Question

Using the Keynesian Cross (KX) framework, illustrate the effect on equilibrium output (GDP) if there is a negative investment shock (those pesky and volatile Keynesian “”animal spirits”). Explain the flow of logic by which the adjustment process (inventory change) ultimately causes output to adjust so that equilibrium occurs between planned expenditure and actual expenditure.

Answer 1

A negative investment shock will lower investment demand, so planned aggregate expenditure (PAE) will fall. This is shown in following Keynesian Cross diagram where initial equilibrium is at point X where initial planned aggregate expenditure (PAE) curve (labelled PAE0), intersects 45⁰ line resulting in initial PAE being E0 and initial aggregate output (real GDP) being Y0. When investment is decreased, the investment curve shifts downward from I0 to I1, which shifts PAE0 curve downward by same magnitude of vertical intercept, to PAE1. New equilibrium is at point Y where new planned aggregate expenditure (PAE) curve, PAE1, intersects 45⁰ line with new level of PAE being E1 which is less than E0 and new aggregate demand (output) being Y1 which is less than Y0.