As the rate of interest decreases the demand for money grows.
R1 is the equilibrium rate of interest.
According to Keynes given that the supply of money is fixed by the central bank, the rate of interest is determined by the demand for money i.e., Liquidity preference theory.
Liquidity Trap.
This is when the rate of interest is so low that the demand for money now becomes infinite i.e. Perfectly elastic.
The Multiplier.
The multiplier is when an injection into the economy such as an increase in government expenditure, investments or exports, will increase national income (Y) not by the initial injection but by multiple of that initial injection, this multiple is known as the multiplier. The formulas for the multiplier is as follows:.
The Closed economy.
.
1/ 1 - MPC.
E.g.: MPC= .75 1/( 1- .75) = 1/.25 = 4 1.
.
In this example, the Multiplier is equal to 4.This means that if there was an investment into the economy of 10 million pounds, national income would increase by 40 million pounds. The closed economy does not take into consideration the affect of imports. .
The Open Economy:.
1/ 1-MPC +MPM.
E.g. MPC = .75 .
MPM= .25 1/ (1 - .75) + .25 = 1/.5 = 2.
If 10 million pounds is invested into the economy in this example, national income will increase by 20 million pounds. .
In this example the open economy multiplier is half the size of the closed economy multiplier. This is due to imports (MPM) and therefore the effect of an increase in exports, government expenditure or investment on national income is less in an open economy than in a closed economy.
Determination of National Income.
What determines the size of a country's national income?.
This is a very important economic question, as the size of GNP determines the rate of economic growth and also effects the level of employment. Keyne's put forward a model of income determination in the 1930's.