We will now look at another theory of economics called Keynesian economics. Once again, we will start the economy in a recession which is identified as price level one and quantity level one. According to Keynes, with unemployment in the economy, Government needs to increase aggregate demand by lowering taxes and increasing spending. By lowering taxes consumers have more disposable income, which means they will have more income to spend on different products; therefore, their consumption will increase. A new equilibrium will be achieved with higher price levels and greater output.
If we start with the economy experiencing high inflation, once again identified by price level one and quantity one, according to Keynes inflation is the biggest problem in the economy, and the government needs to decrease aggregate demands by increasing tax levels and decreasing government spending. By increasing taxes, consumers will have less disposable income, which means their consumption will decrease. A new equilibrium will be achieved with a lower price level and a smaller output.
