Chapter 18: The Keynesian model with a

government and a foreign sector

1. Explain why government spending is regarded as autonomous in a Keynesian model with a
government sector. What determines government spending?

There is no systematic link between the level of economic activity and government spending.
Hence it is regarded as autonomous. Government spending is based on political decisions and is
not linked to the level of income in the economy.

1. How does government spending affect the level of aggregate autonomous spending Ā, the
multiplier α and the equilibrium income Y0 in the economy?

a) Government spending adds to the total (aggregate) autonomous spending in the economy.
This is a direct impact.

b) Because government spending is not related to the level of income, it does not affect the size
of the multiplier. Any government spending will be multiplied by the multiplier, but the size of
the multiplier is not affected by the level of government spending.

c) With the introduction of government spending G, the equilibrium level of income Y 0 increases.

2. Use equations to derive the equilibrium level of income in a closed economy that has a government
sector.

Y = A = C + Ī + G = C + cY + I + G
 Y – cY = C+I+G
Y(1–c) = C+I+G
Y = 1/1–c (C + I + G)
= αA

3. Distinguish between income and disposable income.

Disposable income is the income that taxpayers have at their disposal after their taxes have
been deducted. If my monthly income is R20 000 and I pay R2 000 in tax, then my disposable
monthly income is R18 000.

4. How do taxes affect the level of aggregate autonomous spending Ā, the multiplier α and the
equilibrium income Y in the economy?
 a) The introduction of taxes does not affect aggregate autonomous spending. However, it
does affect aggregate spending in an indirect way. For instance, a proportional income tax
reduces the disposable income of households and therefore also their consumption
spending, which forms part of aggregate spending in the economy. The introduction of a
proportional income tax thus reduces aggregate spending, ceteris paribus.

b) Taxes are a leakage or withdrawal from the circular flow of income and spending in the
economy. When autonomous spending increases, a multiplier process is set in motion. The
greater the leakages or withdrawals in each round, the smaller the multiplier becomes.
With the introduction of tax, an additional leakage or withdrawal is introduced and this
reduces the multiplier. Every additional unit of income that is generated during the
multiplier process first has to be taxed before any additional spending can occur.

c) With the introduction of taxes, the equilibrium level of income Y0 decreases.

5. Calculate the equilibrium level of income if C = R60 million, Ī = R280 million, Ḡ = R310 million, c =
0,75.

Y = A = 60 + 0,75Y + 280 + 310

 Y – 0,75Y = 650
0,25Y = 650
Y = 650/0,25
= 2600

6. Explain the difference between the multiplier without taxes and the multiplier with taxes and
comment on their relative sizes.

When there are taxes, they first have to be paid before spending can occur. In other words, taxes
reduce disposable income and therefore reduce the multiplier as well. In the formula for the
multiplier with taxes, the (1–t) indicates that taxes have to be deducted from every rand of
income before spending can occur. Once this has been done, the marginal propensity to
consume can be applied. Thus, the multiplier becomes 1/[1–c(1–t)] instead of 1/(1–c) (without
taxes).

7. What determines the demand for a country’s exports?

The demand for a country’s exports depends largely on the economic conditions in the rest of the
world, a country’s international competitiveness and exchange rates.

8. What do we mean when we say that exports are autonomous with respect to income Y?

There is no systematic relationship between the level of exports X and the level of income Y in
the domestic economy.

9. Discuss the important elements of the import function.

 The import function Z, resembles the consumption function in that it has an autonomous
component 𝑍̅, as well as an induced component mY, where m is the marginal propensity to
import. The import function may be written as:
Z = 𝑍̅ + 𝑚𝑌
Where the bar above the Z indicates autonomous imports and m indicates the portion of any
increase in domestic income that is spent on imports.

10. How does the inclusion of the foreign sector affect the level of aggregate autonomous spending Ā,
the multiplier α and the equilibrium income Y in the economy?

a) Exports are an autonomous injection and have to be added to the other components of
aggregate autonomous spending. Autonomous imports are a leakage and have to be
subtracted from the other components of aggregate autonomous spending.

b) Because exports are not related to the level of income, it does not affect the size of the
multiplier. However, the introduction of induced imports into the model reduces the size of
the multiplier. Induced imports are a leakage and are positively related to income.

c) With the introduction of the foreign sector, the equilibrium level of income Y0 may increase
or decrease depending on the position and slope of the net export function.

11. What determines the size of the multiplier in a Keynesian model that includes both a government
and a foreign sector?

The marginal propensity to consume (or to save), the tax rate and the marginal propensity to
import. In symbols: c, t and m.

12. Define fiscal policy. How does it differ from monetary policy? Who is responsible for each?

Fiscal policy is government’s policy with regard to government spending, taxation and borrowing.
Monetary policy, on the other hand, pertains to money, interest rates and exchange rates. Fiscal
policy is the responsibility of the Minister of Finance and the National Treasury, while monetary
policy is implemented by the South African Reserve Bank.

13. Explain how fiscal policy can be used to stimulate production and income in the economy.
Comment on the possible side-effects of such a fiscal policy.

In the Keynesian model, fiscal policy can be used in two ways to stimulate the economy.
Government spending, G, can be increased or the tax rate, t, can be lowered. Government
spending will have a direct impact on aggregate spending, while taxes will have an indirect
impact via disposable income (and the multiplier).
At present the assumption is that price level is fixed. As soon as this assumption is relaxed as in
Chapter 9, inflation enters the picture.

14. If C = R40 million, Ī = R280 million, Ḡ = R180 million, c = 0,875, t = 0,143 and Yf = R2 400 million,
by approximately how much must government spending be raised to achieve full employment?
 First calculate the equilibrium level of income Y0 = αA.
α = 1/(1–c(1–t)) = 1/(1–0,875(1–0,143)) = 1/(1–0,875(0,857)) = 1/(1–0,75) = 1/0,25 = 4
A = R40 m + R280 m + R180 m = R500 million
Y0 = αA = 4 x R50 0m = R2 000 million
Yf = R2 400 million
The gap is thus R400 million. Divide this by the multiplier (4) and the answer is that government
spending must be raised by R100 million to achieve full employment.

15. Explain the impact of contractionary fiscal policy in the Keynesian model.

In the Keynesian model, contractionary fiscal policy can be achieved in two ways. Government
spending, G, can be decreased or the tax rate, t, can be raised. Government spending will have
a direct impact on aggregate spending, while taxes will have an indirect impact via disposable
income (and the multiplier). The raising of t will reduce the multiplier and lower the equilibrium
level of income.

16. Define monetary policy.

Monetary policy may be defined as the measures taken by the monetary authorities to influence
the quantity of money or the rate of interest with a view of achieving stable prices, full
employment and economic growth.

17. How does the interest rate affect the decision to invest?

When firms have to borrow funds to finance investment spending, they have to pay interest on
these loans at the current interest rate. The higher the interest rate, the more expensive it will be
to finance investment and the smaller the chance that the expected yield on the capital goods will
exceed the financing cost.
When firms have funds available to finance investment, they have to consider the interest rate
that they could earn by acquiring other financial assets. This interest rate is the opportunity cost
of the investment. Thus, irrespective of whether the firm uses borrowed or own funds, the interest
rate is the opportunity cost of the investment.

18. Use the Keynesian model to explain how a decrease in the interest rate level will affect the income
level in the economy.

There is a negative relationship between interest rates (denoted as i) and Investment spending
(denoted as I). This relationship exists because lower interest rates translates into reduced costs
of borrowing (borrowing becomes cheaper). Once borrowing becomes cheaper more people
would be inclined to borrow more and as a result Investment spending increases.
We know that Investment (denoted as I) is a component of GDP using the expenditure method
(GDP= C + I + G + (X-Z)). As a result, when investment increases it increases autonomous
expenditure (on the vertical axis). This shift is parallel since no changes have been made to the
coefficients.
 The final effect is a shift from Y0 to Y1 (denoting the level of income in the economy) as a
decrease in interest rates leads to an increase in investment and an increase in income level in
the economy.

19. Use a diagram to illustrate the impact of an increase in investment on the equilibrium level of
income. Comment on the relative sizes of the changes.

An increase in investment will increase autonomous expenditure, which is illustrated by a parallel

upward shift of the expenditure function. This increase sets in motion the multiplier process which
results in an increase in production and therefore an increase income. This increase is greater
than the initial increase in investment.