CHAPTER 22 Aggregate Demand, Y ad (US$ billions, 2000) The ISLM Model 581 Y = Y ad Y 1ad Y 2ad +I = 194 45 832 1,184 Y2 Y1 Aggregate Output, Y (US$ billions, 2000) +Y = 352 FIGURE 22-4 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 from Y ad to Y ad and caused the economy to move from point to point 2, where output fell by US$352 billion Source: Economic Report of the President Keynes believed that changes in autonomous spending are dominated by unstable 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 Government s Role 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 especially 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 outlook was so grim Keynes s answer to this question involved 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