THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 613

Keynes believed that changes in autonomous spending are dominated by unsta-ble fluctuations in planned investment spending, which is influenced by emotional waves of optimism and pessimi

Keynes believed that changes in autonomous spending are dominated by unsta-ble fluctuations in planned investment spending, which is influenced by emotional waves of optimism and pessimism factors he labelled animal spirits His view

was coloured by the collapse in investment spending during the Great Depression, which he saw as the primary reason for the economic contraction We examine the consequences of this fall in investment spending in the above application

After witnessing the events in the Great Depression, Keynes took the view that an economy would continually suffer major output fluctuations because of the volatility

of autonomous spending, particularly planned investment spending He was espe-cially worried about sharp declines in autonomous spending, which would inevitably lead to large declines in output and an equilibrium with high unemployment If autonomous spending fell sharply, as it did during the Great Depression, how could

an economy be restored to higher levels of output and more reasonable levels of unemployment? Not by an increase in autonomous spending, since the business out-look was so grim Keynes s answer to this question involved out-looking at the role of government in determining aggregate output

Keynes realized that government spending and taxation could also affect the position of the aggregate demand function and hence be manipulated to restore the economy to full employment As shown in the aggregate demand equation

Y ad

* C , I , G , NX, government spending G adds directly to aggregate

C H A P T E R 2 2 The ISLM Model 581

1

2

832 1,184 Aggregate Output, Y

(US$ billions, 2000)

Aggregate

Demand, Y ad

(US$ billions, 2000)

+I = 194

45

Y2 Y1 +Y = 352

Y = Y ad

Y

2

ad

0

Y

1

ad

F I G U R E 2 2 - 4 Response of Aggregate Output to the Collapse of Investment Spending,

1929 1933

The decline of US$194 billion (in 2000 U.S dollars) in planned investment spending from 1929

to 1933 shifted the aggregate demand function down fromYad1 toYad2 and caused the economy

to move from point 1 to point 2, where output fell by US$352 billion.

Source: Economic Report of the President.

Government s

Role