Question

1.) In the Keynesian framework, which of the following events might cause a recession? Which might cause inflation? Sketch AD/AS diagrams to illustrate your answers.

a.) A large increase in the price of the homes people own.
b.) Rapid growth in the economy of a major trading partner.
c.) The development of a major new technology offers profitable opportunities for business.
d.) The interest rate rises.
e.) The good imported from a major trading partner become much less expensive.
2.) In a Keynesian framework, using an AD/AS diagram, which of the following government policy choices offer a possible solution to recession? Which offer a possible solution to inflation?.)
a.) A tax increase on consumer income.
b.) A surge in military spending
c.) A reduction in taxes for businesses that increase investment
d.) A major increase in what the U.S. government spends on healthcare.

Answer 1

Answer.) 1.) Let us suppose that current market equilibrium is identified by following image.

level Price Real output

We suppose currently market is in full-employment equilibrium at Y* ( if market is below full employment then AD would be on flatten part of AS curve) . Now, we will see what happens when other events occur

a.) A large increase in the price of the homes people own : Remember that the house that people own is part of their property or what we is call is an asset which forms a part of wealth. If there is a rise in price of the homes people own , it simply means it add to their wealth and this leads to increase in their consumption spendings. Remember that consumption spending is a part of aggregate demand with investment spening, government spenings and net exports. Therefore, Increase in consumption spendings shift Aggregate demand rightward from AD to A1D1  as depicted in graph below . now, as its clear from graph below, it certainly ends up in inflation.  

(if the economy is below the full equilibrium output level, , then increase in consumption spendings would lead to a very little or no increase in price level .)

Price level Real output

2.) Rapid growth in the economy of a major trading partner means that there is sharp increase in income levels in the trading partner country thus, this would lead to increase in import demand of trading partner country. Hence, this would end up in increasing your exports. Remember that, Net exports are part of Aggregate demand. Thus, increase in net export demand would shift AD rightward as depicted in graph below. now, as its clear from graph below, it certainly ends up in inflation.

( if the economy is below the full equilibrium output level, then increase in Net exports would lead to a very little or no increase in price level .)

Price level Real output

3.) The development of a major new technology offers profitable opportunities for business. More Profit availability leads to higher investment spendings which leads to increase in Aggregate demand as we investment spenings are part of Aggregate demand. Thus, Increase in Investment spenings would shift AD rightward from AD to A1D1 as depicted in graph below . now, as its clear from graph below, it certainly ends up in inflation.

( if the economy is below the full equilibrium output level, then increase in investment spendings would lead to a very little or no increase in price level .)

Price level Real output

4.) The interest rate rises. Higher interest rates increases cost of credit in the market. Thus, this reduces investment demand and hence aggregate demand too. Decrease in investment spendings leads to leftward shift in AD from AD to A1D1 as depicted in graph below. now, as its clear from graph below, it certainly ends up in recession as both output level decreases.

(Note that even if market is below full employment output, decraese in investment spenings would certainly reduce AD and hence their would be recession.)

Real output