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Economics and the 2008 crisis: a Keynesian view
Economics and the 2008 crisis: a Keynesian view

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4.3 Modelling planned investment

At an income level of £600, households are planning to spend £520 on consumption and to save the remaining £80. But firms are not planning to invest at all! Let’s now incorporate planned investment into our diagram. This will mean two slight changes.

  1. We re-label the vertical axis ‘Aggregate demand’, as we are adding investment demand to consumption demand.
  2. We reinterpret the 45 degree line accordingly. Recall that at any point on the 45-degree line the variable plotted on the vertical axis is equal to the variable plotted on the horizontal axis. So in this diagram, at any point on the line, aggregate demand is equal to income.

The Keynesian model treats planned investment as an exogenous component of demand, that is, as not dependent on current income. It will therefore appear as a horizontal line on our diagram but, when we add planned investment to planned consumption, the aggregate demand line, which at present shows only planned consumption, will move upwards by the amount of planned investment we introduce.

Activity 7

Look at Figure 9 and complete the tasks that follow.

Task 1

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Figure 9 The aggregate demand model with investment
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(a) At present, the planned investment line is lying along the horizontal axis as we have not yet shown any planned investment. Pick up and drag the line till it shows a level of planned investment equal to the level of planned saving at an income level of £600. (Note that the scales on the axes have been changed to make this task easier - the income level of £600 is now towards the far right of the diagram.

Task 2

(b)  What is the equation of the aggregate demand function you have derived?

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Answer

The equation is: AD = 180 + 0.7Y, as there are now two constants: exogenous consumption (100) and planned investment (80).