According to the Keynesian theory, what is the effect of a decrease in the money supply on investment spending?

According to the Keynesian theory, what is the effect of a decrease in the money supply on investment spending?

• A. Real GDP decreases by the same amount as the change in investment
• B. Real GDP decreases by a larger amount than the change in investment
• C. Real GDP decreases by a smaller amount than the change in investment
• D. Real GDP increases by a smaller amount than the change in investment

Answer: (B)

In the context of Keynesian theory, a decrease in the money supply typically leads to higher interest rates as the availability of funds diminishes. Higher interest rates discourage borrowing, making it more costly for businesses and consumers to finance investments. As investment spending decreases, it has a cascading effect on the economy. When investment falls, it does not merely reduce real GDP by the same amount because of the multiplier effect. The multiplier effect suggests that a change in investment has a greater overall impact on the economy due to the interconnections of economic activity. For instance, when businesses invest less, they may cut back on hiring or expansions, which can lead to reduced income for households. This, in turn, can diminish consumer spending, creating further reductions in aggregate demand. Because of this cascading effect, the overall drop in real GDP is greater than the initial decrease in investment spending. Thus, the explanation aligns with the Keynesian perspective that the decline in real GDP resulting from a reduction in investment will be larger than the initial fall in investment itself.

In the context of Keynesian theory, a decrease in the money supply typically leads to higher interest rates as the availability of funds diminishes. Higher interest rates discourage borrowing, making it more costly for businesses and consumers to finance investments. As investment spending decreases, it has a cascading effect on the economy.

When investment falls, it does not merely reduce real GDP by the same amount because of the multiplier effect. The multiplier effect suggests that a change in investment has a greater overall impact on the economy due to the interconnections of economic activity. For instance, when businesses invest less, they may cut back on hiring or expansions, which can lead to reduced income for households. This, in turn, can diminish consumer spending, creating further reductions in aggregate demand.

Because of this cascading effect, the overall drop in real GDP is greater than the initial decrease in investment spending. Thus, the explanation aligns with the Keynesian perspective that the decline in real GDP resulting from a reduction in investment will be larger than the initial fall in investment itself.