Question

1. Use an income/spending graph and IS curve graph to show the short- run impact of an increase in autonomous investment on output in the goods market. Include a brief explanation in your answer and be sure to properly label your graphs.

Answer 1

When there is an autonomous increase in in the investment. the slope of the AE curve don't change it is the same. the AE curve shifts upward from AE₁ to AE₂ as the intercept of the curve increases due to autonomous increase in investment and since investment is autonomous so it leads to upward shift of AE curve. Initial equilibrium is at point e₁ where 45 degree line and AE₁ curve intersect and this yield Real GDP Y₁. But with increase in investment at Y₁ the output is less than the aggregate expenditure at AE₂. hence this will result in depletion of inventory investment in this period so accordingly producers will plan to increase the output in next period hence their will be a movement along AE₂ (i.e. from A to e₂) and output increases from Y₁ to Y₂ and the new equilibrium will be at e₂ where again output is equal to AE.

Imapct of this on the IS curve can be seen in the parllel diagram drawn below it where due to autonomous increase in investment IS curve shifts from IS₁ to IS₂ to increase in real GDP at given interest rate i_1.