Question

In a closed economy Keynesian Cross framework show how a decline in investment will lead to a fall in income. Explain the role of the consumption function and the multiplier in this process.

Answer 1

In a closed economy Keynesian Cross framework, the investment level is independent of the National Income and the Investment line is the flat horizontal line with income on X-axis.

The investment level affects the national income through aggregate Expenditure.

Aggregate Expenditure in a closed economy Keynesian Cross framework is defined as follows:

AE = C + I + G + NX

where C = consumption

I = investment

G = government spending

NX = Net Exports

Equilibium in the Keynesian Cross Model is determined where AE = Y. A fall in the investment level leads to fall in the AE. Consequnetly, the AE curve shifts down and intersect the Y curve at a lower level. At the new level, the National Income decreases.

Hence, Lower investment level leads to lower income.

Consumption Function is defined as follows:

C = a + MPC*Yd

where Yd = disposable income

and Multiplier = 1 / (1-MPC)

Consumption function is used to observe the MPC and the multiplier value.

Mutliplier tells us by how much the income is changed due to change in the investment level by 1 unit. So, any change in the investment level is the multiple of some value for a change in the income.

Multiplier helps in reaching to an equilibrium income level with a slight increase in investment level. It will tell by how much the income will reduce due to fall in investment.