Chapter 15, Problem 1VQP

To determine

Keynesian transmission mechanism.

Explanation of Solution

The Keynesian transmission mechanism maintains that money supply affects the aggregate demand through the changes in rate of interest or exchange rates. That is, the Keynesians maintains the indirect transmission mechanism.

In Figure 1, panel (a), (b), and (c) represents the operation of Keynesian transmission mechanism. Panel (a) represents the money market, in which a rightward shift in the money supply from ${\text{S}}_1$ to ${\text{S}}_2$ reduces the rate of interest from ${\text{I}}_1$ to ${\text{I}}_2$. Panel (b) represents the investment goods market, in which a decrease in interest rate increases the investment. Panel (c) represents the goods and service market. Here, an increase in investment increases the total expenditure and shifts the aggregate demand curve to the right. As a result, there is an increase in real GDP from ${\text{Q}}_1{\text{to Q}}_2$. From this, it is clear that an increase in money supply affects the aggregate demand indirectly via changes in the interest rate.