AP Macroeconomics Page 1 of 5 Assignment: Apply the Keynesian
Model to AD/AS
1. The Keynesian AE model is a basic representation of the economy in a situation where,
for whatever reason, prices don’t change.
A. Show, in an AE diagram, the change in equilibrium Y from a given increase in
autonomous expenditure. (6 points)
Assuming that the economy is operating within the PPF and thus on the horizontal section of the
AS curve, equilibrium income is determined where AD (aggregate demand) or AE (aggregate
expenditure) curve equals the Aggregate supply curve.
An increase in autonomous expenditure leads to a rightward shift in aggregate demand curve
leading to an increase in new equilibrium income. However, there is no increase in price level.
B. This simple Keynesian result relies on prices not changing when Y increases. One
reason prices wouldn't change is that input costs don't change. Explain why an
increase in GDP might not lead to increased costs for producers. Hint: The economy
is operating inside the PPF. (5 points)
When the economy is operating within the PPF, it implies that resources are unemployed in
the economy and that there is excess capacity in the economy. Hence a rightward shift
in aggregate demand does not lead to rise in price level as increase in aggregate demand
leads to utilization of unemployed resources without rise in the wage level. Since the
cost of production remains unaffected so long as the economy is operating in the
horizontal section of AS, the price level remains unchanged. Thus an increase in RGDP
may not be accompanied by rising price levels.
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An increase in GDP results of a change in aggregate demand. An increase in output occurs from
an increase in productivity, that means less inputs and less cost could be with more outputs.
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AP Macroeconomics Page 2 of 5 Assignment: Apply the Keynesian
Model to AD/AS
2. A typical AS curve has three parts: a flat, horizontal portion at low levels of output, a
middle section with a more-or-less gentle upward slope, and a steep or vertical portion
at high levels of output. Let’s consider two of these parts individually, the horizontal
portion and the vertical portion.
A. Imagine that AS and AD intersect in the horizontal portion of the AS curve. Assume a
technological breakthrough increases the full-employment level of RGDP and shifts the AS
curve to the right. In this case, when aggregate supply increases, how does the output of
the economy change? Does supply create its own demand? (5 points)
As AS shifts outward from AS0 to AS1, AD remains unchanged at AD0. Price level remains
same at P0 and equilibrium output remains same at Y0.
So, there is no change in supply and therefore, supply is not created at its own demand.
B. Imagine that AS and AD intersect in the horizontal portion of the AS curve. In this
case, if aggregate demand increases, how does the output of the economy change? Does
demand drive the economy here? (5 points)
In this case, 3 situations may emerge based on magnitude of increase in AD (how much AD
shifts rightward).
If AD shifts rightward at the horizontal area, price is unchanged at P0 and output will
increase.
When AD shifts outward from AD0 to AD1 in the upward sloping region, price increases to
P1 > P0 and equilibrium output increases from Y0 to Y1.
When AD shifts to AD2 in the vertical area, output increases to Y2, price is P2 > P1 and
output is further higher at Y2.
So, economic equilibrium depends on the position of aggregate demand curve which
determines price and output. So this is a demand driver situation.
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AP Macroeconomics Page 3 of 5 Assignment: Apply the Keynesian
Model to AD/AS
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C. Imagine that AS and AD intersect in the vertical portion of the AS curve. In this case, if
aggregate demand increases, how does the output of the economy change? Does
demand drive the economy here? (5 points)
As AD shifts upward and right from AD0 to AD1, only the price level increases, but output
is unchanged at Y0. Demand drives the economy only to the extent of a price change, but
output is not demand driven.
D. Imagine that AS and AD intersect in the vertical portion of the AS curve. Assume a
technological breakthrough increases the full-employment level of RGDP and shifts
the AS curve to the right. In this case, when aggregate supply increases, how does
the output of the economy change? Does supply create its own demand? (5 points)
When AS increases, the AS curve shifts rightward from AS0 to AS1. Price falls from P0 to
P1 and output increases from Y0 to Y1. Therefore, an increase in AS has increased the
equilibrium output by lowering price. Supply has created its own demand.
E. Which part of the AS curve is consistent with the Keynesian model, and which part of
the AS curve is consistent with the classical model? (2 point)
The horizontal portion of the AS curve indicates that prices are sticky in the short run, and is
the Keynesian range.
The vertical portion reflects full price flexibility and is the Classical range.
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AP Macroeconomics Page 4 of 5 Assignment: Apply the Keynesian
Model to AD/AS
3. Aggregate expenditure equals the sum of consumption, investment, government
spending, and net exports. These are also the components of aggregate demand. The
aggregate expenditure model looks at the effects of changes in demand on income (Y),
assuming that the price level does not change. Likewise, in the flat or Keynesian portion
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of the AS curve, the price level will not change when output changes.
A. In an AE model with MPC = 0.80, the government increases spending by $100
million. What will be the increase in equilibrium Y in the Keynesian AE model? (6
points)
In an AE model with MPC equals 0.80, the increase in government expenditure will
lead to increase in Y. Formula used to calculate increase in Y is as follow:
Therefore, increase in Y will be $500 million
B. Say you have two graphs of an economy: a graph showing the Keynesian model
(as discussed in part A, above) and another showing the AD/AS model. In the
AD/AS diagram, the AD curve will shift to the right by the amount of the increase
in Y predicted by the Keynesian AE model. If the AD curve intersects the AS
curve in the flat, Keynesian portion of the AS curve, what will be the increase in
real output in the AD/AS model resulting from the $100 million increase in
government spending? (5 points)
Since, the intersection of AD and AS is at the flat part of the AS curve, it means that
price will not increase at all. And it leads to a full multiplier effect of the increase in
fiscal policy. No crowding out of the fiscal Expansion because price remains
constant.
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AP Macroeconomics Page 5 of 5 Assignment: Apply the Keynesian
Model to AD/AS
C. Continuing the line of questioning from part B, above, now say the AD curve
intersects the AS curve where the AS is vertical. What will be the increase in real
output in the AD/AS model resulting from the $100 million increase in government
spending? (5 points)
Now the equilibrium is stuck at the vertical part of the AS curve, this means that increase
in government spending will lead to increase in price only and no increase in GDP.
Full crowding out is present. In this case, an increase of government spending by $100
will lead to increase in prices only and the GDP.
Increase in Y is zero.
D. If the AD curve intersects the AS curve in the middle section of the AS curve, can
you calculate the increase in real output in the AD/AS model resulting from the
$100 million increase in government spending? If not, what additional information
would you need? (6 points)
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Lastly the equilibrium is struck at the upward sloping part of AS curve and it will lead to
partial crowding effect because in this case the price level rises and this price rises
will lead to change in rate of interest and this in turn affects the investment level in the
economy. So, this increase in Y will depend on the investment function and other
components affecting multipliers as well.
E. In general, what effect does the slope of the AS curve have on the size of the
change in real output due to an increase in autonomous expenditure in the AE
model? (5 points)
In general, if the slope of the AS curve is steeper, then an increase in AE has a smaller
effect on real output. If the slope of the AS is flatter, an increase in AE has a larger
effect on real output.
AE is an aggregate expenditure model, it is an addition of all planned expenditure and
also autonomous expenditure.
AS curve is aggregate supply curve,
Due to increase in autonomous expenditure AS curve will go up and also the real output
will increase.
This was practiced in stimulus packages all over the world after the 2008 recession.
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