# Low unemployment and a sizzling stock market have made American consumers

Problem
#1: One could easily find either of the following
explanations in the press for strong U.S. economic performance during the
1990s:
1.
Low unemployment and a sizzling stock
market have made American consumers feel wealthy and secure. Therefore, they
have raised their spending to unprecedented levels, which has driven real
growth rates to new heights.
2.
The revolution in computing and
telecommunication technologies has changed the way that things are made in this
country. The result is the fastest growth of labor productivity since the
1960s.
a. Graph
each situation using the AD/AS model, including the AD, SRAS and LRAS
curves. Label equilibrium. Assume that each situation began in a
recessionary gap.
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b.
Which one of these interpretations is most obviously consistent with Keynesian
Problem #2: Many economists argue that Americans need to
increase their saving.
a. Using
the graphical version of the Keynesian Cross below, show the effect of an increase
in saving on equilibrium output.
b. Explain
why any curve shifts.
c. Carefully
describe the adjustment process that the economy goes through as it moves from
the old equilibrium to the new one (using injections and leakages).
d. What
happens to employment?
e. What
can you conclude from this model about government policies designed to increase
saving?
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Problem #3:What
is wrong with the following statement?
According
to the Keynesian Cross model, higher aggregate demand raises output and
employment. Therefore, since government spending is part of aggregate demand,
higher government spending always raises output.
Problem #4:
Suppose that the economy is accurately described by the equations of the
following “Keynesian Cross” model.
C
= 350 + .75Yd
I
= 80
G
= 220
T
= 220
Xn
= -50
a. Solve
for equilibrium output.
b. Assume
Full Employment occurs at an output level of
2,000. Identify the value and
type of the output gap.
c. What
is the economic evil associated with this type of output gap? Explain why a Keynesian would argue that the
gap would need to be closed versus relying on the free market to self-correct
the economy.
d. What
is the value of the investment multiplier for this model? What is the new level of investment that
would be required to close the output gap?
e. Identify
two shortcomings of this approach.
f. What
is the value of the government multiplier for this model? What is the new level of government spending
that would be required to close the output gap?
g. How
would this impact the balanced budget?
h. Identify
three reasons why deficits matter.
i.
What is the value of the tax multiplier
for this model? What is the new level of
taxation that would be required to close the output gap?
j.
Identify two shortcomings of this
approach.
k. Deficits
are larger with the tax multiplier approach.
How would a supply-sider justify larger deficits in an economy that
already has a \$500b. deficit, and a \$19tr. debt?
Problem 5:
Answer the questions below about an economy that is initially operating below
potential output. Also assume that the economy has a “balanced
budget” restriction in its constitution that prevents deficit spending in
any situation.
a) Why is it a problem for the
economy to have an equilibrium level of output that is below the potential
level?
b) Suppose the economy is
described by the following simple Keynesian Cross model in algebraic form:
Y = AD = C + I + G + Xn
C = 500 + .8Yd
I = 275
G = 400
T = 400
Xn = -100
c.) Solve the model to obtain equilibrium
output. Full employment output occurs at
\$4,000.
d.) Using your solution from part c)
show that it is possible to raise equilibrium output using fiscal policy in
this economyeven with the balanced budget restriction.What
kind of fiscal policy would you recommend? Why does it work? Be sure to show
your work!!! (Hint: The balanced budget restriction implies that any change in
government spending must be matched by an equivalent change in taxes.)

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