1. 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?

2. 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)

3. 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:

4. 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.

5. 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:

6. 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.

7. 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.

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

9. 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?

10. 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

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

12. 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

13. 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!

14. 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

15. 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!