The simple Keynesian model (SKM) implies that the government can boost GDP in the short-run by raising planned expenditure (E) on "G"

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.

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Expert Solution

In case of simple Keynesian model (skm) investment is assumed to be fixed which is not the case in IS-LM model. So the effects of increase in "G" i.e the government purchases is different in case of SKM and IS-LM model because in case of IS-LM the crowding out effect comes into picture. Go through the following images to get detailed answer

Rahul Sunny answered 1 year ago

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