Determination Of Equilibrium Level Of Income (Y) Or Spending Balance of The Economy In simple Keynesian Model, the economy is in (short - run) equilibrium whenever Y = AD. However if Y > AD (Excess supply) or Y< AD (Excess demand) The economy is not in (short- run) equilibrium. (it is in disequilibrium) If the economy finds itself in disequilibrium, how does it come to equilibrium?

If Y > AD Excess supply of output  Inventory Accumulation  This gives signal to firms to reduce production  lay-off some workers (unemployment increases) Y decreases  This continues until Y = AD. (Equilibrium) If Y < AD  Excess demand of output  Inventories deaccumulate  This gives signal to firms to increase production  hire new workers (or make existing workers work longer hours) Unemployment decreases  Y increases  This continues until Y = AD (Equilibrium)

Now we want to show this graphically and understand better the dynamics of adjustment to a new point of equilibrium from an old point of equilibrium:

The Case of Fiscal Policy Suppose that we want to analyze the impact of Expansionary Fiscal Policy on the equilibrium values of Y, C, S, T, M, B.D (Budget deficit), I and X (Net Exports) of the economy: We will show it graphically and also understand the impact of such a policy intuitively based on the theoretical relationships that we developed.

In the Framework of Simple Keynesian Model Expansionary Fiscal Policy: Instruments: An increase in G or a decrease in t or both (at the same time) Contractionary Fiscal Policy: Instruments: A decrease in G or an increase in t Let’s analyze the impact of Expansionary Fiscal Policy conducted by INCREASING G:

Economic Rationale of the Adjustment Mechanism Assuming that initially the economy is in equilibrium; an increase in G Increase in AD Y < AD  Excess Demand for output  inventories deaccumulate  gives signal to firms to increase output (Y)  firms hire more labor  output increases (Y increases)continues until Y = AD again.

Economic Rationale of the Adjustment Mechanism (Cont’d) However as Y increases C, S, T and M all increase as well! WHY? Because C = f (Y), T = f (Y) S = f (Y), M = f (Y) in our Keynesian Model. What happens to Investment (I)? If I is autonomous of Y (as we assumed) there is no change in I.

However since M increases as Y increases, X decreases because X = g – mY where g=Exports And M (imports)= mY!

How about BUDGET DEFICIT of the government? BD = G – T If G > T  BD > 0 (Budget deficit) If G < T  BD < 0 (Budget surplus) As G increases, initially BD increases ( or B. Surplus decreases) But as Y increases this increases T leading to a decrease in BD. So the net effect of an increase in G and BD is ambiguous. So what are the net effects of an increase in G?

Net effects of an increasing G Equilibrium values of Y, C, S, M, T all increase relative to their levels at the initial equilibrium point. Unemployment decreases, Net Exports (X) decrease, (Trade balance deteriorates) Net ∆ in BD is ambiguous

WE NOTE THAT: Adjustment mechanism in response to other types of shocks such as changes in other autonomous components of AD is exactly same

HOME-WORK Analyse the impact of each one of the following on equilibrium levels of Y, C, S, I, T, B.D, X, M and unemployment

HOME-WORK (Cont’d) An increase in Autonomous part of consumption expenditures An increase in foreign demand for exports A decrease in G An increase in Investment Spending due to more optimistic expectations about the future A decrease in t (income tax rate) Use graphs and explain the economic rationale of the adjustment mechanism and the net effects!

CASE 2: The impact of Contractionary Fiscal Policy (Case of increase in t) Step by step explanation of adjustment mechanism Higher t  higher tax payments by households (T increases)  A decrease in Disposable Income (Yd)  lower C (and lower S) A decrease in AD Excess Supply of output (Y > AD) Inventory Accumulation  gives signal to firms to decrease Y and lay-off workers Y decreases and unemployment increases  As Y decreases, C, S, T, M decrease This process continues until Y=AD Converges to new equilibrium Now we show this adjustment graphically on blackboard

NET EFFECTS OF AN INCREASE IN INCOME TAX RATE (t) Y decreases, Unemployment Increases C and S decreases (as Y decreases!) M decreases and X increases Net ∆ in T is ambiguous; Because initially T increases but later on as Y decreases T decreases! Therefore Net ∆ in B.D is ambiguous! If I is autonomous of Y (as we assumed) we have NO ∆ in I!