Keynesian Economics: The Income-Expenditure Model

Which of the following is true in the income-expenditure model about export and import expenditures as a function of national income?

Exports are shown in the model as a horizontal line, while imports are shown with a upward-sloping line

This year the economy is strong and there is every expectation that it will continue to be strong over the next few years. With this confidence in the economy, what would most likely happen to the consumption function?

• It will shift the consumption function upward.

• With optimism consumers are likely to increase consumption for any given income and the entire consumption function will shift upward.

A key part of the Income-Expenditure model is understanding that as GDP (or national income) rises, so does ________.

• aggregate expenditure

• GDP is composed of the aggregate expenditures.

Which of the following aggregate expenditure components is not impacted by real income?

Autonomous expenditures

Consumption still exists even if income is zero because ________.

people still have basics needs they must meet

Suppose an economy is defined by the following: C = 136 + 0.9 (Yd). The (Yd) in this algebraic equation represents the ________.

disposable income

National disposable income is the Yd in the equation.

In a Keynesian cross diagram, what name is given to the distance between an equilibrium level of output that is below potential GDP and potential GDP?

recessionary gap

Imagine the economy is at macro equilibrium. Suppose businesses become pessimistic about the future, and as a result, reduce investment expenditure. The result will be

A decrease in total expenditure and a decrease in GDP.

Since investment is a component of investment expenditure, a decrease in investment spending will reduce total expenditure, shifting the total expenditure curve down, leading to a new macro equilibrium at a lower level of GDP.

When the real aggregate supply curve is vertical, increased expenditures cause higher prices, but no additional output. This is because

resources, like labor and physical capital, are fully employed so there are none available to produce more output.

The real aggregate supply curve becomes vertical at potential GDP. This corresponds to full employment of resources. Thus, any additional spending causes higher prices, but no additional output.

In the figure, which line is the potential GDP Line?

line 1

What is the income=expenditure line called in the Keynesian Cross Diagram?

45-degree line

Suppose the level of potential GDP is $6,000 billion, but the equilibrium level of GDP is $7,500 billion. If the marginal propensity to consume is 0.67, how much should government spending be decreased to eliminate the inflationary gap?

$ 500 billion

In the figure, the spending multiplier is represented by ΔY/ΔAE and ________.

ΔY/ΔAE.

This year the economy is strong and there is every expectation that it will continue to be strong over the next few years. With this confidence in the economy, what would most likely happen to the consumption function?

It will shift the consumption function upward.

With optimism consumers are likely to increase consumption for any given income and the entire consumption function will shift upward.

The aggregate expenditure determines the total amount that firms and households plan to spend on goods and services at each level of income. Therefore this model focuses on the short run relationship between ________ and national income or GDP.

real spending

The model focuses on the relationship between real spending and GDP

Which of the following is true in the income-expenditure model about export and import expenditures as a function of national income?

Exports are shown in the model as a horizontal line, while imports are shown with a upward-sloping line.

Exports (purchases by foreigners) are independent of national income (income of US citizens) so they are shown as a horizontal line. Imports (purchases by US citizens) are positively related to national income, so when national income rises, people buy more imports. In other words, imports are an upward-sloping line with respect to income.

Autonomous expenditures are NOT affected by what factor?

National income

Autonomous expenditure is not affected by national income.

Algebraically, the consumption function is represented as ________.

C = a + MPC*Y, where a is autonomous consumption (the amount of consumption expenditure when Y = 0), MPC is the marginal propensity to consume, and Y is national income

The consumption function is dependent on income, the marginal propensity to consume and autonomous consumption.

Imagine the economy is at macro equilibrium. Suppose businesses become pessimistic about the future, and as a result, reduce investment expenditure. The result will be

A decrease in total expenditure and a decrease in GDP.

Since investment is a component of investment expenditure, a decrease in investment spending will reduce total expenditure, shifting the total expenditure curve down, leading to a new macro equilibrium at a lower level of GDP.

An increase in labor and physical capital

would shift the real aggregate supply curve to the right.

Increased labor and capital resources would increase potential GDP.

The current economic policy being implemented by the Keynesian economists in government is moving the economy bach toward potential GDP through increased taxation. Knowing this policy, what would you say is the current state of the economy?

The economy is experiencing an inflationary gap.

By increasing taxes the government is reducing the aggregate expenditures and the GDP, which means the economy was facing an inflationary gap.

Suppose an economy is defined by the following: C = 150 + 0.7 (Yd). The 0.7 in this algebraic equation represents the ________.

The marginal propensity to consume is the slope of the consumption function.

During an inflationary gap due to overly sufficient aggregate demand, the government should ________ spending by an amount determined by the spending multiplier in an attempt to return the economy to potential GDP/full employment.

decrease

In the case of an inflationary gap, spending needs to be reduced.