The Keynesian explanation of macro instability requires government intervention to shift the aggregate demand curve to the desired rate of output. The government can do this by balancing aggregate spending with the economy's full-employment potential.
To boost aggregate demand, the government may either increase its own spending or cut taxes. To restrain aggregate demand, the government may reduce its own spending or raise taxes.
Any change in government spending or taxes will have a multiplied impact on aggregate demand. The additional impact comes from changes in consumption caused by changes in disposable income.
The marginal propensity to consume tells how changes in disposable income affect consumer spending. The MPC is the fraction of each additional dollar spent (i.e., not saved).
The size of the multiplier depends on the marginal propensity to consume. The higher the MPC, the larger the multiplier, where the multiplier = 1/(1 - MPC).
Fiscal stimulus carries the risk of inflation. The steeper the upward slope of the AS curve, the greater is the risk of inflation.
A balanced budget is appropriate only if the resulting aggregate demand is compatible with full employment and price stability. Otherwise, unbalanced budgets (deficits or surpluses) are appropriate.
