# 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

macroeconomic theory? Briefly explain your answer.

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.)