Theoretical Foundations
According to Keynesian theory, what is the primary determinant of economic output in the short run?
Aggregate Demand (AD)
This term refers to the level of spending that occurs even if a household's disposable income is zero.
Autonomous Consumption.
In the Keynesian Cross diagram, what does the 45-degree line represent?
All points where planned expenditure equals actual output (Y = AE).
What is the term for the mechanism where an initial change in autonomous spending leads to a larger total change in GDP?
The Multiplier Effect
What type of "gap" exists when the equilibrium GDP is lower than the potential (full-employment) GDP?
A Recessionary Gap.
Name the four components that make up Aggregate Demand.
Consumption (C), Investment (I), Government Spending (G), and Net Exports (X - M).
What does "MPC" stand for, representing the fraction of an extra dollar of income that is spent?
Marginal Propensity to Consume.
What acts as the primary "signaling mechanism" that tells firms to increase or decrease production?
Unplanned changes in inventories.
What is the standard formula for the Expenditure Multiplier (k) using MPC?
k = 1 / (1 - MPC).
To close an Inflationary Gap, what type of fiscal policy should a government implement?
Contractionary Fiscal Policy.
What fundamental identity states that everything produced and sold results in equivalent payments to inputs?
The Output-Income Identity (Y ≡ Y).
State the mathematical formula for the Linear Consumption Function.
C = a + bYd (where 'a' is autonomous consumption and 'b' is MPC).
If Planned Expenditure exceeds Actual Output (PE > Y), what happens to inventory levels?
Inventories decrease (deplete).
Provide the mathematical formula for the Tax Multiplier and explain why its value is negative compared to the government spending multiplier.
The formula is $-MPC / (1 - MPC)$ (or $-MPC / MPS$). It is negative because an increase in taxes reduces disposable income, which leads to a decrease in consumption and overall equilibrium output.
Name two specific fiscal policy tools used to shift the Aggregate Expenditure line upward.
Increasing Government Spending (G) or decreasing Taxes (T).
Unlike classical economists, Keynes argued that an economy could settle into equilibrium without achieving this specific employment status.
Full Employment.
According to the Fundamental Psychological Law, as income rises, consumption increases but at what relative rate?
It increases by less than the increase in income (MPC < 1).
What is the specific condition required for a macroeconomic equilibrium to be reached?
Planned Expenditure must equal Output (PE = Y).
If Government Spending increases by $20 billion and the multiplier is 4, what is the total resulting increase in GDP?
$80 billion.
Why is it not necessary for the government to increase spending by the full amount of a recessionary gap?
Because the Multiplier Effect amplifies the initial spending to cover the rest of the gap.
Keynesian theory assumes that in the short run, prices and wages possess this characteristic, preventing them from clearing markets instantly.
They are "sticky" (or inflexible).
If the Marginal Propensity to Consume (MPC) is 0.7, what is the Marginal Propensity to Save (MPS)?
0.3 (Since MPC + MPS = 1).
When Planned Expenditure is less than Output (PE < Y), how do firms typically respond to the resulting inventory buildup?
They decrease production/output.
Why is the Government Spending multiplier typically larger than the Tax multiplier?
Because part of a tax cut is saved by households, while government spending enters the economy directly.
During an Inflationary Gap, an increase in Aggregate Demand primarily leads to what economic problem rather than more output?
Rising prices (Inflation).