Question

In the Keynesian Cross model an increase in government spending leads to an increase in income that is a multiple of the increase in spending. Explain why. Why is the increase in equilibrium income following a change in G less than what the Keynesian Cross model predicts in the full IS-LM model? (Hint for this last part: what is the horizontal shift in IS following a change in G?)

Answer 1

Increase in government spending increases the income by multiple times. this happens because of the multiplier effect of initial increase in government spending. Note that when government spending increases aggregate demand increases initially with the size of increase in government spending. But due to the marginal propensity to consume, keeping a fraction of the interest income as saving, the remaining is again consumed which increases the aggregate demand again. due to this reason there is multiple increases in the aggregate demand which causes the real income to increase multiple times the initial increase in government spending

Increase in equilibrium income due to increase in government spending is generally less than what is predicted by the IS LM model. This is because there is is an upward sloping aggregate supply function in the goods market. Some of the increase in the aggregate demand is absorbed by higher price level. due to this reason the final increase in income due to increase in government spending is less than what is predicted by the model.