• Keynesian economics

Exercise 1
Suppose that for a particular economy and period,
investment was equal to 100,
government expenditure was equal to 75,
net taxes were fixed at 100, and
consumption (C) was given by the consumption function
C = 25 + 0.8YD
where YD is disposable income and Y is GDP.

a. What is the level of equilibrium income (Y̅) ?

b. What is the value of the government expenditure multiplier
(ΔY/ Δ G) ? Of the tax multiplier (Δ Y> Δ T) ?
c. Suppose the investment declined by 40 units to a level of 60.
What will be the new level of equilibrium income?
Exercise 2
Suppose that initially equilibrium income was 200 units
and that this was also the full employment level of income.
Assume that the consumption function is C = 25 + 0.8YD
and that, from this initial equilibrium level, we now have a
decline in investment of 8 units.

What will be the new equilibrium level of income?

What increase in government spending would be required to restore
income to the initial level of 200?
Alternatively, what reduction in tax collections would be sufficient to
restore an income level of 200?
Exercise 3
Suppose that government spending was
increased by 10 units and that this increase was
financed by a 10-unit increase in taxes.

• Would equilibrium income change or remain

the same as a result of these two policy actions?
• If equilibrium income changed, in which
direction would it move, and by how much?
 Exercise 4
• Suppose that, instead of a fixed level of taxes, we had
an income tax so that
T = t 1Y
• where t1 was the income tax rate.

• Derive an expression for equilibrium income Y

analogous to equation (Y̅ = (1/1-b) (a - bT + I +G)) for
this case in which the level of tax collections depends
on income.
• What is the expression equivalent to the autonomous
expenditure multiplier [1>(1 - b)] for this case of an
income tax?
 Exercise 5
• In the exercise# 1, assume that, beginning from the
initial equilibrium position (investment equal to 100,
government expenditure equal to 75, and net taxes
fixed at 100), there was an autonomous fall in
consumption and an increase in saving such that the
consumption function shifted from
• C = 25 + 0.8YD to C = 5 + 0.8YD
• a. Find the change in equilibrium income resulting from
this autonomous increase in saving.
• b. Calculate the level of saving before and after the
shift in the consumption and, therefore, the saving
function. How do you explain this result?
a. Equilibrium income would fall by 100 units.
b. Using the saving function (S = (-a) +(1-b Yd) = the level of
saving dropped from 75 to 95 units.
S= (-25 + 0.2* (600-100))=75
S=(-5 + 0.2* (600-100))=95
b. The result here is an example of the “paradox of thrift.” The
attempt to save more simply reduces income by enough to
restore saving to its initial level. This must be the outcome,
because for equilibrium we must have S + T –– I + G, and T, I,
and G are all assumed not to change.
• Paradox of thrift (popularized by Keynes): individuals try to
save more during an economic recession, which essentially
leads to a fall in aggregate demand and hence in economic
growth
 Exercise 6
• Suppose that within the open-economy version of the
Keynesian model, we now include taxes. Disposable income
(YD = Y - T) therefore replaces GDP ( Y ) in the consumption
function
• Compute the expression for equilibrium income for this
version of the open-economy model. Compute an expression
for the tax multiplier (Y>T) in the model.
• Start with the equilibrium condition: Y = a + b (Y - T) + I + G + X - u - v (Y - T). Then solve for Y
resulting in:

• The autonomous expenditures multiplier is equal to

• and the tax multiplier is equal to

 Exercise 7
• Within the open-economy version of the Keynesian model,
including taxes (see the exercise 6), suppose there is an
autonomous increase in imports of 20 units [ u in equation
(Z = u + vY ) rises by 20].
• To counteract the effects of this contraction in domestic
aggregate demand, assume that the government cuts taxes by
20 units.
• Will equilibrium income rise or fall?
• By how much? Explain.
• Because of the increase in imports, output will fall by the amount
of the autonomous expenditures multiplier derived in exercise #6
times $20.

• Because of the reduction in taxes, output will rise by the amount

of the tax multiplier derived in exercise #6 times $20.

• Because the autonomous expenditure multiplier is larger than the

tax multiplier, output will fall by the difference in the two
multipliers, which is 1, times $20. Thus, output falls by $20.