Your economy has a marginal propensity to consume (MPC) of 0.70. It is currently operating at a level at less than full employment. Prices appear to be sticky in this economy, but by some lucky stroke the rate of interest falls. This interest rate change causes private investment (I) to rise by 40 billion dollars.
1. Using the Keynesian Cross diagram indicate by how much national income (Y) will rise once the economy completely absorbs the 40 billion in new investment? Describe the logic by which you get to get your answer.
2. What will happen to the level of national savings (S) once the economy has fully reacted to the new 40 billion in investment? Describe the logic by which you get to your answer.
3. What does the dynamic that you just described in (1) and (2) above tell you about the shape of the IS curve? How is the IS curve (its slope and position in the graph) related to the economy’s Investment Demand Function?
Now, introduce a fixed level of REAL BALANCES (money supply) into the economy (M/P), Represent this on the fixed-price IS-LM diagram.
4. In the IS-LM diagram, there is no fall in the interest rate, but there is a new $40 billion spending by your government. Does this government spending have the same impact on national income as the $40 billion new “I” did in your answer to part (1) above? If yes, why? If not, why not?