Answer to Question #232902 in Macroeconomics for Kayy

Question

Using graphs, explain how interst rate works in the classical system to stabilise aggregate demand in the face of autonomous changes in components of aggregate demand such as investment or government spending.   

Answer 1

The rate which equates the demand of loanable funds consisting of investment and government deficit with the supply of loanable funds consisting of savings is known as equilibrium interest rate.

Autonomous decline in investment demand: 

A decline in investment would tend to cause a shift from I₀ to I₁ in investment. There is a decline in interest rate to r₁ from r₀. There is an increase in induced investment when the interest rate tends to fall. This causes a decline in saving causing an equal increase in consumption. The investment and consumption increases being induced by interest rates tend to balance the autonomous investment decline.

Effect of Increase in Government Spending:

Adding (G−T) being the government deficit spending leads to shifting of the demand curve for loanable funds towards the right which causes the equilibrium rate of interest to rise. The increased rate of interest leads to a decline in investment to I₁ from I and also an increase in the level of saving to S₁ from S₀. The decline in the level of investment and consumption tends to balance an increase in the spending of the government.