Question

Use the Keynesian-cross model to illustrate graphically the impact of: (1) anincrease in interest rate, (2) a reduction in government spending on the equilibrium level of income. Be sure to label the axes, the curves, the initial equilibrium values, the direction the curve shifts, and the terminal equilibrium values.

(3)Use the Keynesian-cross model to derive the IS curve.

Answer 1

In the following graph, Planned Aggregate Expenditure (PAE) is measured vertically and real GDP (Y) is measured horizontally. Initial equilibrium is at point A where 45⁰ line intersects PAE curve P0 with equilibrium PAE = AE0 and equilibrium real GDP = Y0 (Note that AE0 = Y0).

Higher interest rate will decrease consumption demand, which will shift PAE curve downwards to P1. New equilibrium is at point B with PAE = AE1 and real GDP = Y1, where AE1 = Y1, but AE1 < AE0 and Y1 < Y0.