Business Cycles in the Keynesian Model: Investment and Net Exports Questions 1 through 4 use the following graphs ADA 15 ADT 50 AEo AEo = AEI ANX Yo YI V Yo V ADA 450 ADA 450 - AEo AEo AEI ANX- D AI- Y1 Yo Y1 Yo Y 1. Which of the graphs above illustrates the effect on the U.S. economy if the nominal interest rate falls in Canada, holding expected inflation (En) fixed? (a) A ( b) B (c) C (d) D 2. As taught in class, which of the reasons below best justifies the answer to question 1? (a) This shock affects only the Canadian economy, not the U.S. economy (b) Investment rises since the real interest rates fall (c) U.S. net exports fall because Canadians will produce more output following the drop in interest rates in Canada (d) U.S. net exports increase because Canadian consumers demand more U.S. goods 3. Which of the graphs above illustrates the effect on the U.S. economy of an appreciation of the U.S. dollar relative to the Canadian dollar? (a) A (b) B (c) C (d) D 4. As taught in class, which of the reasons below best justifies the answer to question 3? (a) As the dollar gains value, American goods become more competitive in world markets (b) As the dollar strengthens, investors become more confident about the future (c) As the dollar gains value, American goods become less competitive in world markets (d) Both (a) and (b) are correctThe Paradox of Thrift For questions 5 through 14, consider the Keynesian model with the following parameters: C = 200 + 0.84*DI; I - 250; X - 90; M = 60. For simplicity, assume there is no government, SO G - TR = t=0. 5. Equilibrium output (YEQ) is (a) 2500 (b) 480 (c) 571.4 (d) 3000 6. ... disposable income (DI) is (a) 571.4 (b) 600 (c) 3000 (d) 2500 7. ... consumption (C) is (a) 2720 (b) 680 (c) 603.2 (d) 2200 8. ... and saving (S) is (a) 300 (b) 280 (c) -108.57 (d) -123.2 Now suppose everyone visits their Grandma, and Grandma convinces us that spending is sinful and that thrift is a virtue. Consumers decide that their saving should increase by 100. Suppose that consumers believe (incorrectly, as it turns out) that output and disposable income will stay at the same level as in questions 5 and 6 regardless of their saving behavior. 9. If their disposable income were fixed at its level from question 6, how much would consumers have to cut autonomous consumption (A) in order to raise their saving by 100? (a) 0 (b) 100 (c) 280 (d) 300 Now suppose that consumers do cut their autonomous consumption to the level you found in question 9. In fact, this will change equilibrium output and thus disposable income, contrary to consumers incorrect beliefs in question 9. 10. The new level of equilibrium output (YBo) following the change in autonomous consumption is [HINT: Find Yeo again with the new value of A] (a) 380 (b) 2000 (c) 2375 (d) 452.39 11. ... the new disposable income (DI) is (a) 452.39 (b) 380 (c) 2375 (d) 200012. ... the new consumption (C) is (a) 419.2 (b) 1700 (c) 480 (d) 2095 13. ...and the new saving level (S) is (a) 300 (b) 280 (c) -108.57 (d) -27.6 If you did these questions right, the new level of saving (S - DI - C) that you found in question 13, allowing for both the change in autonomous consumption and the change in equilibrium output, should be exactly the same as the level of saving that you calculated in question 8. That is, consumers cannot increase their saving in equilibrium by being thriftier by reducing A. This surprising fact about the Keynesian model is known as the Paradox of Thrift. 14. Intuitively, why does the paradox of thrift arise? That is, why doesn't saving rise when consumers try to be thriftier? (a) When consumers cut down on their autonomous consumption, aggregate demand falls (b) In the Keynesian Model, firms respond by producing less when there is less demand for their goods (c) In the Keynesian model, when output falls, so does disposable income (d) All of the above