Conceptual Questions
1. Read the article Baby-Sitting the Economy” by Paul Krugman and explain how it relates to
Keynes’s idea of involuntary employment. How is the story with the babysitters connected to the
example with apples and bananas given in class?
2. Explain in words how the Keynesian multiplier process works. Why does an increase in spending
lead to an even greater increase in total spending than the value of the initial increase?
3. Read the article Government Spending is No Free Lunch” by Robert Barro. Why is Barro skeptical
of government spending as a way to replace private investment?
4. Explain the dierences between Hayek’s and Keynes’s views on business cycles and the role of
government intervention. In particular you should comment on what each viewed as the cause of
business cycles and what they thought the government should do during a recession. You may nd
it helpful to read the article Friedrich August Hayek” and watch the Keynes-Hayek rap battles
(Fear the Boom and Bust” and Fight of the Century”).
5. What is a liquidity trap? Explain how being in a liquidity trap changes the eectiveness of monetary
and scal policy. Connect your answer to the policy response to the nancial crisis of 2008. You
may want to look at the article “The Liquidity Trap: An Alternative Explanation for Today’s Low
In
ation”
Analytical Questions
1. Assume an economy of 1000 people is described by the following equations:
Y = 10L
C = 0:75(Y T)
IP = 2000
G = 2000
T = 2000
a. Assuming the economy is at full employment (i.e. L = 1000), nd consumption, private
saving, public saving, and total saving
b. Assume MPC falls to 0.5 but production stays at the full employment level
i. What is unplanned investment in this scenario? What happens to inventories? How
does this aect rms’ production next period?
ii. What is consumption? What is total savings? Does total savings equal total investment?
Does total saving equal planned investment?
c. After the rm adjusts its production levels (still keeping planned investment xed at 2000),
a new equilibrium is re-established
i. What is the new equilibrium level of income? How many people will be employed?
ii. What are consumption and total savings in the new equilibrium? Did consumers accom-
plish their goal of increasing their savings? Why or why not? To answer this question,
it might be helpful to look at the reading “Wait, Is Saving Good or Bad? The Paradox
of Thrift”.
d. The government proposes a stimulus to get back to the previous level of output
i. How much does government spending have to increase (if taxes remain the same)?
ii. Does total savings change? Explain why by looking at the changes in private saving and
public saving.
2. In this question we will adjust the IS-LM curve seen in class slightly. In particular, we will assume
that taxes are taken as a percentage of income rather than as a lump sum. Then we have
C = a + b(1 )Y
where is the percentage (between 0 and 1) of income the government collects in taxes (so that
1 is left to the consumer). Assume that investment is a linear function of the interest rate
IP = e fr
And government spending is xed at G = G
a. Derive the IS curve (solve for r as a function of Y and parameters)
b. Which parameters aect the slope of the IS curve and which aect the intercept?
Now let:
a = 500; b = 0:8; = 0:25; e = 5000; f = 300; G
= 2500
c. What is the IS curve with these numbers?
d. What is output if the interest rate is 10%? What if it is 5%? 15%?
Assume money demand is given by:
Md
P
= 2Y 1000r
And that the price level is xed at P = 1 and the money supply at Ms = 10; 000
e. What is the LM curve with these numbers?
f. Using the IS curve in part c and the LM curve in part e, nd the equilibrium interest rate
and output for this economy.
g. How much does the government collect in taxes in equilibrium? What would the new
equilibrium income if the government eliminated the income tax and instead collected a
lump sum to get the same total tax revenue?
h. Government spending increases by 500. Compare the increase in income in the model with
the income tax to the model with the lump sum tax (holding the lump sum at the value you
found in part g). Explain the economic intuition.
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