Self-Check Questions

Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left.

12.4 The Keynesian Perspective on Market Forces

The Keynesian prescription for stabilizing the economy implies government intervention at the macroeconomic level—increasing aggregate demand when private demand falls and decreasing aggregate demand when private demand rises. This does not imply that the government should be passing laws or regulations that set prices and quantities in microeconomic markets.

Self-Check Questions

1 . In the Keynesian framework, which of the following events might cause a recession? Which might cause inflation? Sketch AD/AS diagrams to illustrate your answers. a. A large increase in the price of the homes people own. b. Rapid growth in the economy of a major trading partner. c. Business confidence increases. d. The interest rate rises. e. The good imported from a major trading partner become much less expensive. 2 . In a Keynesian framework, using an AD/AS diagram, which of the following government policy choices offer a possible solution to recession? Which offer a possible solution to inflation? a. A tax increase on consumer income. b. A surge in military spending. c. A reduction in taxes for businesses that increase investment. d. A major increase in what the U.S. government spends on healthcare. 3 . Use the AD/AS model to explain how an inflationary gap occurs, beginning from the initial equilibrium in Figure 12.6. 4 . Suppose the U.S. Congress cuts federal government spending in order to balance the Federal budget. Use the AD/AS model to analyze the likely impact on output and employment. Hint: revisit Figure 12.6. 5 . How would a decrease in energy prices affect the Phillips curve? 6 . Does Keynesian economics require government to set controls on prices, wages, or interest rates? 7 . List three practical problems with the Keynesian perspective.

Review Questions

8 . Name some economic events not related to government policy that could cause aggregate demand to shift. 9 . Name some government policies that could cause aggregate demand to shift. 10 . From a Keynesian point of view, which is more likely to cause a recession: aggregate demand or aggregate supply, and why? 11 . Why do sticky wages and prices increase the impact of an economic downturn on unemployment and recession? 12 . Explain what economists mean by “menu costs.” 13 . What tradeoff does a Phillips curve show?