Question

Using the simple Keynesian model and starting in equilibrium, explain what will happen to E (Expenditures), the relationship between AI (Actual Inventories) and OI (Optimal Inventories), and Y (Real GDP) as a result of taxes declining. In the process of answering the question, explain the equilibrating process in the model.

Please provide graphs/diagrams along with your explanation.

Answer 1

The initial equilibrium in the economy occurs at point E1. where Y1* is the level of real GDP in the economy. As taxes decline , the level of consumption expenditure increases due to increase in disposable income and thus aggregate expenditure curve shifts upwards which leads to actual inventories being less than optimal inventories at the initial level of output , thus at new equilibrim E2, the level of equilibrium level of National Output will increase to OY2.