ELS Chapter 11: Graphing Exercise Answers
Using the Basic Keynesian Model
1. What is the initial short-run equilibrium level of output in the economy illustrated in the model above? How do you know? What are the initial levels of consumer expenditures (C), investment (I), government purchases (G), and net exports (NX) at this equilibrium?
  The initial short-run equilibrium level of output is $10,000 billion. At this level of output, planned aggregate expenditure (PAE) is exactly equal to output, as illustrated by the intersection of the PAE and 45-degree line. At any other level of output, PAE is greater or less than output. Firms will respond by increasing or reducing production, respectively, until output and planned aggregate expenditures are equal. At the initial short-run equilibrium, the level of consumer expenditures is $6500 billion, investment spending is $1000 billion, government purchases are $2000 billion, and net exports are $500 billion: C + I + G + NX = $10,000.
2. The U.S.-led war against Iraq increased U.S. government spending in 2003. According to the basic Keynesian model, what effect would an increase of $100 billion in government spending have on output in the economy?
  answer: Increased government spending increases planned aggregate expenditures, shifting the PAE line up. At the original level of output, $10,000 billion, PAE > Y and firms respond by increasing production until output and planned aggregate expenditure are again equal. This occurs where the PAE line crosses the 45-degree line, at the output level $10,200 billion (use the Adjust Income button to see the movement to the new equilibrium). Output has increased by $200 billion from the initial increase of $100 billion in government spending, according to the model. Lesson: increases in government spending help to increase output in the economy and can be used to bring the economy out of a recession.
3. Restore the original values in the model by clicking on the Reset button. In 2000 and early 2001, investment spending on new capital goods, particularly in high-tech industries, fell dramatically. What effect would a $300 billion drop in autonomous investment have on equilibrium output in the economy, according to the basic Keynesian model?
  answer: A decrease of $300 billion in autonomous investment spending shifts the PAE curve down. At the original level of output, $10,000 billion, PAE < Y and firms respond by cutting back production and employment until output and planned aggregate expenditures are equal again. This occurs where the PAE line crosses the 45-degree line, at the output level $9,400 billion (use the Adjust Income button to see the movement to the new equilibrium). Output has fallen by $600 billion from the initial decrease of $300 billion in autonomous investment, according to the model. Lesson: reduced spending on new capital goods by firms can lead the economy into a recession.

4.

 In question #3, by how much has short-run equilibrium output decreased due to the decrease in autonomous investment spending? From this information, can you determine the value of the multiplier?
  answer: Output decreased by $600 billion from the decrease of $300 billion in autonomous investment spending. The multiplier is the effect of a one-unit change in autonomous expenditure on short-run equilibrium output. In this case, a $300 billion change in autonomous expenditure led to a $600 billion change in equilibrium output, so the multiplier is equal to 2.0. We can determine this by dividing the change in equilibrium output ($600 billion) by the change in autonomous expenditure ($300 billion) or $600 billion/$300 billion = 2.0.

5.

 Restore the original values in the model by clicking on the Reset button. Reduce autonomous consumption expenditure by $500 billion and determine the new equilibrium level of output. How big is the resulting recessionary gap? By how much does government spending need to increase to eliminate the recessionary gap?
  Answer: The decline in autonomous consumption shifts the PAE curve down and reduces the equilibrium level of output to $9,000 billion, leaving a recessionary gap of $1,000 billion. To eliminate the recessionary output gap, the government needs to increase government spending. Increase government spending until the PAE line intersects the 45-degree line at potential output. In this case, the level of government spending that will bring about equilibrium at potential output ($10,000 billion) is $2500 billion, which is $500 billion higher than the original amount.

6.

 Restore the original values in the model by clicking on the Reset button. Repeat question #5, but this time change taxes to move the economy back to potential output. By how much do taxes need to be changed to reach this goal? Why is the change in taxes (in $) needed to bring the economy back to potential output different from the change in government spending you determined in question #5? Explain.
  answer: Taxes need to be reduced to $0, a $1000 decrease, to bring the economy to potential output after a $500 billion drop in consumer spending. This is double the size of the change in government spending that was necessary to bring the economy to potential output in question #5. Why? When taxes are reduced, part of the tax cut is saved (if the marginal propensity to consume, or MPC, is less than 1.0), so the change in autonomous expenditures is less for a tax cut than for a similar dollar-value change in government spending. Therefore, to achieve the same change in output, a larger change in taxes is necessary, relative to the change in government expenditures.

7.

 The U.S. Congress passed tax reduction legislation in the spring of 2003 that significantly reduced taxes for many consumers. Part of the rationale for the tax cut was that it would spur economic growth and help the U.S. economy move out of a recession that began in 2001. According to the basic Keynesian model, is this rationale economically plausible?
  answer: A reduction in taxes that is used to increase consumption expenditures, as the model assumes, shifts the PAE up and increases the equilibrium level of output, so it's possible that the tax cuts passed in 2003 could help the economy move out of an economic recession. However, if consumers save most of their tax cut, the effect on autonomous consumption expenditures, the PAE line, and equilibrium output will be less. Also, because there is some delay in the effects of tax cuts, it is possible that autonomous consumption expenditures may increase after the economy is already back at potential output, which would move equilibrium output beyond potential GDP and risk increasing inflation.