Chapter 18: Problem 1

Discuss the aggregate demand-aggregate supply approach to the determination of the equilibrium income and output in the Keynesian theory.

Short Answer

Expert verified

Question: Explain the aggregate demand-aggregate supply approach to determining the equilibrium income and output in the Keynesian theory. Answer: In the Keynesian theory, the equilibrium income and output are determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves. Aggregate demand represents the total expenditure on goods and services in an economy, while aggregate supply represents the total output of goods and services produced. The equilibrium point is where the total expenditure (AD) is equal to the total output (AS). Policymakers can use fiscal and monetary policies to influence AD or AS in order to achieve desired economic objectives, such as stimulating economic growth during a recession or stabilizing the economy during inflation.

Step by step solution

1. Understanding Aggregate Demand (AD)

Aggregate demand represents the total expenditure on goods and services in an economy during a specific period. It is the sum of consumption expenditure (C), investments expenditure (I), government expenditure (G), and net exports (exports minus imports, X-M). Mathematically, it is expressed as: AD = C + I + G + (X - M) In the Keynesian theory, aggregate demand is influenced mostly by consumption and investment expenditures, which are affected by various factors such as income, interest rates, and expectations of future economic growth, among others.

2. Understanding Aggregate Supply (AS)

Aggregate supply represents the total output of goods and services produced in an economy during a specific period. In the Keynesian model, aggregate supply is mainly determined by the level of production capacity and resources available in an economy, including labor, capital, land, and technology. The Keynesian aggregate supply curve is flat, meaning that firms will supply whatever amount of goods and services demanded at a given price level, as long as they have unused capacity. When the economy is operating at full capacity, the aggregate supply curve becomes vertical.

3. The Aggregate Demand-Aggregate Supply Model

The AD-AS model is a graphical representation of the relationship between aggregate demand and aggregate supply. On the vertical axis, we have the price level, and on the horizontal axis, we have the level of real income or output (usually represented as Real GDP). The AD curve is downward sloping, representing the negative relationship between income and the price level. The AS curve, in the Keynesian model, is flat until the economy reaches its full potential output (potential GDP), at which point it becomes vertical.

4. Finding the Equilibrium Income and Output

The equilibrium income and output in the Keynesian theory is determined by the intersection of the aggregate demand and aggregate supply curves. At this point, the total expenditure on goods and services in the economy (AD) is equal to the total output of goods and services (AS). To find the equilibrium income and output, we can solve the equation: AD = AS By substituting the components of AD and AS, and solving for the equilibrium level of income or output, we can determine the point at which the economy is in equilibrium.

5. Policy Implications

Understanding the aggregate demand-aggregate supply approach to determination of equilibrium income and output in the Keynesian theory helps policymakers to formulate policies that can influence AD or AS in order to achieve desired economic objectives. For example, if the economy is experiencing a recession due to insufficient aggregate demand, expansionary fiscal or monetary policies can be employed to increase demand and stimulate economic growth. On the other hand, if there is excessive aggregate demand leading to inflation, contractionary fiscal or monetary policies can be used to reduce demand and stabilize the economy.