CHAPTER

 5:  THE  KEYNESIAN  SYSTEM  (I):  THE  ROLE  OF  

AGGREGATE  DEMAND  
ANSWERS TO QUESTIONS IN CHAPTER 5

1. The Keynesian revolution had its origins in the “problem of unemployment” in the sense that
severe and persistent unemployment was not well explained by the classical equilibrium
model and the classical model did not provide a solution to the problem of massive
unemployment. The classical system stressed the self-adjusting properties of the economy.
The high unemployment in Great Britain in the 1920s and in the rest of the Western
economies in the 1930s led Keynes and others to seek a new macroeconomic theory.

2. The three ways to write the condition for equilibrium income in the simple Keynesian model
are:

Y=C+I+G

S+T=I+G

Ir = I

The first version states that output must equal aggregate demand or desired aggregate
expenditures on output. The second states that the amount of income households do not spend
on output, S + T = Y –C, and therefore the amount of output that is produced but not sold to
households, is just equal to the desired purchases by the other two sectors, I + G. The third
version of the equilibrium condition states that desired investment must equal realized or
actual investment; there must be no undesired accumulation or rundown of inventory stocks.
All three versions are equivalent in that they are all statements that the total demand for
output must equal actual output for equilibrium in the simple Keynesian model.

3. Desired investment, as the name implies, is the amount the business sector wants to spend on
plant, equipment, and changes in the stock of inventories. Realized investment is the amount
they actually spend for these purposes in a given period. The difference comes in the
inventory component where there is unintended inventory accumulation when realized
investment exceeds desired investment and an unintended shortfall in inventory investment
when desired investment exceeds realized investment.

4. According to Keynes’ theory, expectations concerning the future profitability of investment

projects were an important determinant of investment spending. The key feature of such
sh

expectations in Keynes’ view was the weak foundation on which they rested. Consequently,
such expectations were subject to sudden and, at times, drastic revisions. Such shifts in
business managers’ expectations about the future profitability of investment are responsible
for the unstable behavior of investment demand in the Keynesian theory. If businesses
believe the government stabilizes output, investment demand is stabilized, hence stabilizing
output.

5. Yes. The Keynesian consumption function does predict that consumption will be a higher
proportion of income in recessions or low-income periods. This follows because, according to
Keynes’ consumption function, the APC, which gives the ratio of consumption to disposable
income (C/YD), is equal to:

C/YD –– a/YD + b

This expression implies that as disposable income falls the APC rises. During recessions,
consumption becomes a higher percentage of disposable income and, therefore, of national
income as well.
6. Consider the case of a $10 million autonomous increase in investment demand. The $10
million increase in the output of investment goods generates $10 million in national income.
This income is paid out to factors of production and a proportion of this increased income (b –
– MPC) is spent on consumer goods. The increased production of consumer goods generates a

further increase in factor incomes and still another induced increase in consumer demand. In
other words, someone’s spending is another’s income. Increases in income have induced
effects on consumer demand, which is behind the multiplier process in the Keynesian model.

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7. The tax multiplier is negative because an increase in taxes will reduce disposable income and
consumption demand for a given level of GDP. This will reduce the equilibrium level of
income. Each $1 increase in taxes will, however, reduce autonomous expenditures by only a
fraction (b) of $1; the rest of the $1 decrease in disposable income will be absorbed by a
decrease in saving. A change in government spending has a full dollar for dollar effect on
autonomous expenditures. Therefore, the tax multiplier is smaller in absolute value than the
government spending multiplier.
8. a. Y = 600
b. The value of the government expenditure multiplier is 5; the tax multiplier is –4.
c. 400
9. After the decrease in investment, the new level of equilibrium income will be 160. An
increase of eight units in government spending or a reduction of 10 units in taxes would be
required to restore income to the initial equilibrium level of 200.

10. As shown in the text, the sum of the government expenditures multiplier and the tax
multiplier is equal to one. Therefore, if government expenditures and tax revenues go up the
same amount, equilibrium income would rise by that same amount. This is called the
balanced budget multiplier.

11. Following the same steps as in deriving (6.14), the expression for equilibrium income is
shown to be:

where the new autonomous expenditure multiplier is the first term on the right-hand side of
this expression.
12. a. Equilibrium income would fall by 100 units.
b. Using the saving function, the level of saving is computed as 95 units before and after the
autonomous increase in saving. 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.
13. 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

14. Because of the increase in imports, output will fall by the amount of the autonomous
expenditures multiplier derived in #13 times $20. Because of the reduction in taxes, output will
rise by the amount of the tax multiplier derived in #13 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.