If an economy is experiencing both full employment and price stability, within the Keynesian model, a major tax reduction probably would cause
A) an increase in unemployment in the near future.
B) an increase in the general level of prices unless government expenditures are also reduced.
C) an increase in the interest rate since individuals will reduce their savings in response to the tax cut.
D) a decrease in consumption unless the expected budget deficit is financed by selling bonds to foreigners.

Question

Quizplus · Accepted Answer

According to the Keynesian model, an increase in aggregate demand caused by a tax reduction would result in an increase in the general level of prices, also known as inflation. This would happen unless there is an accompanying reduction in government expenditures or an increase in productivity to offset the increase in demand. Full employment means that there are no available workers, so an increase in demand in the short run would not lead to an increase in employment. The interest rate may increase if there is increased demand for borrowing due to the tax cut, but this alone would not cause a decrease in consumption. Selling bonds to foreigners to finance the deficit is not directly related to the impact of a tax cut on the economy.

If an Economy Is Experiencing Both Full Employment and Price