In the Keynesian framework, which of the following events might cause a recession? Which might cause inflation? Sketch AD/AS diagrams to illustrate your answers. a. A large increase in the price of the homes people own. b. Rapid growth in the economy of a major trading partner. c. The development of a major new technology offers profitable opportunities for business. d. The interest rate rises. The good imported from a major trading partner become much less expensive.

Understanding the Keynesian framework starts with the core concept of Aggregate Demand and Supply (AD/AS), which is crucial for analyzing the overall economic activity. Aggregate Demand (AD) represents the total demand for goods and services within an economy at a given overall price level and at a given time. Conversely, Aggregate Supply (AS) represents the total supply of goods and services that firms in an economy plan on selling during a specific time period.

When AD increases, which can arise from factors like increased consumer spending or higher investment, it can lead to economic expansion and potentially inflation if the supply does not keep up. On the other hand, if AD decreases due to lower spending or investment, it might result in a downturn or recession. The AD/AS model is depicted in diagrams where the AD curve is generally downward sloping while the AS curve can be upward sloping, flat, or vertical.

Shifts in these curves can indicate different economic scenarios, such as inflation with a rightward shift of AD or recession with a leftward shift of AD, whereas shifts in the AS curve can suggest changes in the productive capacity of the economy.

The Wealth Effect is an economic theory suggesting that when the value of assets, like property or stocks, increases, individuals feel more prosperous. This perceived increase in wealth often leads consumers to spend more, since they feel richer than before, even if their income has not changed.

Real-Life Implications

In practice, a large increase in home prices, for instance, might make homeowners feel wealthier and encourage them to increase their consumption. This uptick in spending can, in turn, drive up Aggregate Demand (AD) in the economy, which—without a corresponding increase in Aggregate Supply (AS)—could lead to a rise in the general price level, or inflation. This concept helps to explain how changes in the value of assets can have tangible effects on consumer spending and broader economic conditions.

Net Exports, which are the difference between a country's exports and imports, play a significant role in its economic growth. When a country's exports exceed its imports, it has a trade surplus, and net exports are positive; conversely, when imports are greater than exports, it is a trade deficit, and net exports are negative.

Growth in the economy of a major trading partner can be beneficial for a country's exports, as the trading partner may increase their importation of goods and services due to their own growth-induced demand. This can raise the exporting country's net exports and contribute positively to its AD. An increase in net exports elevates AD, possibly leading to higher economic growth rates and inflationary pressures if the AD increases move beyond the economy's capacity to produce goods and services.

Interest rates exert a powerful influence on investment and economic activity. When interest rates rise, borrowing costs increase, making loans for homes, cars, and business investments more expensive. As a result, both consumers and businesses may cut back on spending and investment, leading to a decrease in Aggregate Demand (AD).

This reduction in AD can slow economic growth and, in more severe cases, trigger a recession characterized by lower output and employment. Furthermore, when the cost of borrowing increases, businesses may delay or reduce investing in new technologies or expansion efforts, which could hinder long-term economic growth and innovation. Conversely, low-interest rates typically encourage more investment and spending, contributing to economic expansion.