Chapter 09 - The Short-Run Keynesian Policy Model: Demand-Side Policies
THE SHORT-RUN KEYNESIAN POLICY MODEL:
DEMAND-SIDE POLICIES PROBLEM SET
NAME: _______________________________________ DATE: ____ / ____ / ____
Give the best answer to each of the following questions.
1. Match each of the following reasons for the aggregate demand’s slope with their correct
explanation:
a. money wealth effect ___
b. interest rate effect ___
c. international effect ___
d. multiplier effect ___
1.
2.
3.
4.
As domestic prices fall, exports increase and imports
decrease.
As prices fall, people can buy more with the accumulated
money that they hold.
As prices fall, people do not need to hold as much cash, so
they deposit cash in banks, making more available to lend.
Initial increases in expenditures are magnified as the effects
of the initial increases circulate through the economy.
2. Given the following, state whether the SAS curve will shift up, down, or not at all:
a. Productivity rises by 2% while wages rise by 3%.
b. Productivity falls by 2% while wages remain constant.
c. Productivity rises by 4% while wages rise by 2%.
3. An economy is currently at point A in the graph below.
a. Is the economy in a recessionary gap or an inflationary
gap?
b. How would this economy return to equilibrium if fiscal
or monetary policy alone were used? On the graph,
label the new equilibrium point that would result from
this policy as point B. (Do not draw any new curves.)
c. How would this economy return to equilibrium if no policy action were taken? On the graph, label
the new equilibrium point that would result from this policy as point C. (Do not draw any new
curves.)
Chapter 09 - The Short-Run Keynesian Policy Model: Demand-Side Policies
4. State whether the following events would shift the AD curve to the right, to the left, or not at
all:
a. Foreign income decreases.
b. The exchange rate value of the dollar falls.
c.
Consumers expect lower income in the future.
d. The distribution of income shifts toward wealthier families that purchase more imported
goods.
e. Home heating oil prices rise, so people switch to natural gas.
f.
The U.S. price level rises as expected.
5. State, in your own words, the paradox of thrift.
6. Describe the short-run and long-run effects on real output and the price level for each the
following events. Assume the economy begins at short-run and long-run equilibrium.
a. Import prices suddenly rise.
b. Government institutes a significant reduction in taxes on production.
c. People hold off on spending because they expect prices to fall.
d. Government increases spending.
7. What are two problems with using fiscal policy to address problems in the economy?
Chapter 09 - The Short-Run Keynesian Policy Model: Demand-Side Policies
Answers to the Problem Set
The following are the correct answers to the problem set that follows on the next two
pages, along with the learning objective associated with each question. The problem set
is designed to be photocopied directly from this book and distributed for student use.
1. (LO2)
a. 2; b. 3; c. 1; d. 4
2. (LO3)
a. Up; b. Up; c. Down
3. (LO4)
a. Recessionary gap.
b. The government will have to use monetary or fiscal policy to shift the AD
curve to the right enough so that the AD, SAS and LAS curves all intersect at
the same point. The price level and output both rise. See the graph below for
placement of point B.
c. Because there is an excess supply of the factors of production, input prices
decline, shifting the SAS curve down sufficiently so that the SAS, AD, and
LAS curves intersect at the same place. See the graph below for placement of
point C.
4. (LO2)
a. Left; b. Right; c. Left; d. Left; e. Not at all; f. Not at all
5. (LO1)
The paradox of thrift is grounded in the notion that higher savings rates can cause
economic activity to slow down, reducing income. If this reduction in income is
severe enough, then the increased rate of saving could actually lead to a lower
overall amount of saving.
6. (LO4)
a. In the short run, output will fall and the price level will rise. In the long run,
there will be no change in output or the price level.
b. In the short run, output will rise and the price level will fall. In the long run,
there will be no change in output or the price level.
c. In the short run, output will fall and the price level will fall. In the long run,
there will be no change in output, but the price level will be lower.
Chapter 09 - The Short-Run Keynesian Policy Model: Demand-Side Policies
d. In the short run, output will rise and the price level will rise. In the long run,
there will be no change in output, but the price level will be higher.
7. (LO5)
One problem is that changing government spending and taxes is a slow legislative
process and these changes are generally made for political, not economic,
reasons. A second problem is that potential output is very difficult to estimate,
making it difficult to know what policy is appropriate.