Econ 162B A0 A1 Fall 2011 Kenny Christianson due December 2 ANSWER KEY PROBLEM SET NUMBER NINE 1 a The rap video highlights the basic differences between the ideas of Keynes and Hayek Keynes states that unemployment is the result of sticky wages During a bust cycle we need to increase aggregate demand Government spending can provide a stimulus to the economy Keynes believed that markets are ruled by animal spirits In the long run we re all dead Hayek expressed a faith in the free market The process of aggregation ignores human motivation He argues that we should not live high on the credit hog by spending our way out of a recession Markets provide the proper incentives for the economy to correct itself Hayek believes that economists should focus on the structure of capital He believes that credit is the beginning of the bust cycle and that attempts at stimulus will only make things worse Hayek is expressing the views of the classical model while Keynes is obviously expressing the views of the fixed price Keynesian model b According to Alan Blinder Keynes believed that insufficient demand leads to growing unemployment The Keynesian remedy for recession is to increase aggregate demand It s very simple that if there aren t enough buyers the sellers won t produce Blinder says And if they don t produce they don t hire workers And if they don t hire workers the workers don t have income and if the workers don t have income they can t buy stuff c According to Keynes in the long run we re all dead d Keynesian economics would recommend deficit spending during periods of recession Republicans are opposed to deficits and increases in government spending in general When Republicans took control of the House in 2011 the focus of Congress has been on controlling deficit spending e According to Dick Durbin the final internment of Keynes was the agreement to raise the debt ceiling back in August 2011 when Congress agreed to cut spending to reduce the deficit 2 a To find the Aggregate Expenditure function use AE C I G X M AE 400 0 9Yd 200 100 200 100 0 1Yd AE 800 0 8Yd so AE 800 0 8 Y 100 AE 720 0 8Y In equilibrium Y AE so Y 720 0 8Y 0 2Y 720 Econ 162B A0 A1 Fall 2011 Answer key 9 2 Y 3600 c spending multiplier 1 1 MPC MPIM 1 1 0 9 0 1 5 tax multiplier MPC MPIM 1 MPC MPIM 0 9 0 1 1 0 9 0 1 0 8 0 2 4 So spending multiplier tax multiplier 1 d To show that leakages injections injections I G X 200 100 200 500 leakages S T M S Yd C Yd Y T 3600 100 3500 C 400 9Yd 400 9 3500 3550 S Yd C 3500 3550 50 T 100 M 100 1Yd 100 1 3500 450 S T M 50 100 450 500 I G X e G 100 and T 100 so the deficit is Def G T 100 100 0 The government has a balanced budget in this example f If government spending increases by 100 then according to the multiplier formula Y spending multiplier x G Y 5 x 100 500 So Y Y Y 3600 500 4100 b Graphically Y AE AE AE 4100 AE 3600 820 720 3600 4100 Y 3 Assume that the aggregate supply curve is upward sloping and aggregate demand is downward sloping Econ 162B A0 A1 Fall 2011 Answer key 9 3 a A decline in the price level will shift neither the aggregate demand nor aggregate supply curves Changes in the price level lead to movements along the curves since the price level is the variable on the vertical axis Overconsumption results P P AS P AD Ys Y Yd Y b An increase in export spending will shift AD to the right so both prices and real GDP increase P AS c An increase in the price of resources will lead to a decrease in AS Real GDP declines and the price level rises P P P P P AD AD Y Y Y AS AS stagflation AD Econ 162B A0 A1 Fall 2011 Answer key 9 4 Y Y Y d In the Keynesian model an income tax cut will increase consumption spending which will lead to an increase in AD so that both P and Y increase P P P AS AD AD In a supply side model an income tax cut would also increase after tax wages so that labor supply and aggregate supply would both increase Y Y Y 4 a GDP Gap potential real GDP actual real GDP 2000 1250 750 million b There is a recessionary gap since actual real GDP potential real GDP c Since the MPC is 0 75 and the MPIM is 15 the spending multiplier is 1 1 MPC MPI 1 1 0 75 0 25 2 5 Since the Y spending multiplier x G then 750 2 5 x G so G 750 2 5 300 million Graphically Y AE AE AE recessionary gap 300 AE 2000 1250 300 1250 2000 GDP gap 750 Y Econ 162B A0 A1 Fall 2011 Answer key 9 5 d The tax multiplier is MPC MPI 1 MPC MPI 0 75 0 15 1 0 75 0 15 0 6 0 4 1 5 So Y tax multiplier x T or 750 1 5 x T so T 750 1 5 500 A 500 million decrease in taxes will increase GDP by 750 million e The balanced budget multiplier occurs when any increase in government spending is financed through an equal increase in taxes Since the spending multiplier is 1 1 MPC MPI and the tax multiplier is MPC MPI 1 MPC MPI if they both change at the same time the multiplier would be 1 MPC MPI 1 MPC MPI 1 1 MPC MPI 1 MPC MPI 1 MPC MPI Since the balanced budget multiplier is 1 then Y G T 750 million So if G and T are both increased by 750 million then GDP will increase by 750 million increase of G by 750 increase of T by 375 Y increases by 2 5 x 750 1875 Y decreases by 1 5 x 750 1125 net change in Y 750 5 a The fixed price Keynesian model would suggest that in 1937 the amount of output produced was greater than the level of aggregate expenditure so overproduction resulted As Roosevelt said Production in many important lines of goods outran the ability of the public to purchase them The economy was at a level of real GDP where the AE function was above the 45 degree line As a result output fell in 1938 as the model would predict b Roosevelt suggested three programs to stimulate the economy First he proposed continued government spending on work relief programs such as the Works Progress Administration and the Civilian Conservation Corps Secondly he proposed increasing bank reserves to increase the amount of credit and borrowing in the economy Thirdly he …