Question

PROBLEM: The simple Keynesian model (SKM) implies that the government can boost GDP in the short-run by raising planned expenditure (E) on "G" since output (Y) must equal E = C+I+G. Keynes recognised that additionalE from any sources would increase the demand for money. Consequently, he had a separate money market to show how a fiscal expansion would increase the interest rate. A theoretical problem arises if we also allow the negative feedback from a higher interest rate (r) on private investment expenditure by settingI = I (r) such that if r increases, thenI decreases. It concerns potential inconsistency between balancing E and Y in the SKM and ensuring the money market balance.

Identify the theoretical problem precisely in your words. Explain how the Hicksian IS-LM model solves this theoretical PROBLEM.  

(Word Limit = 300)

Answer 1

In simple Keynesian model, an increase in government spending increases expenditure but due to this fiscal expansion , demand for money increase given the supply of money which leads to increase in interest rate in money market. Thus , part of the increase in government spending is offset by a decrease in investment. This is called CROWDING OUT as increase in investment crowds out the effect of incease in govt. spending on output level.

Accoding to Hicksian IS-LM model , fiscal policy will be more effective in influencing output when more interest elastic is the demand for money (the flatter is the LMcurve)  and the less interest elastic is the investment(steeper is the IS curve).