Tutorial Topic: The Keynesian Model

1. There is some controversy surrounding macroeconomic theory. The two general schools of
thought, or camps, are the Keynesians and the classical economists. The debate between them
is really a matter of emphasis on what is the key determinant for the economy.
a. What is the key determinant to the level of macroeconomic activity according to each of these
schools of thought?
b. What are the policy implications for the government in the classical and Keynesian theories?
The classical economists believed that the economy would cure itself and the government
need not play an active role in the economy, whereas the Keynasian economists believed to
cure the economy the government should play an active role in.
[PLEASE JUST EXPLAIN ABOUT WHAT CLASSICAL ECONOMIST BELIEVE.]
[Include Says Law.]
[Include how it will cause the economy to rebound on its own]
No need for government intervention in the economy.
{naturally cure themselves}
{supply creates its own demand}
{natural tendency}
{restore full employment over time}
{no need for government intervention}
[Keynesian arguments Explain this shit.]
Hence the government has to step in to boost aggregate demand through the use of monetary
(decrease increase rates to increase consumer spending) and fiscal policies (increase
government spending and reduce taxation).
{demand creates its own supply}
{could tend towards a less than full employment equilibrium}
{not self-correcting}
{government has to step in}
c. Classical economists were shocked when the Great Depression of the 1930s occurred. Why
did classical economists believe that recessions were just temporary episodes and thus the
Great Depression would be an impossible event in their mind?
[Definition of Depression]
[Laissez-faire]
[Invisible hand]
[Says law]
2. Refer to the table below and answer the following questions.
Real Disposable Income
($ billion)
0
100
200
(i)400
600

Consumption
($ billion)
60
145
230
400
570

Saving
($ billion)
-60
-45
-30
0
30
1

800
1000

(ii)740
910

60
90

a. Fill in the two missing cells.

b. The marginal propensity to consume (MPC) is (230 145) / (200 100) = 0.85.
c. The marginal propensity to save (MPS) is (-45 + 60) / (100 0) = 0.15 or 1 0.85 = 0.15.
d. The autonomous consumption is $60billion.
e. Using the data in the table, the equation for the consumption function is consumption = 6
billion + 0.85 (real disposable income).
f. The break-even, or no-saving income, is $400billion. Since Yd is exactly = C, there is no
saving (45 degree line and consumption line intersects).
g. What are the main characteristics of the consumption function?
The consumption function is a straight line that has a positive slope because consumption
spending increases with real disposable income and vice versa. Straight line does not start
from the origin, it starts from where the autonomous consumption starts at 60 billion and the
slope of the consumption function is 0.85
h. Derive the Saving column in the table.
i. Using the information in the above table, sketch the consumption function diagram. Show
where the break-even or no-saving income is.
3. For each of the following, determine whether there is a movement along a consumption line,
or a shift of the line. If there is a shift, indicate the direction of the shift and interpret that
shift.
a. Consumer expectations become more optimistic
Consumption line will shift parallel upwards and this represents an increase in consumption
as all levels of disposable income.
b. An increase in the interest rate
The consumption line will shit parallel downwards and this represents a decrease in
consumption at all levels of disposable income.
c. Consumer incomes rise
There will be upward movement of the consumption line as the real disposable income of the
consumer rises.
4.

Suppose you could borrow money to buy a new machine for your business which costs
$4,000. You have estimated that this new machine will increase your revenue by $4,500. If
the interest rate is 12 percent, should you borrow the money to buy this machine? Why or
why not?
You should borrow the money to buy this machine as the expected rate of return is 12.5%,
which is more than the interest rate of 12%. [(4500 4000) / 4000 x 100% = 12.5%]. A
company should invest as long as the rate of return is more than the interest rate.

5.

For each of the following, determine whether there is a movement along an investment
demand curve or a shift of the curve. If there is a shift, indicate the direction of the shift and
interpret that shift.
a. Business expectations become more optimistic (bullish)
The investment demand curve will shift rightward and this represents an increase in
investments at all levels of interest rate as more businesses expect a higher return, profit and
sales. They may expect a lower cost of production as well.
b. The interest rate falls
There will be a downward movement along the investment demand curve. As interest rate
falls, investment will increase as the cost of borrowing decreases.
c. Technology increases
The investment demand curve will shift to the rightward and this represents an increase in
investment at all interest rates as firms are more likely to buy the latest innovations in order to
improve their production. A lower cost of production can be expected as well due to improved
production.
d. There is a decline in the capacity utilization rate of businesses
Investment demand curve shifts leftward as when much of the nations capital stock stands
idle, firms have less incentive to buy more.

6.

Refer to the table below and answer the following questions. All amounts are in billions of
dollars per year.
Real Disposable Income
100
120
140
160
180
200

Consumption
102
118
134
150
166
182

Investment
10
10
10
10
10
10

Aggregate Expenditure
112
128
144
160
176
192

a. Why is Investment a constant at $10 billion?

It is constant because it is an autonomous investment (independent of real disposable
income). It depends on technology, expectations, capacity utilization, business tax and
interest rates but not real disposable income.
b. Fill in the column for Aggregate Expenditure.
c. At what level of real disposable income is the economy at equilibrium?
When real disposable income is $160 billion
d. Based on the data in the table, sketch the Keynesian Cross diagram. Indicate where the
equilibrium level of real disposable income is.