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Chapter 18 p534 1.What is the key assumption of the basic Keynesian model? Explain why this assumption is needed if one is to accept the view that aggregate spending is a driving force behind short-term economic fluctuations.

The Keynesian model shows how fluctuations in planned aggregate expenditure can cause actual output to differ from potential output. This method is necessary because if it were not used companies would have to change prices every time there was a possible change in demand or quantity shift in inventory. With this method short term economic flux can happen when the a company does shift their price to meet demand.

3. Define planned aggregate expenditure and list its components. Why does planned spending change when output changes relatively infrequently. What accounts for the difference?

This is a total planned spending on goods and services including; consumption, investment, government purchases and net ports. If spending change happens infrequently then added goods go into inventory causing company to spend capital on invested inventory. Consumption function accounts for the difference between changes in expenditure.

Chapter 19

1. Why does the real interest rate affect planned aggregate expenditure? Give examples.

Because the raising or lowering affects the cost of borrowing, which affects consumption and planned investment (which all is a part of aggregate expenditure). If the Fed raises rates the housing market will slow down buying. If the Fed lowers rates more people are likely to buy homes and refinance.

2. The Fed faces a recessionary gap. How would you expect it to respond? Explain step by step how its policy change is likely to affect the economy.

The Fed’s position is to eliminate output gaps and maintain low inflation. To eliminate a recessionary output gap, the Fed will raise the real interest rate.

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