Description
Review Questions: The Classical Model
1. In the Classical Model individuals only hold cash in order to satisfy the transactions demand
for money. Explain. What does this imply as far as the market for goods and services is
concerned?
2. With fully flexible wages, prices and interest rates the economy always settles at the full
employment level of GDP. Explain.
3. What form of unemployment is consistent with the Classical Model?
4. Provide a brief explanation of the Quantity Theory of Money.
5. Why is monetary policy ineffective to combat recession in the world of the Classical Model?ZOOM
Review Questions – GDP and Keynes
1. Consider an economy with three goods – wheat, flour and bread. Wheat and flour are
intermediate goods (non-durable capital goods) whereas bread is the only consumer good
and no inventory of any good is maintained.
i.
Assuming wages and profits are the only forms of income, construct an example
showing the payments of the producers of the three goods (including inter-
producer payments)
ii.
Calculate the GDP of this imaginary economy using the product, income and
expenditure methods. Explain how these methods deal with the problem of double
counting in the calculation of GDP.
2. Draw, label and explain the circular flow of income and expenditure.
3. With reference to the circular flow, explain the concept of an equilibrium level of GDP.
4. In the Keynesian system, what forces operate to restore GDP to its equilibrium value if
disequilibrium prevails?
5. Explain Keynes’ theory of the consumption function. What implications does the value of
the marginal propensity to consume have for the relationship between the amount of
savings and the level of income?
6. Why, in the Keynesian system, might the level of equilibrium GDP fail to coincide with
the level of GDP that ensures full employment in the labor market?
7. Explain the concept of the marginal efficiency of capital (use a numerical example if
required).
8. Using the concept of the MEC, explain why the level of investment expenditure shares a
negative relationship with the prevailing rate of interest in the Keynesian system.
9. Investment expenditure, for Keynes, is driven by animal spirits. Explain. What
implications does this have for the attainment of full employment equilibrium?
10. Distinguish between necessary and idle cash balances. Why, according to Keynes, do
individuals hold idle cash balances?
11. Derive the negative relationship between the amount of money held to satisfy the
speculative demand for money and the rate of interest. What implications does the
existence of this speculative demand for money have for attaining full employment?
12. Why, in the Keynesian system, does fiscal stimulus held in attaining full employment?
Explain with the aid of the Keynesian Cross.
13. Explain the working of the Keynesian multiplier.
Explanation & Answer
Attached.
1. In the Classical Model individuals only hold cash in order to satisfy the transactions demand
for money. Explain. What does this imply as far as the market for goods and services is
concerned.
Answer: This implies that when times wages as well as prices quickly go up. And when
times are bad, wages and prices freely adjust downwards.
2. With fully flexible wages, prices and interest rates the economy always settles at the full
employment level of GDP. Explain.
Answer: When circumstances causes the economy to fall below or exceed the nature level of
real GDP self-adjustment mechanism exist within the market system that work to bring the
economy back to the level of real GDP.
3. What form of unemployment is consistent with the Classical Model?
Answer: Voluntary unemployment.
4. Provide a brief explanation of the Quantity Theory of Money.
Answer: If an amount of money in economy doubles the level of prices doubles too that
causes inflation. Or if the supply decrease marginal value, the increase of money supply
causes prices to rise as it compensate for the decrease in money’s marginal value.
5. Why is monetary policy ineffective to combat recession in the world of the Classical
Model?ZOOM
Answer: The monetary policy becomes ineffective because the policymaker’s attempt to
influence nominal interest rates in the economy by altering the nominal money supply is
frustrated by private agents’ willingness to accept any amount of money at the current
interest rate.
Review Questions – GDP and Keynes
1. Consider an economy with three goods – wheat, flour and bread. Wheat and flour are
intermediate goods (non-durable capital goods) whereas bread is the only consumer good
and no inventory of any good is maintained.
i.
Assuming wages and profits are the only forms of income, construct an example
showing the payments of the producers of the three goods (including interproducer payments)
Answer:
ii.
Calculate the GDP of this imaginary economy using the product, income and
expenditure methods. Explain how these methods deal with the problem of double
counting in the calculation of GDP.
Answer: cost of intermediate goods or raw material used by a firm in making a product is
excluded and only the value added at each stage of production by every producing
enterprise (firm) is included. The value added is found out by subtracting the value of
inputs (intermediate goods which enter into final goods) from the value of output (final
goods) of a firm.
2. Draw, label and explain the circular flow of income and expenditure.
(Equilibrium in the Macroeconomy)
Three types of leakages from the spending stream: savings, taxes, and imported goods
and services. There are three types of injections as well: investment, government
spending, and exported goods and services. Equilibrium still requires that all income
be spent, either as consumption by households, investment by businesses, spending by
government, or exports to foreign countries. If all of the income is spent, then the
entire output that businesses have produced will be purchased. Total spending equals
total output and the economy is in equilibrium. If total output exceeds total spending,
then the economy cannot be in equilibrium since some of the output is unsold. In this
situation, businesses will react at least partially by reducing their output level, leading
to lower employment and a lower real GDP. If total spending exceeds total output,
then businesses will tend to increase output, as long as the economy is not at full
employment, leading to higher employment and a higher real GDP in the economy.
3. With reference to the circular flow, explain the concept of an equilibrium level of GDP.
Answer: Equilibrium still requires that all income be spent, either as consumption by
households, investment by businesses, spending by government, or exports to foreign countries.
If all of the income is spent, then the entire output that businesses have produced will be
purchased. Total spending equals total output and the economy is in equilibrium. If total output
exceeds total spending, then the economy cannot be in equilibrium since some of the output is
unsold. In this situation, businesses will react at least partially by reducing their output level,
leading to lower employment and a lower real GDP. If total spending exceeds total output, then
businesses will tend to increase output, as long as the economy is not at full employment, leading
to higher employment and a higher real GDP in the economy (Equilibrium in the
Macroeconomy).
4. In the Keynesian system, what forces operate to restore GDP to its equilibrium value if
disequilibrium prevails?
Answer: Dis...