Eco 304L: Introduction to Macroeconomics
Fall 1998
Professor Harry Cleaver

Second Test

Part I: The Basic Keynesian Macro Model

(Answer 1 of the following questions for 20% of total grade.)

1. Explain how the centrality of the wage --which we studied in the section on the Keynesian solution to the Great Depression-- shows up in the Keynesian cross model (the one with the 45 degree line) that we have been working with. How does the model demonstrate that rising wages can be a good thing for the economy and for business?

2. In our earlier discussion of growth we examined a model in which the more that was saved and invested, the faster the rate of growth. But in the Keynesian cross model an upward shift in the savings function will reduce the level of Y. Are these two approaches contradictory? If so, why? If not, why not?

Part II: Keynesian Theory and Policy

(Answer 1 of the following questions for 20% of total grade.)

3. Given a simple model of the sort: Y = C + I + G, C = a + bYd, Yd = Y - T, T = e + fY, I = g + hY and G = G, show how to derive the government expenditure and tax multipliers. What are these "multipliers", what do they tell us and why are they important for the calculation of fiscal policy?

4. Using words and graphs explain how the Keynesian model provided a policy guide for getting the economy out of a deep recession. Discuss the ways fiscal and monetary policy could be used separately or conjointly to achieve this result. In our earlier discussion of the Keynesian solution to the Great Depression "productivity" figured prominently. Here it seems to be missing. How might monetary or fiscal policy be organized to have an impact on productivity?

5. Not long after the Keynesian model appeared it was reworked into what came to be called the IS-LM model. Show graphically how to derive such a model. What are the advantages of this model over the other, Keynesian cross model?

Part III: Policy Problem w/model

(Answer all the following questions for 40% of total grade)

The 1960s Inflation

It is the late 1960s. An extended period of steady growth --fueled by Great Society expenditures at home and defense expenditures for the Vietnam War-- is beginning to show signs of a troublesome, accelerating inflation. Over the last few years the inflation rate has moved up from 4% to 8% and seems likely to get worse. As policy advisor, you are called upon to recommend ways to deal with this problem.

Assume you have constructed the following model of the macro economy based on existing data:

C = 40 + 0.75Yd
Moreover, for the present period, you expect:
T = -10 + 0.1Y
government expenditures to = 80,
exports to = 13 and
the Fed to expand the money supply to 100.
Moreover, you estimate that:
I = 110 + 0.1Y - 400i (Note: 0 < i <1, e.g., ten percent interest appears as 0.10) and i = 5.1 - 0.05Md
M = - 37 + 0.05Y (M = imports)

Given this model and information answer the following questions:

6. Solve for the equilibrium level of income. Solve for the amount of taxes that will be forthcoming at that level of income and calculate the state of the government's budget (G - T). Solve for the level of expected imports and calculate the trade balance.

7. Suppose that you estimate that an equilibrium level of 880 would slow the rise in prices to a more acceptable level. Therefore, your problem is to recommend policies that would achieve this level of national income.

a) By how much would you have to change government expenditures to accomplish this by fiscal policy alone? By how much would you have to change taxes to achieve the same thing, with no change in government expenditures? What political problems might you foresee resulting from each of these two approaches?

b) By how much would you have to change the money supply to achieve a national income of 880 by monetary policy alone?

Part IV: The Crisis of the Keynesian Era

(Answer 1 of the following questions for 20% of total grade.)

8. The breakdown of the Keynesian era was signaled at the international level by Nixon's abandonment of the Bretton Woods system of fixed exchange rates on August 15, 1971. What growing international economic problems led Nixon to this decision? In what ways had the American government tried and failed to deal with these problems at the domestic level in 1970? So, how did the shift to flexible exchange rates signal a breakdown in the domestic foundations assumed in the Bretton Woods agreements?

9. At the core of the rise of the Keynesian era was the "productivity deal" embedded in union contracts and the welfare state. At the core of the fall of the Keynesian era was the collapse of that deal and the failure of the state to either renew it or find a substitute. Discuss that collapse both within the economy and within the larger society in as many dimensions as you can think of.