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PRINCIPLES OF MACROECONOMICS
Project Two -- The Keynesian Model
DUE APRIL 22
FOLLOW THESE INSTRUCTIONS: Each question should be answered using clear, complete sentences or
equations. Show your work by first writing the equation, then substituting in the appropriate values. Write legibly.
Answer the questions in the space provided below. Use additional lined paper when you need additional space.
Clearly label each of your answers. The formulae you need are provided on page 3. You may also wish to refer to
my version of the slides for of chapter 15. There is a link to these on the assignment calendar.
Background: Hoover was elected in 1928. At the beginning of 1929, US real GDP was $1028 billion (in 1992
dollars) and exceeded potential GDP (assume potential GDP = $1000 billion). The unemployment rate was 3.2
percent. The GDP deflator was 15 (1992=100). During the year, signs of economic weakness began to appear. In
October, the stock market crashed, losing one-third of its value in two weeks. In 1930, real GDP fell by 9 percent to
$936 billion, and the price level fell to 14.6 by the end of the year (a 3 percent fall, or "deflation"). The money wage
fell to 55 cents per hour, but it fell by less than 3 percent.
Imagine that you are President Hoover’s economic advisor. The date is January 2, 1931. Real GDP is falling, and the
unemployment rate is rising. Investment has collapsed. You are preparing the proposed budget for the coming fiscal
year. Use the values shown in the table below for your analysis. They represent your best forecast for the state of the
economy in 1931.
Parameter
Value
(billion $ per year)
a
39
I
55
G
85
X
50
Ta
Tr
1.
Graph the Aggregate Expenditure line on the attached graph. Label it
AE. Write the equation here:
2.
Solve for equilibrium expenditure.
3.
Briefly describe what is happening to inventories at this equilibrium.
11
4.
Compute the value of net taxes (at equilibrium expenditure).
Marginal…
1
Value
(proportion)
5.
What is the government surplus or deficit at equilibrium expenditure?
b
0.9
6.
What is the value of net exports at equilibrium expenditure?
t
0.1
m
0.06
7.
What is the value of the government purchases multiplier?
8.
If the marginal tax rate were raised, would the value of this multiplier change? Explain.
9.
What is the value of the lump-sum tax multiplier?
10. Why does the lump-sum tax multiplier differ from the government purchases multiplier?
11. What is the value of the lump-sum transfer payments multiplier?
12. If the marginal propensity to import rose, would the value of this multiplier change? Explain.
13. Assume that potential GDP equals $1000 billion per year. Find the change in government purchases
necessary to restore the economy to full employment if the SAS is horizontal.
14. Graph the new Aggregate Expenditure line for question 13. Label it AE’.
15. Assume that potential GDP equals $1000 billion per year. Find the change in lump-sum taxes necessary to
restore the economy to full employment if the SAS is horizontal. Is this possible?
16. Assume that potential GDP equals $1000 billion per year. Find the change in lump-sum transfer payments
necessary to restore the economy to full employment if the SAS is horizontal.
17. Hoover opposes federal aid to the unemployed and wants to balance the budget. He has never heard of the
multiplier. Recommend a fiscal policy to restore the economy to full employment. Write an informative
and persuasive essay in support of your policy. Use lined paper and write neatly or type.
18. Assume that potential GDP equals $1000 billion per year. Find the new marginal tax rate necessary to
restore the economy to full employment. Graph the new Aggregate Expenditure line. Label it AE”.
19. Assuming that SAS is horizontal at the current price level (P=14.6), and that potential GDP equals $1000
billion per year, illustrate the effects of your proposed fiscal policy using an Aggregate Demand –
Aggregate Supply diagram. Draw SAS, LAS and New AD on the last page. Label the graph completely.
Symbol
Name
Y
a
I
G
X
T
Ta
Tr
A
b
t
m
g
Real GDP
Autonomous consumption
Investment
Government Purchases of goods and services
Exports
Net Taxes
Lump-sum Taxes
Lump-sum Transfers
Autonomous expenditure
Marginal propensity to consume
Marginal income tax rate
Marginal propensity to import
Slope of Aggregate Expenditure line
Formulae:
AE  C  I  G  X  M
C  a  b Y  T 
T  Ta  Tr  tY
M  mY
AE  A  gY
A  a  I  G  X  bTa  bTr
g  b 1  t   m
Y eq 
A
1 g
 1  Y


 1  g  G
 b  Y


 1  g  Ta
 b  Y


 1  g  Tr
Aggregate Planned Expenditure Model
1200
1100
1000
Aggregate Planned Expenditure
(billion $ per year)
900
800
700
600
500
400
300
200
100
0
0
100
200
300
400
500
600
700
Real GDP
(billion $ per year)
800
900
1000
1100
1200
Label each line: Original AD, SAS, LAS and New AD
Correctly label this axis:_______________________
100
90
80
70
60
50
40
30
20
10
0
0
200
400
600
800
Correctly label this axis:_______________________
1000
1200