Question

Keynes determined the equilibrium state of aggregate demand. What does equilibrium mean by aggregate demand? If the government cuts taxes, how will equilibrium aggregate demand change? Use IS LM model and PD-GS model to illustrate.

Answer 1

The Keynesian theory starts with the point of effection demand.Effective demand is obtained when aggregate demand equals the aggregate supply.Thus ,this point of intersection is the equilibrium point.Aggregate demand price is a schedule of proceeds expected from the sale of output resulting from varying amounts of employment.Therefore according to Keynes, the actual amount of employment in an economy is determined by the intersection of aggregate demad(ADF) and aggregate supply(ASF) or at this equilibrium point.Aggregate demand depends on the consumption funtion and investment function.The level of employment can be increased by raising either consumption expenditure or investment expenditure or both.Thus it is the aggregate demand price which is the effective element in the principle of effective demand.

In the given figure,E represents the equilibrium point or the effective demand where the aggregate demand and aggregate supply intersects.

A cut in taxes or an increase in the government spending leads to a rise in consumer spending .Government spending is one of the important components of aggregate demand.Thus higher the government spending or reduction in taxes will cause the aggregate demand curve to shift to the right.

The figure represents the IS-LM and PS-GD model for the shift in aggregate demand curve.The IS-LM stands for "investment savins-liquidity preference -money supply".Here the initial equilibrium is at point E and a futher increase in government spending or fall in the taxes leads to a rightward shift in the demand curve.Hence, the new equilibrium is at point E₁.

The determination of income can also be represented using a formula.Here ,let us go through a three sector model.Income is the sum of consumption , investment and government expenditure(Y=C+I+G).Since consumption depends on disposable income ,it is represented as C=a+b(Y-T_n).Therefore the equation is as follows.