Aggregate Demand in Keynesian Analysis

Self-Check Questions

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.

  1. A large increase in the price of the homes people own.
  2. Rapid growth in the economy of a major trading partner.
  3. The development of a major new technology offers profitable opportunities for business.
  4. The interest rate rises.
  5. The good imported from a major trading partner become much less expensive.

Hint:

  1. An increase in home values will increase consumption spending (due to increased wealth). AD will shift to the right and may cause inflation if it goes beyond potential GDP.
  2. Rapid growth by a major trading partner will increase demand for exports. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
  3. Increased profit opportunities will increase business investment. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
  4. Higher interest rates reduce investment spending. AD will shift to the left and may cause recession if it falls below potential GDP.
  5. Demand for cheaper imports increases, reducing demand for domestic products. AD will shift to the left and may be recessionary.

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?

  1. A tax increase on consumer income.
  2. A surge in military spending.
  3. A reduction in taxes for businesses that increase investment.
  4. A major increase in what the U.S. government spends on healthcare.

Hint:

  1. A tax increase on consumer income will cause consumption to fall, pushing the AD curve left, and is a possible solution to inflation.
  2. A surge in military spending is an increase in government spending. This will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to the right of potential GDP, then the AD curve will shift farther to the right and military spending will be inflationary.
  3. A tax cut focused on business investment will shift AD to the right. If the original macroeconomic equilibrium is below potential GDP, then this policy can help move an economy out of a recession.
  4. Government spending on healthcare will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to th right of potential GDP, then the AD curve will shift farther to the right and healthcare spending will be inflationary.