Keynesian Economics

• A. 1919
• B. 1929
• C. 1936 ✓
• D. 1945

Why: The General Theory was published in 1936. It challenged classical economics by arguing that aggregate demand can remain persistently below full employment levels.

• A. The hyperinflation in Germany
• B. The Great Depression ✓
• C. The oil crisis of the 1970s
• D. The dot-com bubble

Why: The Great Depression, with its massive unemployment and falling output, showed that markets did not self-correct quickly, which motivated Keynes's argument for active government intervention.

• A. Changes in aggregate demand ✓
• B. Changes in the money supply only
• C. Changes in population growth
• D. Changes in technological innovation

Why: Keynes argued that shifts in aggregate demand, driven largely by volatile business investment and consumer spending, cause short-run fluctuations in output and employment.

• A. Government regulations on farming
• B. Spontaneous optimism and emotional impulses that drive investment decisions ✓
• C. The natural instincts of consumers to save
• D. Animal-based commodity prices

Why: Keynes used 'animal spirits' to describe the spontaneous, sometimes irrational confidence and emotion that influence business investment, which he saw as a key source of economic instability.

• A. Reduce spending to balance the budget
• B. Increase public spending or cut taxes to boost aggregate demand ✓
• C. Raise interest rates sharply to attract foreign capital
• D. Wait passively for markets to self-correct

Why: Keynes advocated countercyclical fiscal policy: during recessions, governments should increase spending or reduce taxes to raise aggregate demand and reduce unemployment.

• A. Excessive government spending that crowded out private investment
• B. A deficiency of aggregate demand, so total spending fell short of what was needed to employ the economy's workers ✓
• C. Rising wages that made labor too expensive for firms to hire
• D. An overabundance of money supply that caused runaway inflation

Why: Keynes argued that the Depression resulted from insufficient aggregate demand (consumption plus investment plus government spending plus net exports). When spending is too low, firms cut production and employment, and the economy can remain stuck below full employment without intervention.

• A. The total quantity of goods and services that households, firms, government, and foreign buyers wish to purchase at a given price level ✓
• B. The total amount of money held by commercial banks as reserves
• C. The total wages paid to all workers in an economy during a year
• D. The total output of a single industry, such as manufacturing

Why: Aggregate demand is the total planned spending on final goods and services across all sectors of the economy at a given price level. Keynes focused on this measure because fluctuations in it drive changes in output and employment in the short run.

• A. Saving is always beneficial for individuals, but it can reduce total income and output for the economy when everyone saves more at once ✓
• B. Spending money during a recession always lowers unemployment
• C. Lower interest rates always increase household savings
• D. Governments should always balance their budgets regardless of economic conditions

Why: The paradox of thrift holds that an individual who saves more is prudent, but if everyone increases saving simultaneously, aggregate demand falls. Lower spending reduces firms' sales and incomes, which can lower total saving as well, so the economy contracts.

• A. Reducing government spending to restore business confidence
• B. Increasing government spending and, if needed, running budget deficits to boost aggregate demand ✓
• C. Allowing wages and prices to fall until the market self-corrects
• D. Raising interest rates to attract foreign capital

Why: Keynes advocated active fiscal policy, including increased government spending and deficit financing during recessions, to fill the gap in private demand. This injection of spending raises incomes and encourages further private spending through the multiplier effect.

• A. The process by which an initial change in spending leads to a larger total change in national income ✓
• B. The ratio of a country's exports to its imports
• C. The increase in interest rates caused by rising government debt
• D. The percentage of the population that is employed

Why: When government or private spending rises, the income it creates is partly spent again by recipients, generating successive rounds of spending. The cumulative effect on national income is larger than the initial injection, which is why fiscal stimulus can have a magnified impact on output.

• A. The tendency of prices to rise faster than wages during inflation
• B. The process by which an initial change in spending leads to a larger total change in national income ✓
• C. The ratio of government debt to GDP
• D. The number of firms that enter a market when profits are high

Why: The multiplier effect describes how an initial injection of spending circulates through the economy: one person's spending becomes another's income, which is partly spent again, so the total increase in income exceeds the initial amount.

• A. 0.8
• B. 1.25
• C. 4
• D. 5

• A. A higher marginal propensity to consume
• B. A higher marginal propensity to save ✓
• C. A decrease in income tax rates
• D. An increase in transfer payments to households

Why: A higher marginal propensity to save means households spend less of each additional dollar of income, so less money re-enters the spending stream in each round, shrinking the multiplier.

• A. $33 million
• B. $100 million
• C. $300 million ✓
• D. $103 million

Why: National income change equals the multiplier times the initial change in spending: 3 × $100 million = $300 million.

• A. Because spending always rises exactly in proportion to income
• B. Because leakages such as taxes, savings, and imports reduce the amount of spending recirculated in each round ✓
• C. Because the government always offsets any spending increase immediately
• D. Because consumers never change their spending habits

Why: Leakages like taxes, saving, and imports remove money from the circular flow of spending in each round, so each successive round is smaller and the total multiplier effect is limited.

• A. The fraction of total income that is saved
• B. The fraction of an additional dollar of income that is spent on consumption ✓
• C. The total amount of consumption spending in an economy
• D. The ratio of investment to consumption

Why: The MPC measures how much of each additional unit of disposable income households spend on consumption, calculated as the change in consumption divided by the change in income.

• A. 0.2 ✓
• B. 0.8
• C. 1.8
• D. 0.08

Why: In Keynesian models, each additional dollar of income is either consumed or saved, so MPC + MPS = 1. Therefore MPS = 1 - 0.8 = 0.2.

• A. The interest rate
• B. The money supply
• C. Current disposable income ✓
• D. Government debt levels

Why: Keynes argued that current disposable income is the main determinant of consumption, with households spending a large portion of any income change.

• A. C = a + bY, where a is autonomous consumption and b is the MPC ✓
• B. C = Y - S, where S is the interest rate
• C. C = bY / a, where a is the savings rate
• D. C = I + G, where I is investment and G is government spending

Why: The consumption function C = a + bY expresses consumption as autonomous consumption (a, spending independent of income) plus a fraction b (the MPC) of income Y.

• A. Saving more always increases economic growth
• B. If everyone saves more at the same time, total income may fall, reducing total savings ✓
• C. Saving should be discouraged in all economic conditions
• D. Investment rises automatically when households save more

Why: The paradox of thrift holds that when all households increase saving simultaneously, aggregate demand falls, lowering output and income, which can leave total saving unchanged or even lower.

• A. To reduce the national debt by cutting government spending
• B. To increase aggregate demand by raising government spending or lowering taxes ✓
• C. To control inflation by reducing the money supply
• D. To increase interest rates to attract foreign investment

Why: Keynesian theory holds that recessions stem from insufficient aggregate demand. Expansionary fiscal policy, through higher government spending or tax cuts, injects demand into the economy to restore output and employment.

• A. The ratio of government debt to GDP
• B. The total change in GDP resulting from a one-unit change in government spending ✓
• C. The percentage of tax revenue spent on public goods
• D. The interest rate charged on government bonds

Why: The spending multiplier measures how much total output changes for each dollar of government spending. Because spending becomes someone else's income, which is partly spent again, the effect on GDP can exceed the initial outlay.

• A. A congressional vote to approve a new infrastructure bill
• B. Unemployment benefits that rise automatically during a downturn ✓
• C. A central bank decision to lower interest rates
• D. A one-time stimulus check sent to households

Why: Automatic stabilizers are features of the tax and transfer system that adjust without new legislation. Unemployment benefits increase as joblessness rises, supporting disposable income and dampening the downturn.

• A. Tax cuts always increase inflation more than spending does
• B. Some of the money from tax cuts may be saved rather than spent by households ✓
• C. Tax cuts can only be applied to businesses, not individuals
• D. Government spending has no effect on aggregate demand

Why: Households receiving tax cuts may save a portion of the extra income, so less of it flows into spending immediately. Direct government purchases inject demand fully into the economy, usually producing a larger immediate effect.

• A. Government spending pushes private borrowers out of credit markets by raising interest rates ✓
• B. Tax revenue falls so sharply that the government cannot pay its employees
• C. Foreign governments refuse to buy domestic government bonds
• D. Consumer spending becomes so high that it causes unemployment

Why: When government borrowing increases demand for loanable funds, interest rates may rise, reducing private investment. This offset to the stimulus is the crowding out effect, a key debate in evaluating fiscal policy.

• A. A situation where the central bank raises interest rates to control inflation
• B. A situation where interest rates are near zero and monetary policy becomes ineffective at stimulating spending ✓
• C. A situation where banks hold excess reserves and the money supply grows rapidly
• D. A situation where government spending crowds out private investment entirely

Why: A liquidity trap occurs when nominal interest rates are at or near zero, so further increases in the money supply fail to lower rates or stimulate investment, because people prefer to hold cash rather than bonds.

• A. Because they expect interest rates to fall further, making bonds less attractive to hold ✓
• B. Because inflation is rising rapidly and they want to protect purchasing power
• C. Because the government requires citizens to hold a minimum cash balance
• D. Because banks refuse to accept deposits when rates are low

Why: Keynes argued that when interest rates are very low, people expect them to rise (meaning bond prices will fall). Holding cash avoids this capital loss, so they hoard money rather than lend or invest it, even as the money supply expands.

• A. Open market purchases of government bonds by the central bank
• B. Lowering the discount rate charged to commercial banks
• C. Reducing the target for the short-term policy interest rate below its current level ✓
• D. Expansionary fiscal policy through government spending

Why: Once the policy rate is already near zero, the central bank cannot push it much lower, so conventional rate cuts lose their power. This is why Keynesians often recommend fiscal policy instead.

• A. Reducing government spending to balance the budget and restore confidence
• B. Relying solely on the central bank to expand the money supply further
• C. Using expansionary fiscal policy, such as increased government spending or tax cuts ✓
• D. Raising interest rates to attract foreign capital inflows

Why: Because monetary policy loses traction at the zero bound, Keynes advocated fiscal stimulus to boost aggregate demand directly, supplying the spending that private investors and consumers are not providing.

• A. It rises sharply as people spend money quickly to avoid inflation
• B. It falls because people hold onto money instead of spending or lending it ✓
• C. It remains constant regardless of changes in interest rates
• D. It becomes negative as banks start charging depositors fees

Why: During a liquidity trap, money circulates more slowly because people hoard cash. A falling velocity offsets the effect of a larger money supply, so the expansion fails to raise spending and output.

• A. Milton Friedman
• B. Robert Lucas ✓
• C. Arthur Pigou
• D. Joan Robinson

Why: Robert Lucas argued in his 1976 critique that policy evaluations based on historical econometric relationships fail when agents change their behavior in response to new policies, and that Keynesian models lacked consistent microfoundations.

• A. Consumption depends mainly on current disposable income alone
• B. Temporary tax changes have little effect on consumption because people base spending on long-run expected income ✓
• C. Government spending always crowds out private investment one-for-one
• D. The velocity of money is perfectly stable over time

Why: Friedman argued that consumers smooth spending based on expected permanent income, so temporary changes in taxes or transfers have a weaker effect on consumption than simple Keynesian multiplier models assumed.

• A. Inflation and unemployment should move in the same direction
• B. A stable money supply would always eliminate inflation
• C. Inflation and unemployment should trade off against each other via the Phillips curve ✓
• D. Fiscal policy would have no effect on output

Why: The original Phillips curve implied a stable inverse relationship between inflation and unemployment, so experiencing both high at once contradicted the simple Keynesian trade-off.

• A. Real output and employment permanently
• B. Only the price level, with no lasting effect on real output ✓
• C. The distribution of income between wages and profits
• D. The level of government debt directly

Why: Friedman argued the economy returns to its natural rate of unemployment in the long run, so money growth mainly changes prices rather than the sustained level of real output.

• A. Perfect information and instant market clearing
• B. Nominal rigidities such as sticky prices and wages ✓
• C. Fixed exchange rates under all conditions
• D. Complete absence of expectations in decision-making

Why: New Keynesian economists built microfoundations around nominal rigidities, such as menu costs and long-term contracts, to explain why the economy can deviate from full employment in the short run.