Question

Explain and diagrammatically represent the change in Y (as shown in the simple Keynesian goods-and-services market) as a result of each of the following:

a.      an increase in autonomous money demand

b.      a rise in autonomous consumption

In both cases (a) and (b), explain the equilibrating process in the goods-and-services market.

Answer 1

The change in Y can be explained using Keynesian cross diagram where Planned aggregate expenditure (PAE) and Real GDP or output (Y) are measured vertically and horizontally respectively. Initial equilibrium is at point X where initial PAE curve, AE0, intersects 45⁰ line with initial aggregate expenditure E0 and initial real GDP Y0.

(a) An increase in money demand will increase the interest rate, which will decrease investment, lowering PAE and shifting PAE curve downward. As a result, both AE and Y will fall. In following graph, as investment falls, investment curve shifts downward from I0 to I1 and PAE curve shifts downward to PAE1, intersecting 45⁰ line at point Y with lower aggregate output E1 and lower real GDP Y1.

(b) An increase in autonomous consumption will increase PAE, shifting PAE curve upward. As a result, both AE and Y will rise. In following graph, as autonomous consumption rises, consumption curve shifts upward from C0 to C1 and PAE curve shifts upward to PAE1, intersecting 45⁰ line at point Y with higher aggregate output E1 and higher real GDP Y1.