Deriving the investment multiplier - KEYNESIAN THEORY AND POLICY AT A GLANCE DERIVATION OF THE INVESTMENT MULTIPLIER The notion of an investment

Deriving the investment multiplier - KEYNESIAN THEORY...

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KEYNESIAN THEORY AND POLICY AT A GLANCE DERIVATION OF THE INVESTMENT MULTIPLIER The notion of an investment multiplier is most relevant when (1) the economy is functioning somewhere below its full-employment level and (2) market forces, which normally impinge on prices, wages and the interest rate, are (for some reason) not working. In these circumstances, a (Keynesian) macroeconomic equilibrium (one involving a substantial amount of economywide unemployment) is achieved through changes in the levels of spending and income. When the level of investment increases by some amount, Ä I, the equilibrium level of income will increase by some multiple amount, Ä Y. The ratio of Ä Y to Ä I is called the investment multiplier. It can be derived, as follows, from the equilibrium condition (Y = C + I + G) together with the consumption equation (C = a + bY). 1. Y = C + I + G where C = a + bY 2. Y = a + bY + I + G 3. Y + Ä Y = a + b(Y + Ä Y) + I + Ä I + G 4. Y + Ä Y = a + bY + b Ä Y + I + Ä I + G 5. Y = a + bY + I + G _________________________________________ 6. Ä Y = b Ä Y + Ä I 7. Ä Y - b Ä Y = Ä I 8. (1 - b) Ä Y = Ä I 9. Ä Y = Ä I or 10.

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