement along the Aggregate Demand Curve. The remaning
responses would shift the curve to the left.
Question 4) Aggregate Demand may be measured by adding:

a) consumption, investment, savings, and imports

b) savings, government spending, and business inventories
c) consumption, investment, government spending, and net exports
d) domestic private expenditures and government spending
e) domestic expenditure and imports

Explanation: The correct answer is "consumption, investment, government spending, and net
exports." There are four sectors of spending which constitute Aggregate Demand:
Consumption, Business Investment, Government, and Net exports.

Question 5) Which of the following would cause the aggregate demand curve to shift to the
left?
a) Providing investment tax credits for businesses
b) Higher value of the dollar on the foreign exchange market
c) Reducing personal income tax rates
d) Increase in consumer confidence
e) Faster increase in foreign countries’ income compared to the US

Explanation: The correct answer is "Higher value of the dollar on the foreign exchange
market." If the value of the dollar rises (or appreciates), US goods will be relatively more
expensive for foreigners and they will buy less, while foreign goods will look cheaper to US
consumers and they will import more. Thus, net exports will decrease and shift aggregate
demand to the left. All other responses will cause aggregate demand to shift to the right.

The Multiplier Effect

Introduction

You now know that a change in the price level will cause a movement along the aggregate
demand curve, reflecting a change in the amount of real goods and services demanded.

You also know that an autonomous change in any one of the four sectors of aggregate
demand (C, Ig, G, Xn) will cause a shift in the aggregate demand curve reflecting a change in
the amount of real goods and services demanded at every price level.
Activity

In this section, you will see that an autonomous change in any one of the four sectors can
result in a much greater change in aggregate demand (and even real GDP). The additional
increase in aggregate demand is called the multiplier effect. It is important to consider the
multiplier effect in determining the magnitude of necessary fiscal and monetary policy
changes in the effort to fine tune the economy. Activity Overview

Now you will try some exercises that will help you practice the multiplier effects. It is
important to bear in mind that any autonomous change in one of the four sectors of aggregate
demand (C, Ig, G, Xn) will result in a much greater change in aggregate demand as a result of
the multiplier effect.

Activity 1

Assume the government increases government spending by $10 billion to improve border
security. Also, assume the marginal propensity to consume is .75. What will be the maximum
total change in aggregate demand based on the increase in government spending?

multiplier=1/0.25=4
Total changes in aggregate demand: 4 x $10 Billion = $40 Billion

Activity 2

Assume consumers become concerned about the direction the economy is headed and they
decrease their spending on consumer goods and services by $800 million. Assuming the
marginal propensity to save is .2, what will be the maximum total change in aggregate
demand?

multiplier=1/0.2=5
Total change in aggregate demand:
5 x $-800 million = $-4 Billion

Activity 3

Assume the exchange rate for the Mexican Peso changes such that it costs more Dollars to
buy a Peso. As a result, Americans buy less Mexican goods and services while Mexicans buy
more American goods and services. Assume the result of these changes is an increase in U.S.
Net Exports of $2 billion. Assuming the marginal propensity to consume is .8, what will be
the maximum total change in aggregate demand?

multiplier=1/0.2=5
total change in aggregate demand
5 x $2 Billion =$10 Billion
Question 1) An increase in the marginal propensity to consume causes an increase in which
of the following?

a) Marginal propensity to save

b) Spending multiplier
c) Savings rate
d) Exports
e) Aggregate supply

Explanation: The correct answer is the Spending multiplier. Looking at the formula for the
spending multiplier (M= 1/1-MPC), you can see that an increase in MPC will reduce the
denominator, and thus increase the value of the multiplier. This makes sense intuitively as well
in that more spending generates more income.

Question 2) In an economy with lump-sum taxes and no international sector, assume that the
marginal propensity to consume is equal to .8. Which of the following will necessarily be
true?

a) The economy will be running a deficit, since consumption expenditures exceed

personal saving.
b) Wealth will tend to accumulate in the hands of a few people.
c) A $10 increase in consumption spending will bring about an $80 increase in
disposable income.
d) The government expenditure multiplier will be equal to 5.
e) An increase in taxes of $80 million will result in a decrease in aggregate demand of
$5 million.

Explanation: The correct answer is the government expenditure multiplier will be equal to 5. checking
the formula (M = 1/1-MPC): M = 1/1-.8 or 1/.2 or 5.

Question 3) Assume the government feels the economy is “overheated” and would like to see
aggregate demand decrease by $200 billion. By how much would the government need to
change government spending if the marginal propensity to save in the economy is .25?

a) $50 billion increase

b) $50 billion decrease
c) $200 billion increase
d) $200 billion decrease
e) $25 billion decrease

Explanation: The correct answer is a $50 Billion decrease. Since the marginal propensity to
save is .25, the multiplier is = 4, or (1/.25). If government decreases government spending by
$50 Billion, then Aggregate Demand will decrease by 4 times or by $200 Billion
Question 4) Assume the government increases government spending by $800 billion and the
ultimate change in aggregate demand is approximately $4 trillion, then the economy’s
marginal propensity to consume must be:

a) .2
b) .8
c) 5
d) $3.2 trillion
e) $800 billion

Explanation: The correct answer is .8. If the increase in government spending of $800 billion
results in an increase in aggregate demand of $4 trillion, that is a fivefold increase meaning the
multiplier is 5. For the multiplier to be equal to 5, then the marginal propensity to consume
must be .8. The multiplier would be calculated as (1/1-.8) which is equal to 5.

Question 5) Assume consumers have a new bright and positive attitude about the economy
and they increase spending on consumer goods by a total of $400 billion. As a result,
aggregate demand ultimately increases by approximately $1.6 trillion. Assuming the marginal
propensity to consume for the economy is .75, by what amount did the consumers initially
change their saving?

a) 4
b) .25
c) -$400 billion
d) -$1.2 trillion
e) no change in saving

Explanation: The answer is -$400 billion. Consumers have two choices concerning what they can do
with their income. They can either spend it or save it. Once again, that is why the sum of the marginal
propensity to save plus the marginal propensity to consume is equal to 1. Therefore, if the consumers
decide to increase their spending by $400 billion, then they must reduce their saving by $400 billion.

Question 6) Assume the government increases government spending by $10 billion and the
Marginal Propensity to Consume (MPC) is .75. Then aggregate demand will eventually:

a) decrease and shift to the left by a maximum of $10 billion

b) increase and shift to the right by a maximum of $10 billion
c) decrease and shift to the left by a maximum of $40 billion
d) increase and shift to the right by a maximum of $40 billion
e) not change since this is an autonomous increase

Explanation: The correct answer is increase and shift to the right by a maximum of $40 billion.
Since the multiplier is 4 or 1/(1 - 0.75) = 1/0.25, the initial increase is $10 billion, but due to
the multiplier effect, the eventual change may be as great as $40 billion.
Question 7) The three reasons the aggregate demand curve slopes down and to the right
when graphed as a function of the price level are:

a) real balance effect (or wealth effect), foreign purchases effect, and interest rate effect
b) real balance effect (or wealth effect), price level effect, and interest rate effect
c) real balance effect (or wealth effect), foreign purchases effect, and price level effect
d) income effect, wealth effect, and price level effect
e) income effect, personal gain effect, and price level effect

Explanation: The correct answer is the real balance effect, foreign purchases effect, and interest rate
effect. All of these effects start with a change in the price level and represent the three important reasons
that more real goods and services will be demanded at lower price levels and less real goods and services
will be demanded at higher price levels.

Question 8) Assume business confidence rises and as a result, business investment spending
rises by $4 billion dollars. Also, assume the marginal propensity to consume is .8. This
increase in spending would be considered:

a) The interest rate effect and aggregate demand would increase ultimately by $20
billion.
b) An autonomous change and aggregate demand would increase ultimately by $20
billion.
c) The interest rate effect and aggregate demand would increase ultimately by $4 billion.
d) An autonomous change and aggregate demand would increase ultimately by $4
billion.
e) An autonomous change and aggregate demand would increase ultimately by $3.2
billion.

Explanation: The correct answer is an autonomous change and Aggregate Demand would increase
ultimately by $20 billion. Since this change is a result of something other than a change in the price
level, it represents an autonomous change. Since the marginal propensity to consume is .8, the multiplier
is 5 = 1/(1-.8) = 1/.2 and Aggregate Demand will increase theoretically and ultimately by $20 Billion
(5 x $4 Billion)

Question 9) If the aggregate demand curve shifts to the left, a likely cause would be:
An increase in income in Germany

a) A decrease in the value of the dollar on the foreign exchange

b) An increase in the price level
c) An increase in interest rates
d) A decrease in taxes

Explanation: The correct answer is an increase in the interest rates. An increase in interest
rates would make the purchase of goods and services that require consumers and businesses to
borrow become more expensive. An increase in the price level would cause a decrease in the
amount of real goods and services demanded or a movement along the Aggregate Demand
curve. The other three responses would cause an increase or shift to the right of the Aggregate
Demand curve.

Question 10) If you observe the aggregate demand curve shifting to the right by $50 billion
dollars based on an increase of $5 billion in business investment spending, then most likely:

a) Government spending was also increased by $40 billion.

b) Government spending was also increased by $10 billion.
c) The marginal propensity to save is .9.
d) The marginal propensity to consume is .9.
e) The marginal propensity to consume is $40 billion.

Explanation: The correct answer is the marginal propensity to consume is .9. Since the
ultimate increase in aggregate demand is 10 times the original increase in spending, the
multiplier is 10. Therefore, the marginal propensity to consume must be 0.9. The multiplier
would be calculated as 1/(1 - 0.9), which is equal to 10.

Question 11) If you observe the quantity of aggregate demand increases by $4 billion with
no change/shift in aggregate demand, then a likely explanation is:

a) There has been a decrease in the price level.

b) There has been an increase in the price level.
c) Government spending has increased by 1 billion and the marginal propensity to
consume is .75.
d) Government spending has increased by 1 billion and the marginal propensity to
consume is .8.
e) Government spending has increased by 1 billion and the marginal propensity to
consume is 4.

Explanation: The correct answer is "there has been a decrease in the price level." If there has
been no change in Aggregate Demand, then the increase in the amount of Aggregate Demand
must be due to a movement along the existing Aggregate Demand curve due to a change in the
price level. In this case, the price level would have to decrease to cause the increase of $4
billion in Aggregate Demand.